The Effect of Conservatism on the Trade-off between Relevance and Reliability: Evidence from China

Large body of literature examined the usefulness of financial statement information in general and the trend of accounting conservatism in particular. Accounting conservatism is known to affect the usefulness of accounting information by incorporating bad news immediately in accounting earnings whereas deferring the recognition of good news until they are realized. Since the mid 2000s, the increased adoption of IFRS across the world driving enhanced reliance on fair value measurements is likely to have caused counter effects on accounting conservatism and consequently have created systematic influence on the usefulness of accounting information. This study empirically investigates the two propositions based on the above perspectives. First, we examine whether the accounting conservatism is associated with the two primary qualities of accounting information of relevance and reliability in opposite directions. Second, we further investigate if the implementation of an accounting regime which is expected to lower the level of accounting conservatism creates structural influences on the relationships between conservatism and the qualities of accounting information. With these research objectives in mind, we conduct a series of empirical tests using 6,131 observations from 508 Chinese firms listed in the Shanghai and Shenzhen Stock Exchanges over the period from 1998 to 2010. We measure relevance as the ability of current earnings to predict future cash flows and reliability as the ability of current earnings to predict future earnings. We use various measures for accounting conservatism borrowing from existing literature. Main results of the studies are summarized as follows. First, it is suggested that there is a positive relationship between accounting conservatism and the ability of current earnings to predict future cash flows. On the other hand, there is a negative relationship between accounting conservatism and the ability of current earnings to predict future earnings. These findings are consistent with the predictions that accounting conservatism tends to enhance the relationship between current earnings and future cash flows with preemptive recognition of expected losses and to decrease the associations between current earnings and future earnings owing to the downward bias in the recognition of accounting income. We interpret the results as accounting conservatism helping accounting income to better reflect the real cash flows by checking the managerial opportunism generally motivated toward overstating operating performance, whereas decreasing the earnings persistence due to the inherent downward bias in income measurement process. Second, after the new accounting standard was introduced in 2007 in China, the relationship between accounting conservatism and the ability of current earnings to predict future cash flows declines whereas the relationship between conservatism and the ability of current earnings to predict futures earnings increases. We interpret the results as suggesting that the introduction of new accounting system which accompanies the increased use of fair value measurements resulted in the reduction of accounting conservatism to cause systematic influence on the relationship between the conservatism and qualities of accounting information. This study contributes to the related literature by demonstrating the trade-offs between the two primary qualities of relevance and reliability in conjunction with the relationships between conservatism and the qualitative characteristics of accounting information. It also helps to understand the changes in the usefulness of accounting information caused by the transition in the Chinese accounting system in the mid 2000s using Chinese accounting information.