1. business and industrial

International Journal of Management and Humanity Sciences. Vol., S (3), 3906-3910, 2014
Available online at http://www.ijmhsjournal.com
ISSN 2322-424X©2014
An Empirical Study of Relationship between Conditional and
Unconditional Conservatism on Cost of Equity Capital in Accepted
Companies in the Tehran Stock Exchange
1
2
Ahmad Poulaie Mooziraji, and Fereshteh Darash
1- Master of Acounting
2- Agricultural and natural resources Ramin Khouzestan University
*Corresponding author E-mail: [email protected]
Abstract
Financial information has different economic consequences. The study of economic
consequence of information is related to the method of measurement of
conservatism. The economic consequence of conservatism measurement cause to
have two different dimensions of conservatism which called conditional and
unconditional. They present different information content for stake holder about
earning quality, expecteded rate of return stock, financial flexibility etc which affect
agency contrac cost of company with stake holders. So this research examine the
impact of Conditional and Unconditional Conservatism on Cost of Capital of 87 listed
company on Tehran Stock Exchange during 2005-2010 with cross sectional and panel
analyses. We use khan and watts model, for measuring of conditional conservatism
and for measuring of unconditional conservatism is used fromratioof book to market
equity owners (B/M).Our findings show there is positive relationship between
conditional conservatism and cost of capital, also, there is negative relationship
between unconditional conservatism and cost of capital. This finding can explain
importance role of conservatism in scope of financial accounting research and theory
also it indicate impact of conservatism on cost of capital from point of investor and
manager view
Keywords: Ex ante (balance sheet or unconditional) conservatism, ex post (earnings or
conditional) conservatism, costs of equity capital
Introduction
The concept of conservatism has a long acquaintance (history in the past). Many researchers have been
studied in this field, such as Ball and Shivakumar (2005). In the empirical research, they had studied about
the impact accounting conservatism on the quality of reported earnings by different (various) approaches.
But how conservatism and the cost of capital equityhaveimpacton the quality of accounting information
has not been reviewed yet. In this study, it is tried that review the effects of various aspects of accounting
conservatism and the cost of information and the role of accounting conservatism in financial reporting are
discussed by adopting a view to examining.
The conservatism is a mechanism which if applied correctly, will lead to solving a lot of agency problems
that all stemming from growing information gap between managers and suppliers in firms. (Watts, 2003)
The study of economic consequence of information is related to the method of measurement of
conservatism. The economic consequense of conservatism measurement cause to have two different
dimention of conservatism which called conditional and unconditional. They present different information
content for stake holder about earning quality, expecteded rate of return stock, financial flexibility and etc.
which affect agency contrac cost of company with stake holders.
Ex ante conservatism is accounting-based, balance sheet related and unconditional or news independent.
It reflects the understatement of book values of net assets (primarily due to unrecorded goodwill) and is
unrelated to changes in future cash flows. Examples of ex ante conservatism include the immediate
expensing of R and D and advertising costs, and the accelerated depreciation of long-lived tangible assets.
Intl. J. Manag. Human. Sci. Vol., S (3), 3906-3910, 2014
،
The ex ante conservatism is related to revenues and expenses, is related to news so, it s concept state that,
the firms recognize bad news in earnings on a more timely basis than good news (Chan, 2009 )
The accounting literature defines ex post conservatism in terms of Basu’s (1997) interpretation of
conservatism as the asymmetric response of earnings to economic gains and losses. Ex post conservatism
is associated with the more timely recognition of economic losses than gains and may involve a higher
degree of managerial discretion as managers can decide the timing and amount of asset write-down or
restructuring charges. We therefore argue that ex ante and ex post conservatism may convey very different
information about the quality of a firm’s current and future earnings to the market. Thus, we predict that a
higher degree of ex ante conservatism is associated with good quality earnings and lower costs of equity
capital, and that a higher degree of ex post conservatism is related to lower quality earnings and higher costs
of equity capital. (Chan, 2009)
In this study, we try to review the impact of different aspects of accounting conservatism on cost of equity
capital and book-to-market ratio (B/M) is used as alternative for ex ante conservatism and also khan and
watts (2010) model is used to measuring Ex post conservatism. The Ohlson and Juettner-Nauroth (2005)
(OJ) model is used to calculating cost of equity capital.
This study of the two terms can be useful for researches related to the field of accounting. First, a lot of
،
researchers are studied about conservatism but the most of them are ignored of it s economic
consequences. We hope that accounting conservatism represent information about the quality of current and
future earnings for investments .Second, the relationship between conditional and unconditional
conservatism and cost of equity capital is studied.
Preview research
 Tariq H. Ismail, Rasha M. Elbolok. Do Conditional and Unconditional Conservatism Impact Earnings
Quality and Stock Prices in Egypt?(2011)
The results suggest that (i) conditional conservatism negatively affects both earnings quality and stock prices
of Egyptian firms, and (ii) unconditional conservatism does not affect earnings quality but has a negative
association with stock prices of Egyptian firms. The findings of this study would help Egyptian accounting
standards setters to recommend accounting choices and policies that lead to high quality of earnings and
provide financial reports that rationalize investors’ decision.
 Song Zhu, Donglin Xia. Accounting conservatism and stock pricing: an analysis basedon China’s splitstock reform. (2010)
Accounting information plays its role on stock pricing through the reform of split-stock reform in the China
securities market, evident in the significantly positive relation between the proxies of accounting
conservatism and cumulative abnormal returns for one day, three days, ten days and 30 days around reopen day after the reform. Also, the profitability of listed firms in the past will further improve the positive
relation between conservatism and market reaction.
 Mozaffar Khan, Ross L. Watts. Estimation and empirical properties of a firm-year measure of accounting
conservatism. (2009)
The results are consistent with themeasure, C_Score, capturing variation in conservatism and also predicting
asymmetric earnings timeliness at horizons of up to 3 years ahead. Cross-sectional hypothesis tests suggest
firms with longer investment cycles, higher idiosyncratic uncertainty and higher information asymmetry have
higher accounting conservatism. Event studies suggest increased conservatism is a response to increases in
information asymmetry and idiosyncratic uncertainty.
Hypothesis
Our hypotheses are as follows:
 Hypothesis 1: Ex ante conservatism has significant impact on cost of equity capital in Tehran stock
exchange.
 Hypothesis 2: Ex post conservatism has significant impact on cost of equity capital in Tehran stock
exchange.
Materials and Methods
We use the library and field research methods from professional journals, books, theses, and Persian and
English articles for providing the theoretical basis and background of this study. Also, we use the Rahavarde
Novin and Tadbir Pardaz software's and information in financial statements of listed companies in Tehran
stock exchange and a website (www.rdis.com) in order to providing the required data for testing the
hypothesis. We use the information of financial statements like balance sheet, income statement, statement
of cash flows, and notes to the financial statements which ends to 29 Esfand (March) of each year. We also
excel and SPSS software's for preparing and analyzing the data.
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Intl. J. Manag. Human. Sci. Vol., S (3), 3906-3910, 2014
The population in this study is all of the companies that are accepted in Tehran stock exchange since
2005. And elimination method is used as a sampling technique. The data of 87 listed companies in Tehran
stock exchange during the period of 20055 to 2010 is used for testing the hypothesis of statistical sample.
Other companies were excluded from the sample for not having the following conditions:
 Financial statement of the companies must include balance sheet, income statement, and statement of
cash flows
 The last date of financial statement should be at the end of Esfand (March) of each year.
 Have the needed information to calculate the variables
 Since the companies which their main goals are financing services don’t have any accruals, they should be
omitted.
The model to assessment the relationship between accounting conservatism and cost of equity capital:
We use OJ (1998) model to test the relation between accounting conservatism and the cost of equity capital
controlling for other risk factors that are as follows:
COSTIT = ∝0 + ∝1 BETAIT + ∝2 LEVIT + ∝3 SIZEIT + ∝4 EVAREIT + ∝5 CON − RANK IT + εIT
Model (1)
In this model, the variables are defined as follows:
COSTit: cost of capital of firm i in year t
In this study, to estimate the expected cost of equity capital asset pricing model (CAPM) is used which is
as
follows:
R i = R f + R m − R f ∗ βi
Ri : rate of return expected by shareholders; Rf: risk-free rate of return; Rm: market rate of return; βi: risk
(correlation coefficient)
BETAit: Betait is firm i ’s capital asset pricing model (CAPM) beta in year t.
Beta factor shows the systematic risk of a stock relative to the systematic risk of securities on the Stock
Exchange.
i 
Cov[Ri , Rm ]
Var[ Rm ]
LEVit: the leverage of firm i in year t measured by the debt-to-equity ratio
SIZEit:firm size (the natural logarithm of equity market value of firm i at the end of year t)
EVARit: the variability of earnings (the coefficient of variation of earnings of firm i in year t 1 - t3 )
CON_RANKit:rank ( decile of the conservatism of firm i in year t )
The model for measuring unconditional conservatism:
In this study, the ratio of opening book to market value of equity (B / M) is used as an alternative for
unconditional or ex post conservatism.
The model for measuring conditional conservatism:
`
Also Khan and Watts s (2010)model is used to measure conditional or ex ante conservatism.In the model
proposed by Khan and Watts, the conditional conservatism is affected by the characteristics of the size,
growth opportunities (market to book value of net assets), and the degree of leverage, which is as follows:
𝐄𝐚𝐫𝐧𝐢 = 𝛃𝟎 + 𝛃𝟏 𝐍𝐞𝐠𝐢 + 𝐑𝐞𝐭 𝐢 𝛍𝟏 + 𝛍𝟐 𝐒𝐢𝐳𝐞𝐢 + 𝛍𝟑 𝐌𝐁𝐢 + 𝛍𝟒 𝐋𝐞𝐯𝐢
+ 𝐑𝐞𝐭 𝐢 ∗ 𝐍𝐞𝐠𝐢 𝛌𝟏 + 𝛌𝟐 𝐒𝐢𝐳𝐞𝐢 + 𝛌𝟑 𝐌𝐁𝐢 + 𝛌𝟒 𝐋𝐞𝐯𝐢 + 𝛅𝟏 𝐒𝐢𝐳𝐞𝐢 + 𝛅𝟐 𝐌𝐁𝐢 + 𝛅𝟑 𝐋𝐞𝐯𝐢
+ 𝛅𝟒 𝐒𝐢𝐳𝐞𝐢 ∗ 𝐍𝐞𝐠𝐢 + 𝛅𝟓 𝐌𝐁𝐢 ∗ 𝐍𝐞𝐠𝐢 + 𝛅𝟔 𝐋𝐞𝐯𝐢 ∗ 𝐍𝐞𝐠 𝐢
+ 𝛍𝐭
Model (2)
In this model, the variables are defined as follows:
Earn: is net income before extraordinary items, divided on market value of equity in the beginning-offiscal-year scaled by lagged market value of equity
Neg: is a dummy variable equal to1 when R<0 and equalto0otherwise,and e is theresidual.
RET: is annual return for firm I in year t.
SIZE:firm size (natural logarithm of market value of equity for firm i in year t)
MB: Rate of market value to book value for firm i in year t
LEV: leverage, firm i in year t (total short-term and long-term debt at end of fiscal year)
Khan and Watts measure conditional conservatism by a newproxy as G_Score and C_Score.C_Score is
the firm-year measure of conservatism, or incremental bad news timeliness. The total bad news timeliness is
the sum of G_Score and C_Score.( Khan and Watts2009)
Hypothesis tests
The results of the first hypothesis:
 H0: Ex ante conservatism doesn, t has impact on cost of equity capital in Tehran stock exchange.
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Intl. J. Manag. Human. Sci. Vol., S (3), 3906-3910, 2014
 H1: Ex ante conservatism has impact on cost of equity capital in Tehran stock exchange.
𝐇𝟎 : 𝛃𝐢 = 𝟎
𝐇𝟏 : 𝛃𝐈 ≠ 𝟎
p-value
0.3427
0.7905
0.001
0.3431
0.0023
2.248975
0.451985
Table 1. Dependent variable: cost of equity capital
-statistict
coefficient
variable
0.950194
84.79389
BETA
0.265903
1.23E-09
LEV
3.324042
0.869044
SIZE
-0.9493
-84.6766
EVAR
3.075022
0.015121
Ex ante conservatism
Durbin-Watson
4.890749
F-statistic
Adjusted R2
0.00000
Prob(F-statistic)
Based on Table 1, the significance of total regression is confirmed in certitude level of 0.99. The
coefficient of 0.015121 shows a positive relation between cost of equity capital and conditioned
conservatism. The P-value of
0.0023, related to independent variable coefficient in t parameter,
corroborates a significant relation between cost of equity capital independent variable and conditioned
conservatism in p<0.01.
Therefore a positive significant relation exists between the cost of equity capital and conditioned
conservatism. Also, the moderated determination is equal to 0.451985, showing that 45 percent of
dependent variable is explained by the independent variable.
The results of the second hypothesis:
COSTIT = ∝0 + ∝1 BETAIT + ∝2 LEVIT + ∝3 SIZEIT + ∝4 EVAREIT + ∝5 CON − RANK IT + εIT
Model (1)
The seceond hypothesis was defined as follows:
 H0: : Ex post conservatism does n, t has impact on cost of equity capital in Tehran stock exchange.
 H1: : Ex post conservatism has impact on cost of equity capital in Tehran stock exchange.
H0 : βi = 0
H1 : βI ≠ 0
p-value
0.1558
0.8207
0.001
0.1559
0.0243
2.374035
0.449769
Table 2
Dependent variable: cost of equity capital
-statistict
coefficient
Variable
1.42263
106.3633
BETA
-0.22681
-9.47E-10
LEV
-3.31653
-0.86458
SIZE
-1.42221
-106.51
EVAR
-2.26234
-0.0325
Ex post conservatism(BM)
Durbin-Watson
4.856087
F-statistic
2
Adjusted R
0.000000
Prob(F-statistic)
Based on Table 2, the significance of total regression is confirmed in certitude level of 0.99. The
coefficient of (-0.0325) shows a negative relation between cost of equity capital and unconditioned
conservatism. The P-value of
0.0243, related to independent variable coefficient in t parameter,
corroborates a significant relation between cost of equity capital independent variable and unconditioned
conservatism in p<0.01.
Therefore a negative significant relation exists between the cost of equity capital and unconditioned
conservatism. Also, the moderated determination is equal to 0.451985, showing that 45 percent of
dependent variable is explained by the independent variable.
Results and Discussion
In the present study, accounting conservatism was divided into two categories: pre-incidence
conservatism (unconditioned) and post-incidence conservatism (conditioned) .Barth et al (2005) believed:
Using the estimation in financial statements will affect the profit and it may leads to be different from actual
result of corporate performance. So, the reported profit will differ from the actual profit; as a result, it won’t
have enough objectivity.Therefore, such a profit is considered as an unqualified one, and the investor is
ready to dispose his/her resources to the company with expect of gaining a higher output. Since the risk of
losing the fund is increasing for them. Hence, by applying conditioned conservatism based on undesirable
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estimation (guessing the occurrence of bad news), the profit quality decreases and fund expense increases,
in turn. Examining the hypotheses of this study confirmed this issue, too. The results of these hypotheses
revealed that the higher rate of post-incidence conservatism (conditioned), the lower profit quality and the
higher fund expense will be (a positive relation between conditioned conservatism and fund expense). On
the other hand, the pre-incidence conservatism (unconditioned) accommodates with acceptable profit quality
and lower fund expense (a negative relation between unconditioned conservatism and fund expense). It
should also be noted that the findings of the present research are consistent with those of chen et al (2009).
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