AN OVERVIEW ON EFFECT OF CONDITIONAL ACCOUNTING CONSERVATISM ON CHANGES IN STOCK PRICE

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1 AN OVERVIEW ON EFFECT OF CONDITIONAL ACCOUNTING CONSERVATISM ON CHANGES IN STOCK PRICE Sara Moozafari a and Farhad Shahveisi b 1. Department of Accounting, college of Humanities, Kermanshah Branch, Islamic Azad University, Kermanshah, Iran. Department of Accounting, college of Humanities, Kermanshah Science and Research Branch, Islamic Azad University, Kermanshah, Iran. Department of Accounting, Razi University, Kermanshah, Iran. Department of Accounting, Kermanshah Branch, Islamic Azad University, Kermanshah, Iran Abstract Conservatism as an accounting trend refers to a higher degree of verification to identify the good news in comparison to the verification to identify the bad news at the area of flexibility in the accepted accounting principles. Demand at conservative reporting refers to this statement that conservatism can come beneficial for the ones who use company's financial reports relying on this reasoning that the principle of conservatism can come effective in controlling the risk in reduction of stock price. For this, the present research aims to recognize the role of applying conservative approach in providing financial reports on the process under changing the stock price. The statistical population consists of all the companies accepted in Tehran stock exchange, of which 117 companies during have been selected via systematic removal method. Further, the data have been analyzed via correlation tests and regression analysis, whereby the results from hypotheses testing indicated that there is a significant relationship between conservatism and risk at stock price based on the proposed model at the first hypothesis, yet there is not a significant relationship between conservatism and risk at stock price based on the proposed model at the second and third hypotheses. Keywords- Conditional Conservatism; Ball's Conditional Conservatism model; Ball & Shivakumar's Conditional Conservatism model; risk at stock price Introduction Managers at economic enterprises strive to hide the bad news as much as they intend to disseminate the good news. Conservative accounting procedures stand against the 1 corresponding auditor : Farhad Shahveisi, Assistant Professor, Department of Accounting, Faculty of social Science, Razi University, Kermanshah, Iran.

2 management tendencies and reduce the investment risk at stock. Conservatism as a strategic mechanism limits the management incentives and abilities to proliferate dissemination of good news and delay at dissemination of bad news. Conservatism by means of the necessity to asymmetric verification to identify the profits and losses results in proliferation in recognizing bad news as the loss than good news as the profit. As the result, bad news than unverified good news enters into the market such that it is expected that conservative accounting avoids agglomeration of bad news inside the company, whereby the probability for sudden entry of a mass of bad news to the market reduces. As the result, higher level of conservatism to reduce agglomeration level, lack of dissemination of bad news and reduction of risk at stock price as well as financial crisis in 2008 have been drawn into attention by numerous scholars. These changes occur as collapse and mutation of stock price. With regard to the importance of stock return mentioned by the shareholders, the phenomenon under collapse of stock price which results in reduction of return than mutation of stock price has been drawn into attention by the researchers. Negative and positive changes in stock price have a direct relationship with the investors' wealth and welfare level. It seems that the normal fluctuations under return on total stock market index have been drawn into attention by the investors. Yet, if negative and severe changes occur at a specific company's stock price, it will severely affect shareholders and people by reduction of stock price. For this, various effective aspects on stock price are taken into account. Information source provided for most of activists at capital market refers to the financial reports issued by the companies and provided as the courses for people and a basis for decision making by potential investors for the purpose of purchase, sale and investment in stock market. By increasing the information sources provided for the management, the number of beneficiaries at the company increases, under which the conflict of interests comes to realize (Jensen, M. and Meckling, 1996). The manager who is centered at this conflict of interests strives to reduce the conflict of interests by providing financial information. Potential managers intend to manifest the company at a favorable status and engage in this procedure due to the managers' discretion in supply of reports. In this regard, accounting principles and processes propose Restrictive Accounting Principles to maintain interests of capital market participants and control managers' profit-seeking motives. Demand for conservative reporting refers to this statement that the conservatism is beneficial to the ones who use financial reports(giuli, 2007). It is argued that the principle of conservatism can come effective in controlling the risk at reduction of stock price. In this regard, the present research seeks to investigate the effects of conservatism processes on changes in stock price at the companies accepted in Tehran stock exchange. With regard to the investors' welfare, existing capitals in companies accepted in stock exchange, the direct relationship between the changes in stock price, investors' welfare and return on investment, and the current economic conditions which affect the stock price, it requires investigating various effective aspects in stock price so as to avoid severe changes in stock price. Accounting conservatism has been assumed as one of the effective factors in decrease in stock price drop. For this, the present research aims to investigate effect of conservatism on changes in stock price. Demand for conservative reporting lies on this fact

3 that the conservatism is beneficial for the ones who use company's financial reports (Giuli, 2007). Optimistic view of managers and owners on the company widely reflects in financial statements. As the result, pessimism in accounting is a necessity so as to neutralize this optimistic view ( LaFond and Watts, 2008). An effective factor in decision-making associates to suitable information well suited with the subject of decision, so that if the required information is distributed among the individuals in an asymmetric way, a variety of results will come to realize. Hence, before giving a priority to the information for the decision maker, a priority has been given to quality of information distribution (Diamond, D., R. Verrecchia, 1991). Negative and positive changes in stock price have a direct relationship with investors' welfare level. It seems that normal fluctuations at the return on total market index might not be considered by the investors. Yet, if negative changes occur at a specific company's stock price, as reduction of stock price at company, it will severely affect the shareholders' and people's status. Accounting conservatism has been argued as one of the factors affecting reduction in stock price drop, as the result the present research investigates effect of conservatism on changes in stock price. Conservatism has been regarded as a disciplinary mechanism which suppresses the managers' profit-seeking motives and reduces the managers' power for proliferation in dissemination of good news and delay at dissemination of bad news. In other words, conservatism in accounting limits the managers' power in dissemination of good news on one hand, because the unverified good news under influence of conservative accounting principle is not recognized, and on the other hand the probability to detect unverified bad news increases by means of employing poorer levels of verification measure (Chen et al. 2001). In this regard, it is expected that the more the accounting principles are conservative, the probability to keep the bad news hidden decreases. As the result, it is expected that the more conservative companies compared to the rest of companies will less likely face the crisis due to dissemination of bad news. The risk at stock price drop at market has been regarded as a major concern for the investors, which the research at this area can be of a great importance for the capital market. Kim & Liandong Zhang(2010) have argued that their study has been the first research conducted at the area of overview of the relationship between accounting conservatism and risk at stock price drop by Followed by the research by Kim & Liandong Zhang(2010), two research have been conducted by Moradi, Valipour & Ghalami(2011) and Fatahi(2010), mentioned that not just internal studies have been conducted at this area, but also foreign studies have been conducted. Kordestani & Amir Beigi Langeroudi(2008) have investigated the relationship between asymmetric timeliness of earnings and ratio of market value to book value as two criteria for measurement of conservatism, and concluded that there is a negative significant relationship between these two variables. Rezazade & Azad(2008) in a research entitled "an overview on the relationship between information asymmetry and conservatism in financial reporting" deduced that there is a positive significant relationship between information asymmetry and conservatism level at financial statements. Bani mahd(2006) in a research entitled "determination and representation of a model to measure accounting conservatism" has deduced that accounting conservatism and profitability index in Iran have undergone drop.

4 Company size and tax have not affected accounting conservatism, so that it cannot consider accounting conservatism as an efficient contractual mechanism to reduce the conflicts in dividend among the investors and creditors. Moradi et al.(2011) in a study examined effect of conservatism on reduction of stock price drop and concluded that there is a negative significant relationship between conservatism and stock price drop. Moradi et al.(2011) in another study examined the relationship between conservatism and stock price drop concerning information asymmetry and concluded that the relationship between conservatism and stock price drop is not significant at the companies with high information asymmetry, under which it can say that lack of information asymmetry failed to increase effect of conservatism on reduction of risk at stock price drop. Chen, Lin and Strong (2009) in a research entitled "overview of the relationship between accounting conservatism and stock price" concluded that unconditional conservatism associates to higher quality of accounting information and lower stock price, and conditional conservatism associates to lower quality of accounting information and higher stock price. Kothari et al.(2009) in a research entitled "refraining managers from bad news" concluded that the managers intend to postpone dissemination of bad news for foreign investors. Management tendency towards hiding bad news from foreign investors raise the risk for negative return or drop in stock price. Baso(1997) in a research examined effect of conservatism on financial statements and interpreted conservatism in accounting as timely detection of bad news compared to good news. At efficient markets, stock return reflects all the news available to people in a systematic way, thus Baso used the stock return to measure news. Timeliness at detection of bad news refers to this point that the profit than negative return is more likely susceptible than positive returns. He indicated that susceptibility of profit to negative returns is bigger than susceptibility of profit to positive returns for two to six times. In addition, Baso believed that timeliness at profit fundamentally relies on timely detection of bad news through accruals. Paeik et al.(2007) in a research entitled "overview of accounting conservatism, stability of earnings and multiple of earnings valuation " concluded that the more conservatism increases, stability at earnings decreases. With regard to the results of this study, it can state that issuance of accounting measures which include accounting principle will impose costs on capital market. These measures reduce the capability for prediction of earnings and distract the potential investors from proper economic decisions. Beatty, A., J. Webber and J. Yu(2008) in a study entitled "Conservatism and debt" concluded that when the agency cost of debt is higher, the contractual conditions will be more likely used. Anyhow, the evidences indicate that contractual conditions do not just meet the creditors' demand for conservatism, but conservative accounting is required to decrease agency cost of debt. Aims of research Primary aim

5 -detection of difference in conditional earnings and return conservatism model of Baso to elaborate the relationship between conservatism and risk at stock price Secondary aims of research -detection of proportionality of Ball & Shivakumar's conditional conservatism model to elaborate the relationship between conservatism and risk at stock price -detection of proportionality of Ball & Shivakumar's conditional conservatism model to elaborate the relationship between conditional conservatism and risk at stock price -detection of proportionality of Baso's conditional earnings conservatism model to elaborate the relationship between conservatism and risk at stock price Research hypotheses Major hypothesis: the applied model in calculating conditional conservatism comes effective in elaborating the relationship between conditional conservatism and risk at stock price. First secondary hypothesis: there is a negative significant relationship between Baso's conditional earnings and return conservatism model and risk at stock price Second secondary hypothesis: there is a negative significant relationship between Ball & Shivakumar's conditional conservatism model and risk at stock price Third secondary hypothesis: there is a negative significant relationship between Baso's conditional conservatism model for the changes in earnings and risk at stock price Conceptual and operational definitions for the research variables -conditional conservatism which was proposed by Baso(1997) is also called prospective conservatism or asymmetric timeliness of earnings and regarded as timely detection of bad news to good news in earnings. For instance, enforcing the minimum market value, removing goodwill to follow testing reduction of market value, asymmetric detection of probable losses against probable earnings are mentioned. To measure conditional conservatism, three models below are used: 1-conservatism model based on Baso's earnings and return (1997) X j,t = b1 + b 2 D j,t + b 3 R j,t + b 4 D j,t * R jt + e j,t Where J, t, x, R and b represent company index, year index, the earnings per share which is regulated based on price of each share at the beginning of financial period, return on stock which equals to difference on price of each share at the early and ending period in addition to the adjustments due to income from shares and division to the share price at the beginning of

6 the period, timely incremental actions in favor of income in detection of bad news from good news. Ball & Shivakumar's conditional conservatism model (2005) To predict the extent to which accounting conservatism was used in private companies, it cannot use Baso's measure because these companies have not the recorded stock price. To cope with this problem, Ball et al.(2005) developed this measure as a version for Baso's asymmetry measure which is not dependant on the stock price. Ball & Shivakumar's conditional conservatism model is calculated via regression equation as follow: TCA j,t = g 0 + g 1 DREV j,t + g 2 GPPE j,t + g 3 DCF j,t + g 4 CF j,t + g 5 DCF j,t * CF j,t + e jt Here, ACC represents total accruals, CFO represents changes in operating cash flow, TCA represents division of current accruals to mean of the entire asset, GPPE represents properties, machineries and gross equipment divided to the entire assets, DCF represents an equal virtual variable, and finally REV represents change in income dividend to mean of the entire asset. Conservatism model based on Baso's changes in earnings(1997) it is argued that the probability for repetition of positive changes in earnings at future periods is more than the probability for repetition of negative changes in earnings, because applying conservative accounting principles causes rapider detection of losses at current period, yet it is delayed at detection of probable earnings, for which the sectional regression below is used: GSCORE º b3 jt = m1t + m2t MKVjt + m3t MBjt + m4t LEVjt Here, Mkv represents natural logarithm for market value, MB represents ratio of book value to market value for shareholders equity, Lev represents financial leverage which is obtained through division of total debt on total assets. Risk at reduction of stock price If the company's stock return at a specific financial period be under the total stock market index, it will be called the risk at reduction of stock price (Hovtun et al. 2009). Risk at reduction of stock price is measured based on the periods during which the company has

7 experienced the substantial events which have resulted in severe reduction of stock price(hovtun et al. 2009). If the company faces this status once or several times during a financial year, it will be considered as the drop in stock price. The model will be as follows: rjt=β0+ β1 r m,t-2+ β2 r m,t-1+ β3 r m,t+ β4 r mt+1+ β5 r m,t+2+єjt Rj,t=company's stock return in a week Rm,t=accumulative return in a week The conceptual model for the variables under study and an explanation for how to examine and measure the research variables The variables under study are classified to independent, dependant and control variables which include: Independent variable of research Conservatism: Baso's conservatism model Xj,t 1 2Dj,t 3Rj,t 4Dj,t *Rjt j, Where J, t, x, R and b represent company index, year index, the earnings per share which is regulated based on price of each share at the beginning of financial period, return on stock which equals to difference on price of each share at the early and ending period in addition to the adjustments due to income from shares and division to the share price at the beginning of the period, timely incremental actions in favor of income in detection of bad news from good news. Ball & Shivakumar's conditional conservatism model(2005) TCAj,t 0 1 REVj,t 2GPPEj,t 3DCFj,t 4CFj,t 5DCFj,t *CFj,t j Here, ACC represents total accruals, CFO represents changes in operating cash flow, TCA represents division of current accruals to mean of the entire asset, GPPE represents properties, machineries and gross equipment divided to the entire assets, DCF represents an equal virtual variable, and finally REV represents change in income dividend to mean of the entire asset. Conservatism model based on Baso's changes in earnings(1997) CSCORE 4jt 1t 2tMKVjt 3tMBjt 4t LEVjt

8 Here, Mkv represents natural logarithm for market value, MB represents ratio of book value to market value for shareholders equity, Lev represents financial leverage which is obtained through division of total debt on total assets. In this study, risk at stock price has been regarded as the dependant variable. rjt=β0+ β1 r m,t-2+ β2 r m,t-1+ β3 r m,t+ β4 r mt+1+ β5 r m,t+2+єjt Rj,t=company's stock return in a week Rm,t=accumulative return in a week Control variables Here, MB, Lev, RoA and SIZEi,t represent ratio of book value to market value for the shareholders equity, financial leverage which is obtained from division of total debt to total assets, return on assets at financial year(t+1), and company size, respectively. Research method The present research has been considered as an applied research type in sake of aim, categorized as a correlation study. this research has been classified as the quantitative research, in which library study has been used to collect theoretical contents and information on financial statements at the companies accepted in stock exchange has been used to collect the required data. 117 companies have been selected as the sample group via filtering method. Further, multivariate regression has been used to examine effect of conditional conservatism on changes in stock price in the mentioned sample. The research has been conducted during Library and field method has been used to collect theoretical data, and books, journals, theses and articles have been used to examine the literature review. Stock exchange website, Rah Avard Novin software, and financial information CDs for the companies accepted in Tehran stock exchange have been used to collect the required data for analysis of the relationship between dependant and independent variables. The statistical population consists of all the companies accepted in Tehran stock exchange, of which 117 companies during have been selected via systematic removal method. The companies included in testing the research hypotheses have been selected in this way that firstly a checklist containing all the companies accepted in Tehran stock exchange was provided at the end of 2012, of which the companies with the conditions below have been selected and those companies without these conditions have been removed from the study: -the companies which have been accepted in stock exchange before starting the research period(2007) and continued their activity in stock exchange till the end of research -financial interruption must not extend to more than 150 days -financial year at company must remain without any change

9 -the financial years of the companies in the sample group must end in the last month of the year per year -the companies in the sample group must not be included in the banks and financial entities Research hypotheses testing First secondary hypothesis: there is a negative significant relationship between Baso's conditional earnings and return conservatism model and risk at stock price H0: there is not a negative significant relationship between Baso's conditional earnings and return conservatism model and risk at stock price H1: there is a negative significant relationship between Baso's conditional earnings and return conservatism model and risk at stock price Table 1. a summary on the coefficient for the first hypothesis Durbin- Watson 2/05 Sig 0/000 f-value 4/21 Determination coefficient 0/042 Table 2. testing the coefficients for the first hypothesis Variable Independent variable Coefficient t-value Sig Risk earnings and 0/0029 3/ 04 0/ 0024 Hypothesis return conservatism model is confirmed Market value to -0/867-1/ 57 0/ 115 book value Financial -0/465-0/ 28 0/ 777 leverage Return on assets -0/ 041-1/ 33 0/ 182 Company size 1/ 62 3/ 64 0/ 000 Explanatory 0/174 0/ 22 0/ 825 variable of R&D Fixed value -3/ 06-1/ 03 0/ 302 In this hypothesis, due to lack of significance at Limer test, sectional method has been used to test hypotheses. According to table above, it can observe that the determination coefficient

10 equaled to 4.2%, that however this value is under the standard level, it indicates that the independent variables have determined the model. Hence, it can say that the model has been determined via independent variable, and also the value of Durbin-Watson indicates that the error at independent variables ranges from 1.5 to 2.5. On the other hand, the significance level for f-test has been under 1%, thus the model has been significant. With regard to table above, it can observe that the significance level at t-test for the variable earnings and return conservatism is under 1%(0.0024), thus it can conclude that earnings and return conservatism has a significant effect on risk at stock price, as the result this hypothesis is confirmed. Y=a+bx The rist at stock price=0.0029(earnings and return conservatism)+1.62(company size) Second secondary hypothesis: there is a significant relationship between Ball & Shivakumar's conditional conservatism model and risk at stock price H0: there is not a significant relationship between Ball & Shivakumar's conditional conservatism model and risk at stock price H1: there is a significant relationship between Ball & Shivakumar's conditional conservatism model and risk at stock price Table 3. a summary on the coefficient for the second hypothesis Durbin- Watson 2/013 Sig 0/125 f-value 2.83 Determination coefficient 0/028 Table 4. testing the coefficients for the second hypothesis Variable Independent variable Coefficient t-value Sig Risk Ball & 7/38 1/ 53 0/ 124 Hypothesis Shivakumar's conditional conservatism is rejected Market value to -0/018-1/ 83 0/ 066 book value Financial -2/21-1/ 34 0/ 179 leverage Return on assets -0/ 027-0/ 92 0/ 357 Company size 1/ 61 3/ 63 0/ 0003 Explanatory 0/ 23 0/ 29 0/ 764

11 variable of R&D Fixed value 0/ 24 0/ 087 0/ 930 In this hypothesis, due to lack of significance at Limer test, sectional method has been used to test hypotheses. According to table above, it can observe that the determination coefficient equaled to 2.8% that is under the standard level. On the other hand, as the significance level for f-test is greater than 5%, thus the model has not been significant. The value of Durbin- Watson indicates the error at independent variables. The significance level at t-test for the variable earnings and return conservatism is greater than 5%(0.124), thus it can conclude that Ball & Shivakumar's conditional conservatism has not a significant effect on risk at stock price, as the result this hypothesis is rejected. Third secondary hypothesis: there is a negative significant relationship between Baso's conditional conservatism model for the changes in earnings and risk at stock price H0: there is not a significant relationship between Baso's conditional conservatism model for the changes in earnings and risk at stock price H1: there is a significant relationship between Baso's conditional conservatism model for the changes in earnings and risk at stock price Table 5. A summary on the coefficient for the third hypothesis Durbin- Watson 2/20 Sig 0/101 f-value 2.6 Determination coefficient 0/028 Table 6. Testing the coefficients for the third hypothesis Variable Risk Independent variable Coefficient t-value Sig Baso's 0/28 1/ 01 0/ 311 Hypothesis conditional is rejected conservatism model Market value to -0/89-1/ 63 0/ 103 book value Financial -1/43-0/ 894 0/ 369 leverage Return on assets -0/ 026-0/ 883 0/ 377

12 Company size 1/ 49 3/ 33 0/ 0069 Explanatory 0/183 0/ 23 0/ 813 variable of R&D Fixed value 0/ 386 0/ 135 0/ 892 In this hypothesis, due to lack of significance at Limer test, sectional method has been used to test hypotheses. According to table above, it can observe that the determination coefficient equaled to 2.8% that is under the standard level. On the other hand, as the significance level for f-test is greater than 5%, thus the model has not been significant. The value of Durbin- Watson indicates the error at independent variables. The significance level at t-test for the Baso's conditional conservatism model is greater than 5%(0.311), thus it can conclude that Baso's conditional conservatism model has not a significant effect on risk at stock price, as the result this hypothesis is rejected. Conclusion The demand at conservative reporting refers to this fact that the conservatism is beneficial for the ones who use company's financial reports. It is argued that the principle of conservatism can come effective in controlling the risk at reduction of stock price, such that the conservatism can reduce the probability of drop in stock price. Theoretical background of research implies that there is a negative significant relationship between conservatism and stock price drop in Tehran stock exchange, i.e. the conservatism in financial reporting can result in reduction of risk at stock price drop. Results of this study indicated that use of Baso's earning and return conservatism model raises an increase in risk at stock price. Hence, use of this model in current conditions undergoing Tehran stock exchange seems improper as use of this model raises an increase in risk at stock price. Hence, it is suggested to the investors to consider the conservatism level affiliated to companies together with rest of information for the purpose of evaluation of information content on financial reporting at investment decisions. Suggestions Few studies have been conducted at the area of this research. The suggestions below are represented to other researchers as the results of this research have been used as an introductory for future studies: -examining the relationship between conditional conservatism accounting and quality of earning management -examining the relationship between unconditional conservatism and the probability for decrease in future earnings -examining the relationship between conservatism and debt contract and agency cost -examining the relationship between conservatism and rest of qualitative features including transparency and timeliness

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