Ultimate Ownership and Earnings Conservatism

Abstract

In this paper we analyze whether the extent of timely recognition of unrealized losses into earnings shown by firms with a controlling owner depends on (1) the ownership share of the controlling owner and (2) the divergence between the controlling owner's voting and cash flow rights. Our results document a negative relation between both aspects of the ultimate ownership structure and timely loss recognition. Our results are consistent with two possible explanations. First, as the controlling owner's stake in the company increases, a smaller portion of the firm's financing needs will be provided by minority shareholders. Minority shareholders do not have access to the company's private information, but demand timely recognition of losses into earnings to protect their claim. Reducing the role of minority shareholders implies also lower demand for timely loss recognition. Second, the results are consistent with an increase in the ownership stake of the controlling owner or in the divergence between the controlling owner's voting and cash flow rights leading to an increase in managerial incentives to share information with the controlling shareholder, reducing the demand for timely loss recognition for monitoring purposes.

Acknowledgement

The authors gratefully acknowledge the helpful comments and suggestions received from Laurence van Lent (Associate Editor) and two anonymous reviewers. Brenda Priebe provided excellent editorial support. All remaining errors are the sole responsibility of the authors.

Notes

Santana Martín and Aguiar Díaz (2007) show that while 27.4% of the ownership structures of listed Spanish firms were pyramidal in 1996, that figure stood at 29.1% in 2002.

Ball and Shivakumar (2005) note that the requirement imposed by the definition of conservatism is that the reduction in accounting earnings necessarily reflects a current economic loss, which represents a fundamental difference from other interpretations of the term.

While the literature has advanced various explanations for the existence of conservatism, such as those related to tax minimization or to the asymmetry in regulators’ costs, shareholder litigation and the contractual explanation are, in general terms, the main reasons that dictate the demand for conservative accounting (Watts, 2003a).

Basu (1997) assumes that positive returns generally reflect increases in net assets, or gains, while negative returns represent decreases in net assets, or losses.

Basu's prediction is that, while returns and earnings tend to reflect decreases in net assets in the same period, positive returns (which proxy for the communication of good news to the capital market) lead earnings.

Note that by definition of the ratio, CV is inversely related to the level of divergence between the voting and cash flow rights in the hands of the controlling shareholder.

According to Greene (2000), Wooldridge (2002), Chenhall and Moers (2007), and Nikolaev and van Lent (2005), we define endogeneity bias broadly as any situation where the disturbance term of the structural equation is correlated with one or more independent variables.

Although Pae et al. (2005), Givoly et al. (2007), and Roychowdhury and Watts (2007) cast the negative correlation between market-to-book and the asymmetric timeliness coefficient as an errors-in-variables problem, Ball et al. (2009) prefer to cast it as a property of income recognition in accounting.