The conservatism from country to country (regional characteristics)

A major challenge to international harmonization highlighted in the literature is culture, defined as “[...] the collective programming of the mind which distinguishes the members of one group or society from those of another” (^{Hofstede, 1984, p. 82}). ^{Hofstede’s (1980)} study of 116,000 questionnaires conducted by psychologists and directed to employees of the International Business Machines Corporation (IBM), a US multinational company operating in 39 countries, culminated in the identification of four cultural dimensions, which would later become milestones in the analysis of the influence of culture in Accounting. These cultural dimensions are defined as follows:

Despite the contribution to scientific research provided by ^{Hofstede (1980)}, this study has been the subject of a number of criticisms, notably by ^{Gernon and Wallace (1995)}, ^{McSweeney (2002)} and ^{Baskerville (2003)}. Later, ^{Gray (1988)} links ^{Hofstede’s (1980)} study with Accounting, relating the culture, social values and accounting systems.

From this link, the author proposed four accounting values verified at the level of the accounting subculture, namely (^{Gray, 1988}):

Following the above linkage, ^{Gray (1988)} related the accounting values to the cultural dimensions advocated by ^{Hofstede (1980)} by formulating the four hypotheses described below:

H1: the greater the positioning of a country in relation to the cultural dimension of individualism and the lesser in relation to others such as risk aversion and the distance of power, the more likely will be its position in terms of professionalism;

H2: the greater the positioning of a country in relation to the cultural variables of risk aversion and distance from power and the smaller in terms of individualism, the more likely is its positioning in terms of uniformity;

H3: the greater the positioning of a country in relation to the cultural variable of risk aversion and a smaller one in relation to those of individualism and masculinity, the more likely is its position in terms of conservatism; and

H4: the greater the positioning of a country in relation to the cultural variables of risk aversion and distance from power and smaller than those of individualism and masculinity, the more likely is its position in terms of secrecy.

^{Gray (1988)} promotes a hierarchy of values explained above at the level of the accounting subculture, highlighting individualism and risk aversion as of greater importance, followed by the distance of power and, later, as of less importance, masculinity. Then, the author proposed the classification of accounting systems according to cultural areas, with emphasis on the position of the Anglo-Saxon countries (including the United States, the United Kingdom and Australia) with high levels of flexibility and professionalism, as opposed to less developed Latin countries (where Portugal is included), characterized by uniformity and statutory control.

Further, accounting values related to measurement and disclosure practices, with respect to conservatism and secrecy, gave rise to another classification of accounting systems, again opposing the Anglo-Saxon countries and the less developed Latin countries, which exhibit high levels of secrecy and conservatism.

The conservative design, in particular, aims to prevent assets and income from being overvalued and to undervalued liabilities and expenditures (^{IASC Foundation, 1989}).

This conservative approach is characteristic of financial information preparers in Western European countries, such as France and Germany, as opposed to Anglo-Saxon countries such as the United States and the United Kingdom. It is important to notice that this principle of prudential recognition and measurement is also supported by the recent Directive 2013/34 /EU of the European Parliament and the Council of 26 June 2013 (^{EPC, 2013}).

The model of ^{Gray (1988)} has even supported the research carried out in the area in the last decades (e.g. ^{Baydoun and Willett, 1995}; ^{Chanchani and Willett, 2004}; ^{Doupnik and Riccio, 2006}; ^{Tsakumis, 2007}; ^{Kanagaretnam, Lim and Lobo, 2013}; ^{Carvalho, Albuquerque, Texeira Quirós and Justino, 2015}).

Recently, ^{Li (2015)} associated country-level timely loss recognition and the cost of capital. So, firms domicilied in countries with more conservative financial reporting systems have significantly lower cost of debt and equity capital (^{Li, 2015}).

The conservatism and the qualitative characteristics

^{Baydoun and Willett (1995)} relate the theory of accounting values in the Accounting subculture developed by ^{Gray (1988)} with the qualitative characteristics provided in the previous Conceptual Framework (CF) of the FASB. It should be noted that until the work developed by these authors, this relationship was not expressly proposed in the literature on this matter. Nevertheless, and like ^{Gray (1988)} in this respect, ^{Baydoun and Willett (1995)} did not submit their hypotheses to empirical validation.

The work developed by those authors addresses the problem of the cultural irrelevance caused by the adoption of accounting systems characteristic of Western countries and, consequently, with accounting values differentiated from developing countries. Therefore, ^{Hofstede’s Theory of Cultural Dimensions (1980)} and its extension promoted by ^{Gray (1988)} are relevant in this context.

^{Baydoun and Willett (1995)} identify levels at which accounting information will be more prone to cultural irrelevance. At the lowest level are the fundamental measurements of Accounting (e.g. inventory cost, fixed assets), and are little affected by cultural or social differences. At the top level are the so-called derivative measures, such as the calculation of depreciation, which are seen as specific statistical decisions and as such are more likely to become irrelevant if arbitrarily transferred to other countries. In the last phase, there is the filtering process promoted by the disclosure, which is by definition culturally determined, being at this level that the practices of the western countries can become insignificant for the users of the developing countries.

^{Baydoun and Willett (1995)} establish a relationship between the practical application of these concepts in financial reporting and three of the accounting values defined by ^{Gray (1988)}, in particular, uniformity, conservatism and secrecy.

Thus, they relate uniformity to comparability and consistency, interrelated concepts, but with distinct relevance to the uniformity of content and presentation of financial reporting. The conservatism, related to the quality of the information disclosed, is associated to the qualitative characteristics of reliability, reliable representation, verifiability and timeliness. Finally, secrecy is related to the amount of information disclosed and its level of disclosure, and thus to the usefulness of decision and accountability.

In spite of the discussions about the qualitative characteristics and their importance in the context of the preparation of the financial report, on the one hand, and its impact and / or importance in the context of international accounting harmonization, on the other hand, few studies have analyzed empirically such underlying issues.

According to ^{Beest, Braam and Boelens (2009)}, in order to assess the quality of the financial reporting, the use of the fundamental and enhancing qualitative characteristics, as defined in the Exposure Draft of the new Conceptual Framework together developed by IASB and FASB, should be highlighted. Following this understanding, they constructed an index consisting of 21 items as operational measures of the indicated qualitative characteristics. The methodology applied was the content analysis being the sample consisting of 231 annual reports published by listed companies in the UK, US and German stock markets, thus applying different regulations (IFRS and US GAAP). The findings evidenced the influence exerted by variables such as accounting regulations, legal systems, enforcement environment, size and industry. Additionally, they obtained the validation of the quality measurement tool used, offering a contribution to the scientific community in order to make qualitative characteristics operationally measurable.

Also noteworthy is the recent study developed by ^{Nobes and Stadler (2015)} on the influence of qualitative characteristics on accounting decisions by managers, particularly regarding the choice and change of accounting policies under IFRS, specifically IAS 8 Accounting Policies, Changes in Accounting, Estimates and Errors. The authors concluded that the references to qualitative characteristics are positively associated with size and the extent of the transparency of the jurisdiction.

The conservatism and the firm-level controls

According to ^{Basu (1997)}, conservatism has been reflected in accounting practices for at least five hundred years, although not necessarily perceived from the point of view of culture as proposed by ^{Gray (1988)}. Conservatism is also identified with the Positive Theory of Accounting, according to which it is possible to explain and predict the practice and choice of accounting policies (^{Watts and Zimmerman, 1990}). Still according to these authors, conservatism means that the assets should be recognized at the lowest value identifiable, conversely to the liabilities. Concerning the timing of recognition, it is asymmetric: income should be deferred as much as possible and the expenses should be anticipated (ibid.).

In this sense, this accounting value is reflected in the financial report by certain attributes of the company, such as size, indebtedness and profitability. Thus, the political costs (e.g. litigation) are commensurate with size and the greater control to which they are attached by government authorities (e.g. tax regulation), which leads to the choice of more conservative accounting policies (ibid.).

However, the recent trend in literature in this area points out into the opposite direction. ^{Khan and Watts (2009)} argue that the internationalization of larger entities, present in multiple jurisdictions, subject to divergent tax rules and rates, enables them to minimize taxes paid by relocating profits to jurisdictions where taxation is significantly reduced. It is precisely this minimization of the present value of tax liabilities that makes possible to reduce the demand for accounting conservatism. Thus, ceteris paribus, the larger the entity size the smaller the conservative levels displayed (^{Callen, Segal and Hope, 2010}).

With regard to indebtedness, ^{Ahmed, Billings, Morton and Stanford-Harris (2002)} and ^{Zhang (2008)} argue that higher levels of accounting conservatism evidenced by entities are directly related to lower levels of indebtedness. The presence of conservatism in financial reporting contributes to the protection of creditors’ interests by mitigating agency costs (bondholder-shareholder conflicts) and the payment of dividends (^{Ahmed et al., 2002}; ^{Billett, King and Mauer, 2007}; ^{Khan and Watts, 2009}). In addition, the need to use external financing and the proliferation of the use of fair value in accounting regulations lead entities to shape their financial information. Thus, in order to satisfy such interests, they opt for the application of more conservative accounting methods (^{Beatty et al., 2008}).

In the context of another company attribute, the level of profitability, ^{Ahmed and Duellman (2011)} conclude that the entities that adopt conservatism in financial reporting significantly present higher levels of profitability in the future, from the obtained cash flows and gross margins, compared to non-conservative firms. In addition, the authors argue that, in line with ^{Watts (2003)} and ^{Ball and Shivakumar (2005)}, the conservatism contributes to the minimization of agency problems associated with managers’ investment decisions. Nevertheless, the meaning of this relationship is not peaceful. ^{Chandra (2011)} argues that the high levels of conservatism exhibited by such firms are primarily a result of reduced operating cash flows (high investment in Research & Development) and a further increase in profits from lower levels of litigation risks. ^{Francis and Martin (2010)} identify a positive association between timely recognition of economic losses in profits and the achievement of profitable investments, measured for example through post-acquisition operating performance. They also state that such relationship is greater in the case of entities that show ex-ante agency costs. However, according to ^{Roychowdhury (2010)} the scientific evidence supporting the establishment of this causal relationship is insufficient.

In addition, other factors are listed in literature as justifications for the connections before-mentioned: the life cycle stage of the company and the asymmetry of information among investors.

In the first case, it is found that more indebted entities are usually more mature firms with higher taxable profits, which increases the demand for conservatism (^{Khan and Watts, 2009}). As for the second, the results are divergent. If, on the one hand, the presence of conservatism in financial reporting reduces information asymmetry by facilitating the firm’s indebtedness capacity (^{Wittenberg-Moerman, 2008}; ^{Chi et al. 2009}; ^{Donovan et al., 2015}), on the other hand, the opposite is also observed (^{LaFond and Watts, 2008}; ^{Khan and Watts, 2009}).

The next section presents the hypotheses and methodological lines that support the empirical study developed in this paper.

Hypotheses

^{Gray’s (1988)} suggestion about the existence of a connection between cultural areas and patterns associated with accounting systems is the supporting argument of the cultural relevance theory of accounting, later advocated by other authors (e.g. ^{Baydoun and Willett, 1995}).

According to this theory, each culture conceives its own accounting system that influences and determines the form of elaboration of the financial report, which can be observed through the use of qualitative characteristics (ibid.).

^{Schultz and Lopez (2001)} and ^{Doupnik and Richter (2004)}, in agreement with ^{Gray’s (1988)} model, argue that culture, specifically expressed from accounting values, exert influence over the choices made in the financial reporting.

Conservatism is especially highlighted in those contexts, which is negatively expressed from the use of relevance as a fundamental qualitative characteristic of financial information: the higher is the level of conservatism, the lower is the concerns on the relevance of financial information.

The literature suggests the existence of support for the association between, on the one hand, firm-level controls, such as size (^{Khan and Watts, 2009}; ^{Calen et al., 2010}); indebtedness (^{Watts and Zimmerman, 1990}; ^{Zhang, 2008}) and profitability (^{Ahmed and Duellman, 2011}; ^{Chandra, 2011}) and, on the other hand, conservatism.

In this sense, the following general hypothesis was conceived, from which derive the other proposed operational hypotheses related to it:

H1: Conservatism, having the qualitative characteristic of relevance as proxy in opposite relationship, is related to regional characteristics and firm-level controls.

Conservatism as defined above is fundamentally based on ^{Gray (1988)} and the further development proposed by ^{Baydoun and Willett (1995)}. In this sense, it is expressed by the selection of measurement criteria and judgments and estimates based on the most cautious options or, in other words, less risk aversion.

^{Doupnik and Riccio (2006)}, aligned with those assumptions, concluded that the choice of measurement practices is influenced by countries’ level of conservatism. In terms of this accounting value (conservatism), the Latin countries are included in the group of countries with the highest levels of conservatism (from the less to the more developed ones), followed by the Germanic, Nordic and Anglo-Saxon countries.

In this way, and taking into account the previous elements, the following operational hypothesis was formulated:

H1.1: In line with the classification attributed by ^{Gray (1988)}, the countries included in the classification of less developed Latin countries, more developed Latin countries, German countries, Nordic and Anglo-Saxon countries have, decreasingly in this order, different levels of conservatism.

On the other hand, the association between size and conservatism level was identified in the opposite direction by ^{Watts and Zimmerman (1990)} because of the linearity between the political costs / statutory control and the size of companies. ^{Khan and Watts (2009)} also argue that there is a negative association between the size of the entities and the level of conservatism, as larger companies have lower levels of information asymmetry and uncertainty. This relationship is due to the fact that these types of companies have higher maturity levels and a richer information context, expressed, for example, by the degree of monitoring of financial analysts. This association is confirmed, for instance, by ^{Calen et al. (2010)}.

In the context of indebtedness, ^{Lara, Osma and Penalva (2016)}, in line with ^{Watts (2003)} and ^{Watts and Zimmerman (1990)}, argue that conservatism emerges as an efficient instrument in resolving disputes between creditors and shareholders, caused mainly by the fact that creditors have information and asymmetric returns. In this way, and since they support the risk of downside risk, the adoption of conservative accounting policies assures them the fulfillment of the assumed obligations, since it implies the timely recognition of losses in both results and net assets. In the same vein, ^{Ball, Robin and Sadka (2008)} point out that accounting conservatism not only prevents expropriation but also allows creditors to be protected by giving them decision-making power in the case of loss-making companies. In fact, the literature converges towards the existence of a negative association between the level of conservatism and the level of indebtedness or the cost of debt (^{Ahmed et al., 2002}; ^{Wittenberg-Moerman, 2008}; ^{Zhang, 2008}).

Likewise, the association between profitability and conservatism is negative insofar as the application of conservative accounting policies reduces both the results and the net assets, reducing the mentioned firm-level controls (^{Watts and Zimmerman, 1990}; ^{Ahmed and Duellman, 2011}; ^{Chandra, 2011}). Notwithstanding the existence of evidence in this sense, some authors have evaluated this relationship as a positive sign, since the timely recognition of losses in results reduces the probability of overestimation of the latter and the assets, preventing managers from investing in projects with negative returns. Further, this makes possible to adopt corrective management measures to minimize losses (^{Duellman, 2006}; ^{Francis and Martin, 2010}).

Therefore, the following hypothesis has been defined:

H1.2: A negative association between conservatism and size or the level of indebtedness is identified as well as an association of indeterminate sign between conservatism and profitability.

The next subsection will present the general methodology to be followed in order to test the hypotheses formulated above.

Methodology

In order to test the hypothesis formulated in the previous subsection, the regional characteristics and the firm-level controls were identified as independent variables.

The former will take into account the country of where the entities included in this study are listed, which include Portugal, Spain, Germany, United Kingdom and Sweden. For the firm-level controls, in turn, several elements based on consolidated accounts were used as proxies of size, indebtedness and profitability. Thus, for the dimension, we used the total assets. In terms of profitability, the return on assets ratio (net profit for the period over the total assets) was used, and finally, for indebtedness, the debt ratio (total liability over total assets).

The independent variables and their notation used in this investigation for the firm-level controls are shown in Table 1.

It is important to notice that, in order to ensure comparability of the data collected, the conversion of the currencies of presentation of the financial information analysed (British pound, US dollar and Swedish krona) were converted into euros, based on daily reference exchange rates provided by Banco de Portugal.

The conservatism (as the dependent variable of this study) will be assessed according to the references of relevance as a qualitative characteristic in the financial reporting (RELEV), in negative relationship, aligned with ^{Baydoun and Willett’s (1995)} proposal for the association between the qualitative characteristics and the cultural values of ^{Gray (1988)}.

In practical terms, within the process of collecting data about the qualitative characteristics, a matrix was built setting out the following elements: in the rows, the items contained in the financial statements’ notes, in accordance with the disclosures established in IFRS and formats usually identified in financial reports; in the columns, the relevance mentioned as a qualitative characteristic. In this sense, we assigned the value ‘1’ when that qualitative characteristics is disclosed and ‘0’ otherwise.

In order to construct an objective and comparable measure as long as possible, we developed an index relative to the level of qualitative characteristic disclosure of relevance. The calculation method is observable in the following equation:

Where number of disclosures, by entity, of the qualitative characteristic of relevance; n = total of possible disclosures for this qualitative characteristic in the financial reporting.

As a novelty proposed in this study, this first proxy underlies the assumption established in the hypothesis of this paper. In fact, and according to several authors, culture introduces asymmetries in international financial reporting and is one of the main obstacles to full harmonisation (see ^{Perera, 1989}; ^{Gray, 1988}; ^{Doupnik and Salter, 1995}).

The association between the accounting values and the dissemination of qualitative characteristics was first proposed by ^{Baydoun and Willett (1995)} based on the theory of the cultural relevance of accounting. Nevertheless, literature has neglected the empirical analysis of this relationship. According to these authors, conservatism is pertinent to assess the quality of the information disclosed, in articulation with relevance as a qualitative characteristic.

In this field, ^{Fah (2008)} theorises that accountants who follow conservative values such as tradition, compliance and security, as defined by ^{Schwartz’s (1992)}, are more likely to assign greater importance to the need for less relevant measurement methods, for instance, the cost model. Conversely, accountants motivated by values associated with openness to change, such as stimulation and self-direction, will tend to be more willing to override reliability in order to provide relevant, yet more volatile, market information (ibid.). In this sense, the preference for using fair value method fits the latter motivational values (^{IFRS Foundation, 2010}). In another context, given the risk aversion that characterises conservatism, when managers change accounting policies (which happens rarely), they do so mainly for reasons of comparability (^{Nobes and Stadler, 2015}), which is expressed by the literature in negative relationship with relevance.

Considering the elements gathered from the authors before mentioned, conservatism is negatively associated with relevance. Implicitly, ^{Gray (1988)} also proposed a negative relationship between conservatism and relevance, given the risk aversion that underlies that accounting value.

Therefore, to sum up, relevance is defined as the cultural value opposite to conservatism, associated with less risk aversion or capacity to take the risk, because the greater the importance attributed to this qualitative characteristic, the lower the level of conservatism of the entities.

In order to assess the validity of the construct for conservatism before mentioned (based on the relevance), considering its novelty, two further dependent variables will be analysed. Simultaneously, three models of multiple linear regression will be performed including the three proxies for conservatism proposed in this paper. In each of the models proposed, one of these proxies will be defined as the dependent variable, while the further will be included as independent variables, in order to assess, one at a time, the confirmatory capacity of the dependent variable under analysis.

The assessment of conservatism will be performed, in this sense, through three distinct proxies. The first one, already presented, is the relevance as a qualitative characteristic (in negative relationship). The other two variables have been frequently used in the literature on conservatism, and object of numerous researches in this field.

The second variable proposed is the market-to-book ratio (MTB). According to ^{Roychowdhury and Watts (2007)}, conservatism leads to an underestimation of the book value, through the adoption of more conservative accounting policies. In this sense, the market value of net assets is potentially higher than the book value in the most conservative companies, expressing a positive relationship between this ratio and conservatism.

Finally, the third variable (ACCRUAL) is based on Basu’s model (1977), evidencing the timing of the recognition of losses as an indicator of the speed with which each adverse economic event is reflected both in the income statement and the statement of financial position (^{Ball and Shivakumar, 2005}; ^{Moreira, Colauto and Amaral, 2010}). According to this model, the accruals are often measured through the difference between an indicator from the income statement (operating results) and the cash from operating activities. Positive accruals often indicate lower levels of conservatism, therefore indicating a negative relationship between the two.

The methodology used in the data collection was the analysis of the content of the annual reports and consolidated accounts of the non-financial activity sectors listed on the European financial markets indexes, namely PSI-20, IBEX-35, FTSE-100, DAX-30 and OMX-S30 relating respectively to the Lisbon, Madrid, London, Frankfurt and Stockholm stock exchanges. After applying the exclusion criteria disclosed in Table 2, the population of this research was made up of 137 European non-financial groups.

The selection of entities included in European country indexes was due to the fact that these entities published accounts since the advent of Regulation No 1606/2002 of the European Parliament and of the Council of 19 July in accordance with the IAS / IFRS standard, which is fundamental to solving the research problem mentioned in the introduction of this study. In addition, the inclusion of different countries of the same continent, linked by the EU by Regulations and Directives of general application by the Member States, allows for a more rigorous testing of the existence of different accounting values even in a context of a common regulatory environment.

The study period comprises the accounting periods ending on December 31, 2013 and 2014, being the reference period for the selection of entities with securities admitted to trading and included in the indexes previously referred to as of December 31, 2014.

Then it results in the analysis of two consolidated reports and accounts by each entity included in the study population. In order to ensure comparability of the information, the translated version of the English language of the financial reports was used, which is not available to a minority of the entities included in the PSI-20 and OMX-S30 indexes.

The next section will present the findings obtained from this research.