Does conditional conservatism cause biases in financial statements? Evidence from Benford’s Law
41 Pages Posted: 5 Jun 2020 Last revised: 11 Aug 2021
Date Written: December 21, 2019
Purpose – In this paper, we examine the effects of conditional conservatism on deviations of the first digits of financial statement items from what are expected by Benford’s Law.
Design/methodology/approach – This research use data of companies listed on the London Stock Exchange. We measure deviations of first digits from Benford’s Law following Amiram et al. (2015) and firm-year conditional conservatism following previous studies (Basu, 1997; Khan and Watts, 2009; García Lara et al., 2016). We use multiple regressions to provide evidence for our hypothesis.
Findings - The results show that conditional conservatism positively affects deviations from Benford’s Law. The findings hold strongly for different measures of deviations and conditional conservatism. Also, we find that the relationship between deviations from Benford’s Law and conditional conservatism is more pronounced for firms with debt issuance, firms with equity issuance versus debt issuance, and leveraged firms facing financial distress. Next, our analyses confirm previous evidence by showing that the first digits of financial statement items of UK listed companies conform to Benford’s Law at the firm-specific level and the market level, with deviations of income statements are larger than that of balance sheets and cash flow statements.
Research limitations/implications – The research makes significant contributions to the literature. First, we are the first to offer an alternative explanation for deviations from Benford’s Law. The findings suggest that conditional conservatism may be a source of deviations. Second, using data from a different context, we provide evidence to confirm the previous findings (e.g., Amiram et al., 2015) that the distribution of first digits of financial statement items of UK-listed companies follow Benford’s Law.
Practical implications – Our findings have implications for auditors. Auditors should pay attention to conservatism-related items such as impairment losses and inventory written-off because managers can manipulate those items.
Originality/value – We provide new and original evidence suggesting that conditional conservatism affects deviations from Benford’s Law.
Keywords: Benford’s Law, Earnings Management, Accounting Conservatism
JEL Classification: M41, M42
Suggested Citation: Suggested Citation