ACCOUNTING CONSERVATISM, COST OF CAPITAL, AND FRAUDULENT
FINANCIAL REPORTING A dissertation submitted to the
Kent State University Graduate School of Management
In partial fulfillment of the requirements
for the degree of Doctor of Philosophy


Approved by

_____________________________ Chair, Doctoral Dissertation Committee
Dr. Pervaiz Alam

_____________________________ Members, Doctoral Dissertation Committee
Dr. Kevin Dow

_____________________________
Dr. Wei Li

_____________________________
Dr. David Booth Accepted by

_____________________________ Interim Doctoral Director, Graduate School of
Dr. Michael Hu Management

_____________________________ Dean, Graduate School of Management
Dr. Frederick Schroath

have been able to work with Dr. Alam over the years. He has mentored me throughout my entire
Ph.D. program and has shared his experiences, wisdom, and knowledge as a researcher, for which
I am very grateful. He has shaped my doctoral experience and provided me with the necessary
skills to be successful in my academic career. Without his unwavering help and guidance, this
journey would not have been possible. I would also like to thank the other members of my
dissertation committee, Dr. Kevin Dow, Dr. Wei Li, and Dr. David Booth for their guidance,
support, advice, and helpful comments. My appreciation is also extended to Dr. Michael Hu and
Dr. John Thornton for their gracious efforts in presiding at my dissertation defense.
I would like to thank my parents, Robert and Ethel, who have always encouraged me and
have taught me to dream big, to never give up on those dreams, and to believe in what you do.
They have always kept my spirits soaring and showed me the importance of remaining positive
and providing help to those who need it. I dedicate this dissertation to them for providing love,
understanding, and encouragement during the pursuit of this degree. To my sisters, Melissa and
Heidi, I thank them for their caring, concern, and understanding.
While there are many other people who have contributed to my success in completing
this final degree, I am thankful to Jan Winchell for her computational assistance and to my fellow
Ph.D. students who have always made the days seem brighter and have always made me smile.
ivTABLE OF CONTENTS
Page
CHAPTER 1 INTRODUCTION 1.1 Background and Purpose……………………………………………………… 1
1.2 Litigation Risk………………………………………………………………………. 5

CHAPTER 3 HYPOTHESES AND RESEARCH DESIGN 3.1 Hypotheses Development……………………………………………………………. 48
3.2 Methodology…………………………………………………………………………. 58
3.2.1 Univariate Descriptive Statistics…………………………………………………… 58
3.2.2 Measures of Conservatism…………………………………………………………… 59
vTABLE OF CONTENTS (continued) 3.2.2.1 The Basu (1997) Model……………………………………………………………… 59
3.2.2.2 Earnings Persistence………………………………………………………………… 62
3.2.2.3 Conservatism and the Sarbanes-Oxley (SOX)Period…………………………………. 63
3.2.3 Alternate Accounting Conservatism Measures………………………………………. 64
3.2.3.1 Accruals Adjusted for Asymmetrical Timeliness……………………………………. 64
3.2.3.2 Q-Score……………………………………………………………………………… 67
3.2.3.3 Earnings Variability and Earnings Smoothness……………………….……………… 68
3.2.3.4 Nonoperating Accruals…………………… ……………………………………… 69
3.2.3.5 Skewness of Earnings……….…… ………………………………………………… 70
3.2.4 Cross-Sectional Variation of Accounting Conservatism…………………………… 70
3.2.5 Measures of Standard Setting………………………………………………………… 72
3.2.6 Measures of Cost of Equity Capital………………………………………………… 74
3.2.7 Cross-Sectional Variation of Cost of Equity Capital Estimates……………………… 77
3.3 Sample Selection and Data Sources………………………………………………… 79


viTABLE OF CONTENTS (continued) 4.7.1 Asymmetric Timeliness of Earnings and the SOX Act of 2002 Partitioned by
Alleged Fraud and Nonfraud Firms……………………… ………………………… 114
4.7.2 Sensitivity Test of Asymmetric Timeliness of Earnings and the Sarbanes-Oxley
Act (SOX) of 2002 for All Firms…………………………………………………… 115
4.7.3 Alternate Sarbanes-Oxley (SOX) Timing Date………………………………………. 117
4.8 Asymmetric Timeliness for Firms Reporting Goodwill Impairment……………… 117
4.8.1 Asymmetric Timeliness of Earnings for Firms Reporting Goodwill Impairment……. 118
4.8.2 Sensitivity Test of Asymmetric Timeliness of Earnings for All Firms Reporting
Goodwill Impairment…………………………………………………… 119
4.9 Firm-Specific Measures of Accounting Conservatism……………………………… 120
4.9.1 Introduction…………………………………………………………………………… 121
4.9.2 Descriptive Statistics and Correlation Coefficients………………………………… 122
4.9.3 Control Variables…………………………………………………………………… 123
4.9.4 Financial Statement Measures of Variables Representing Accounting Conservatism 125
4.9.5 Sensitivity Tests for Financial Statement Variable Measures of Accounting
Conservatism Relating to the Market-to-Book Ratio…………………………………. 128
4.9.6 Sensitivity Tests for Other Additional Financial Statement Variable Measures of
Accounting Conservatism…………………………………………………………… 130
4.10 Accruals-Based Measures of Variables Representing Accounting Conservatism……. 131
4.10.1 Income-Decreasing Discretionary Accruals Models…………………………………. 132
4.10.2 Sensitivity Tests for Firm-Specific Accrual Measures of Accounting Conservatism 135
4.11 Firm-Specific Measure of Accounting Conservatism and the Post-SOX Period…… 138
4.11.1 Financial Statement Measures of Variables Representing Accounting Conservatism

4.16 Controls for Endogeneity/Self-Selection Bias……………………………………… 164

CHAPTER 5 SUMMARY AND CONCLUSIONS, LIMITATIONS, FUTURE RESEARCH

5.1 Introduction………………………………………………………………………… 172
5.2 Summary and Conclusions…….…………………………………………………… 172
5.3 Limitations……………….………………………………………………………… 181
5.4 Future Research……………………………………………………………… 182 APPENDIX A Additional Measures of Earnings Quality……………… ………….…… 184

APPENDIX B Additional Cost of Capital Models………………… …………………… 187

REFERENCES………………………………………………………………………………. 196


TABLE 12: Pooled Basu (1997) Model of Asymmetric Timeliness of Earnings…………… 228

TABLE 13: Asymmetric Timeliness of Operating Accruals, Cash Flows, and Earnings……. 230

TABLE 14: Persistence of Price-Deflated Earnings on Prior Period Earnings News……… 233

TABLE 15: Accounting Conservatism for All Alleged Fraud and Nonfraud Firms …… 235

TABLE 16: Asymmetric Timeliness of Earnings Surrounding the Sarbanes-Oxley Act of
2002…………………………………………………………………………… 236

TABLE 17: Asymmetrical Timeliness of Earnings for All Fraud and Nonfraud Firms
Surrounding the Sarbanes-Oxley Act…………………………………………… 238

x

LIST OF TABLES (continued) TABLE 18: Asymmetric Timeliness of Earnings for Partitioned Firms Reporting Goodwill
Impairment ……………………………………………… ………….…………. 239

TABLE 19: Asymmetric Timeliness of Earnings for All Firms Reporting Goodwill
Impairment………… …………………………………………………….……. 241


TABLE 31: Results of Controlling for Self-Selection Bias………………………………… 270

TABLE 32: Results of Controlling for Self-Selection Bias and the Ex Ante Cost of Capital
on Risk Proxies, Fraud, and Measures of Accounting Conservatism…………… 272
1 CHAPTER 1

INTRODUCTION

1.1 Background and Purpose

The lack of availability of reliable and verifiable estimates between managers and
investors can cause uncertainty and information asymmetry in an entity’s business environment
(Watts, 1993). Managers can use conservatism as a means to manage information asymmetry in
their private information and in their financial reporting strategies (Chaney, 2006). LaFond and
Watts (2008) state that conservatism, “is an equilibrium corporate response to mitigate the value
reduction resulting from information asymmetry between informed and uniformed investors.”
Watts (2003a) advocates that “the evidence on conservatism suggests asymmetric verifiability of
estimates is crucial to constraining manipulation and fraud” and a decrease in conservatism may
allow some managers the opportunity to generate fraud (Watts, 2006). However, in light of these
statements, the Financial Accounting Standards Board (FASB) contends that an inherent conflict

litigation risk are more inclined to use higher levels of accounting conservatism as a choice in
reducing information asymmetry. One of the effects of conservatism could be the responding
change in a firm’s cost of equity capital. LaFond and Watts (2008) state that information
asymmetry between equity investors creates “deadweight losses” that in turn reduce the firms’
cash flows and increase the equilibrium return on the firm’s equity. Whether the role of
conservatism can mitigate the effect of an increase in cost of capital for alleged fraud firms is
examined in this context.
Accounting conservatism can be measured in terms of both the balance sheet and the
income statement. While there is no one conventional definition or method employed to measure
accounting conservatism, and due to it not being directly observable and difficult to calibrate at
the firm level, conservatism has been characterized by the traditional adage of “anticipate no
profits, but anticipate all losses” (Bliss, 1924). It has also been referred to as “the accountant’s
tendency to require a higher degree of verification to recognize good news as gains than to
recognize bad news as losses” regarding future cash flows (Basu, 1997). Accounting
conservatism is one factor that may provide information about earnings quality (Francis et al,
2004; Watts, 2003a) as it involves the timely recognition of bad news versus good news in

3
I use the terminology “allegedly accused” because, although the SEC’s enforcements may be issued and
filed, the proceedings do not in every instance result in civil or criminal charges. For example, some of the
SEC’s Auditing and Enforcement Releases (AAERs) indicate only a cease and desist order pending
restitution in the form of a settlement payment while not admitting to any wrongdoing. 3earnings. It is often termed asymmetric gain and loss recognition, differential timeliness, or
conditional conservatism
4

6
The FASB’s Project Update (FASB, 2005), states that conservatism/prudence should remain excluded
from the qualitative characteristics of accounting information. They assert that neutrality should include
freedom from bias, prudence, and conservatism. The FASB staff has expressed reluctance to continue to
include conservatism or prudence as a list of desirable qualitative characteristics of accounting information
together with neutrality. The FASB Board has suggested that the notion of conservatism should be
eliminated. However, they stated that the FASB’s conceptual framework should note the continuing need
to be careful in the face of uncertainty. In practice, the idea of conservatism has been altered from FASB’s
original intention. The FASB’s definition of conservatism as a prudent reaction to uncertainty does not
imply that financial statements should always be pessimistic. The role of conservatism is for preparers to
acknowledge that risks and uncertainties are present in financial information and to adequately account for
those risks in the information that is presented to decision makers. 4faithfulness.
7
The FASB’s Conceptual Framework relates to the hierchy of favorable accounting
quality characteristics (FASB, 1980). Critics of accounting conservatism claim that it leads to an
understatement of earnings in the current period. This can lead to an overstatement of earnings in
future periods by understating future expenses (Penman and Zhang, 2002) at a point in time that
managers determine “selectively fits their operating results” (Massoud and Raiborn, 2003).
While accounting conservatism in this context explains accelerated loss recognition, accounting
conservatism can also be explained in the context of delayed gains recognition (Srivastava and
Tse, 2007). Advocates argue that the elimination of conservatism could affect managerial
behavior and have economic consequences. Therefore, the study of conservatism remains
relevant and important.
Contemporaneous empirical evidence suggests that the trend in conservative financial

cookie jar reserves, creative acquisition accounting, excessive charges and write-offs, and
abandoning of unprofitable operations) could produce some of the evidence on conservatism, it is
not thought to be the only explanation. In times of economic losses, managers exaggerate the
losses through income-decreasing discretionary accruals for purposes of earnings management.
However, according to Givoly and Hayn (2002), it is important to note that this does not support
the timely loss recognition argument because they do not predict any relation to cash flows nor
can they fully explain the systematic versus idiosyncratic understatement of net assets. Thus,
there is not always a direct relation between asymmetric timeliness and accounting conservatism.
While aggressive accounting choices may reduce the degree of reporting conservatism “they
cannot turn the whole tenor of the financial statements into being non-conservative or even
neutral” (Givoly et al., 2007).

1.2 Litigation Risk

Changes in auditors’ liability exposure in recent decades have been documented by
Kothari et al. (1989) who found an increasing degree of conservatism in high litigation periods.
They categorized liability exposure based on four liability regimes as evidenced from enactments 6and events surrounding securities reforms covering the period 1933 through 1985.
8
Following
Kothari et al. (1989), Basu (1997) examined the period 1963-1990
9
and predicted conservatism
measures to increase in periods following liability increases and to remain constant in periods
following court decisions that restricted liability growth. For example, Basu (1997) empirically
7conclusively documented in the extant literature. Since research has considered accounting
conservatism to be a corporate governance mechanism (Guay and Verrecchia, 2007), it would
seem paradoxical if alleged fraud firms predispose themselves to higher levels of conservatism.
However, based on the theory proposed by Watts (2003a), I argue that the threat of litigation and
exposure to political costs should induce firms to increase their conservative accounting practices.
Since the mechanism of conservatism can be viewed as a corrective action to the over-optimistic
behavior of management, if firms use accounting conservatism while they are also manipulating
earnings and engaging in fraudulent activity, accounting conservatism could have the propensity
to mask fraud. Recently, Bagnoli and Watts (2005) report that there is a positive correlation
between conservative financial reporting policies and the likelihood of a firm beating earnings
expectations. Thus, there is an indication that firms may be “padding” their financial reports in
order to later exceed earnings expectations (Marshall and Heffes, 2005). Levitt (1998) states that
“if these charges are conservatively estimated with a little extra cushioning, [the] conservative
estimate is miraculously reborn as income when estimates change or future earnings fall short.”
This suggests that corporate fraud could be on the rise again. Therefore, the main research
question I address is whether or not the degree of accounting conservatism is higher for firms
allegedly accused of fraudulent activity and examine the point in time that this is most likely to
occur.

1.3 Regulation and Standard Setting

In regards to the role of regulation and standard setting, Watts (2003a) predicts that
increased liability from regulation provides managers and auditors with incentives to be more
conservative. This can be traced back to financial reporting surrounding the U.S. Securities Acts
of 1933 and 1934. Litigation under the Securities Acts encourages conservatism because the

clients after the passage of the Act, a result consistent with decreased audit quality.

11
Watts (2003a) states that “asymmetric verifiability speeds up the recognition of losses and provides the
board of directors and shareholders with a signal to investigate the reasons for those losses.”
12
DeAngelo (1981) suggests that Big 6 auditors face more litigation because they have more resources than
other auditors. 9In terms of accounting conservatism, Chan and Pae (1998) found that the elimination of
joint and several liability of the PSLRA actually caused auditors of firms to adopt even less
conservative accounting practices. Extending Basu’s (1997) analysis of asymmetric timeliness
and legal liability, Liu and Thornton (2005) examined the time period surrounding the PSLRA.
They convey that asymmetric timeliness declined immediately after the PSLRA and marginally
increased again during the 1997 and 1998 period when litigation shifted to state courts. During
1998, conservatism initially declined and increased again when the 1998 Securities Litigation
Uniform Standards Act reversed previous actions and required class action lawsuits to be filed
again in federal courts.

1.3.2 The Sarbanes-Oxley Act (SOX) of 2002

In terms of more recent regulation, The Sarbanes-Oxley Act (SOX) of 2002 was enacted
as a direct result of the more well-known and publicized accounting scandals that swept the U.S.
in the later 1990s.
13
The SOX Act addresses corporate governance and accountability by

of decreasing the level of fraud occurrence. Therefore, it is relevant to determine whether
changes in the recent wave of accounting debacles are associated with changes stemming from
government regulation and standard setting.
14
The effect of changes in the legal environment has
the propensity to alter the degree of earnings quality and subsequent potential fraudulent activity.
However, many question how much more effective the SOX Act will be in deterring
unethical and fraudulent management behavior. The parallels of the former regulatory periods
compared to the current setting raise doubts as to whether this type of behavior can be legislated
(Rockness and Rockness, 1980). Fraud may also be challenging to predict because of the mere
random acts by a few agents (Cloninger and Waller, 2000). Likewise, a corporation’s culture can
determine how people behave when they are not being watched (Tierney, 2002).
It is important to determine the effect of accounting conservatism for firms allegedly
accused of committing fraud as this would lend support as to why the FASB should still continue 14
According to a 2006 report by the Association of Fraud Examiners, the median fraud loss per scheme for
the 2004-2006 period was greater for small organizations than for large organizations (JAcct., 2007). This
finding is timely in that the SEC is granting further compliance relief and leniency from Section 404 of the
Sarbanes-Oxley Act (SOX) to smaller public companies and many foreign private issuers (SEC, 2006).
Small firms have been found to be associated with a greater percentage of loss firms (Klein and Marquardt,
2006). 11to monitor and show cause for controlling and providing better disclosure on the increasing
effects of conservatism and whether conservatism introduces additional bias into the financial

were more likely to employ “big bath” charges. Thus, eliminating amortization expense and
using impairment tests raises net income with no corresponding increase in cash flows. These
write-offs from impairment can signal a loss in economic value. In addition, measuring the
impairment of goodwill when different valuation models are employed could inconsistencies
(Lander and Reinstein, 2005). Statement of Financial Accounting Standards (SFAS) No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets, reflects the demise of the
pooling-of-interests method of accounting for business combinations and specific assets or asset
groups. It also avoids amortization, replacing it with a two-step impairment test. Overall, these
two standards require the estimation of non-verifiable and non-contractible future cash flows
which could lead to manipulation. Nonverifiability is inconsistent with the original concept of
accounting conservatism and does not lead to more transparency in the financial statements
(Watts, 2003a), but to more manipulation (Sevin and Schroeder, 2005) and the potential for
increased litigation risk.
In summary, based on the prior discussion of the role of regulations and standards, in
regards to the Private Securities and Litigation Reform Act of 1995, there is empirical evidence to
suggest that as litigiousness decreases, conservatism may decrease and this relation has the ability
to increase fraud. Given that proof of fraud requires the verifiability of accounting numbers,
conservatism should in theory be associated with a decrease in fraud (Watts, 2003b). However,
since the SOX Act has been predicted to be associated with a shift in the information environment
representing more litigiousness, the amount of conservatism is predicted to increase. The
standard relating to SFAS No. 142, Goodwill and Other Intangible Assets is expected to produce
the opposite results contrary to the SOX Act.