Accounting Conservatism in Borrowers’ Financial Reporting and Earnings Management

Purpose This study examines the association between conservatism in borrowers’ financial reporting and their earnings management behavior. Methodology Based on non－financial companies listed on KOSPI and KOSDAQ for the fiscal years from 2012 to 2021, we find the effect of bank loans on conservatism in borrowers’ financial reporting and their earnings management. We calculate earnings management by using the absolute value of discretionary accruals from the modified Jones model (Dechow et al. 1995) and the absolute value of discretionary accruals from the performance－matched discretionary accrual model (Kothari et al. 2005). We measure the value of firm－year accounting conservatism from Khan and Watts’ (2009) conservatism scores. Findings We find that earnings management behavior of a borrowing firm decreases as the firm’s accounting conservatism increases. Implications The results of this study indicate that firms’ accounting conservatism in financial reporting plays an effective role in constraining their earnings management behavior. In addition, results imply that conservatism in financial reporting has an incremental contribution to the governance role of banks in constraining borrowing firms’ opportunistic reporting behavior. Overall, the findings of this study demonstrate that accounting conservatism plays a complementary role to a bank’s monitoring function.