Accounting conservatism : effect of contract incompleteness, moral hazard and board gender diversity

Abstract

Prior literature on accounting conservatism examines the effect of contracting and corporate governance structure on conservatism. The results from the prior literature show that the demand for conservatism arises from contracting costs and that conservatism is more likely to be employed by firms to facilitate monitoring and thereby improve their governance (Watts 2003a). In this study, I extend previous studies by examining two specific aspects of its association with contracting and corporate governance structure that affects accounting conservatism. I first examine the contracting-based demand for conservatism and hypothesize that it arises from the joint effect of contract incompleteness and moral hazard. I argue that the joint presence of these two factors is sufficient though not necessary for accounting conservatism. However, it is not clear at the outset how these two factors interact in creating the demand for conservatism. The empirical results in this thesis show that the degree of conservatism increases with the level of contract incompleteness. The results also show that firms with both a high (low) degree of contract incompleteness and a more (less) severe moral hazard problem adopt more (less) conservative accounting practices. Furthermore, the results reveal that the positive association between moral hazard and conservatism demonstrated by Lafond and Roychowdhury (2008) is more significant when contracts are more incomplete. Likewise, the results also show that the positive relationship between contract incompleteness and accounting conservatism is more pronounced when the moral hazard problem is more acute. While the demand for conservative accounting practices derives from contract incompleteness and moral hazard, the composition of the board of directors is one of the mechanisms through which this demand is translated into accounting policy. I explicitly address this issue by considering the role of the board in promoting conservative accounting. The literature (e.g. Ahmed and Duellman 2007; Garcia Lara, Garcia Osama and Penalva 2009; Srinidhi, Gul and Tsui 2011) has identified three inter-related board-based factors that might affect the implementation of the accounting policy: independent boards; CEO power; and the diversity on the board. Although there is extensive literature on the first two factors, there is little extant research on the effect of board diversity on conservatism. I address this issue by investigating the effect of board gender diversity on conservatism in accounting. I hypothesize that financial reports in firms with gender-diverse boards are more conservative, because female directors are likely to be more sensitive to ethical issues and exhibit more risk-aversion. In effect, the boards with female directors are likely to be more effective in monitoring managers. As audit committees specialize in overseeing the financial reporting process, firms with female directors on the audit committee are more likely to adopt a conservative accounting approach. In this regard, I hypothesize that firms with female audit committee members exhibit more conservative accounting practices. I identify firms that transit from an all-male board of directors to a board with at least one female director as event years, with the year before the transition year being treated as the benchmark year. The empirical results show that firms in this cohort adopt more conservative financial reporting standards after appointing female directors on board (audit committee). Finally, I perform an exploratory analysis on interaction effect of contract incompleteness and board gender diversity on conservatism. The results show that the effect of board gender diversity on conservatism is more pronounced in the low contract incompleteness group, suggesting a substitution between these two aspects in driving conservatism.