International Differences in Conditional Conservatism: The Role of Unconditional Conservatism and Income Smoothing

Abstract

Prior research documents that conditional conservatism, measured as the asymmetric timeliness of earnings reflecting bad versus good news, varies with cross-country differences in institutional regimes. In this paper, we examine the determinants of conditional conservatism and related earnings attributes internationally. First, using panel data, we investigate whether competing earnings attributes such as unconditional conservatism and income smoothing affect conditional conservatism and its international differences. We find that these attributes are predictably correlated with conditional conservatism. Second, we address the question whether income smoothing and conditional conservatism are two fundamentally different earnings attributes. We show theoretically that both attributes yield different earnings distributions and that the motivations for producing earnings which possess these attributes differ. To test these predictions empirically, we calculate firm-specific time-series measures of asymmetric timeliness, using a novel trigonometric measure based on the standard Basu (1997)-type regression. Using this cross-sectional data, we test whether conditional conservatism and income smoothing are different and find them to be only weakly correlated for a broad international sample. Also, we demonstrate that income smoothing explains international differences in conditional conservatism. Finally, we estimate simple determinant models of conditional conservatism and income smoothing, showing that both earnings attributes are driven by different explanatory firm-level factors: conditional conservatism increases with the importance of debt financing, while income smoothing increases with the importance of dividends. Despite some important limitations, we believe our results to be meaningful because they show that cross-country differences in conditional conservatism are influenced by the effects of other accounting properties, predominantly income smoothing. Especially, legal regime appears to drive income smoothing while losing its explanatory power for conditional conservatism when firm-specific factors are controlled for.

Keywords: conservatism, income smoothing, contracting, earnings timeliness, market-to-book ratio, earnings attributes

JEL Classification: M41, M43, M44, M47, G34