Audit Committee Effectiveness and Accounting Conservatism a Test of Lagged Effect

Audit Committee Effectiveness and Accounting Conservatism a Test of Lagged Effect

Saif Ur-Rehman Khan (Canadian University of Dubai, Dubai, UAE), Faisal Khan (City University College of Ajman, Ajman, UAE) and Elgilani Elshareif (Canadian University of Dubai, Dubai, UAE)
Copyright: © 2018 |Pages: 23
DOI: 10.4018/IJCFA.2018070104

Abstract

This article examines the effect of audit committee effectiveness on two measures of accounting conservatism. In addition, this article also investigates the interaction effect of four endogenous variables (i.e. firm's operating risks, leverage, managerial influence, firm's size) and three exogenous variables on relationship between audit committee effectiveness and two measures of accounting conservatism. A total of 543 sample firms are selected from the Bursa Malaysia for the period from 2004 to 2013. In addition, some information relating to audit committee and auditor quality are collected from firms' annual reports. For data analysis, panel data methodology is employed, and multiple regression analysis technique is used to test the developed hypotheses of this study. Results show that interaction effect of firm's operating risks, managerial influence, external auditor quality and capital market uncertainty found to be significant with two-year-lagged effect on both measures of conservatism. Whereas, the interaction effect of firm's leverage, firm's size and product market completion are found to be insignificant. The findings of this study contribute to the signaling theory, agency theory, reputation theory and accounting conservatism literature with lagged effect in emerging economies settings.
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Introduction

Accounting conservatism is considered as a basic characteristic of financial reporting in relation to earnings quality since it enhances the reliability of financial statements and minimizes the information asymmetry (Mohammad, Ahmed and Ji, 2010; Jeffrey et al., 2014) and monitor and control over overinvestment particularly in research and development cost (Lara et al., 2016). The conventional definition of accounting conservatism (Bliss, 1924 as cited by Watts, 2003; Ren, 2014) that states “anticipate no profit but anticipate all losses” which is also called unconditional conservatism. This concept is later on termed as an asymmetric timeliness of earnings which requires early and timely recognizing of bad news as an expected loss and deferring the good news as expected gain (Basu, 1997). This concept presented by Basu (1997) is one of the popular tools for measuring the conditional conservatism. Hence, both of the explanations (unconditional and conditional conservatism) have defined the accounting conservatism as understatement of earnings rather than overstatement. The principle of conservatism helps in reducing conflicts regarding debt-contracting and managerial contracting and also is advantageous for the business in many ways. Firstly, as discussed by Watts (2003), it limits the management’s overpayment by timely loss recognition and by delaying gain recognition. Secondly, it also restricts the management to invest in risky projects that can have negative NPV (net present value) as also referred to the “prudent concept” (Lara, Osama, and Penalva, 2009). Thirdly, management is also more inclined towards abandonment of the projects with negative NPV by following the conservative accounting principle (Watts, 2003). Fourthly, these principles (of conservatism) also forced the accountants to report true efficiency of their firms in terms of earning quality and net worth. In the light of all these advantages of accounting conservatism, a positive association of the strength of accounting conservatism and performance of the firm is emerged (Duellman, 2006; Lara et al., 2016).

However, on the other hand, there are academics, capital market regulators, and standard-setters who also criticized the concept accounting conservatism. For instance, according to LaFond and Watts (2008), on one hand the accounting conservatism understates the net assets of a firm in the current period, but on the other hand it overstates the earnings of the same firm in future periods because of the understatement of future expenses. Irrespective of the criticisms made by various researchers, the empirical research also designates accounting conservatism as ever-increasing phenomenon for the last few decades (e.g. see Givoly & Hayn, 2000 & 2002; Kim & Kross, 2005; and Lobo & Zhou, 2006; Lara et al., 2016). This seems that the critics have overlooked to the principle of accounting conservatism as Lara et al. (2016) findings report that conservatism is a mechanism that reduces overinvestment (e. g. research and development expenditure). Therefore, a detail investigation in this area is required to answer the important unrevealed questions.

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