Accounting Conservatism, Internal and External Governance, and Stock Price Crash Risk: Evidence from China

The proposed research aims to provide systematic evidence on the firm-level relation between accounting conservatism and stock price crash risk in China. Managers have incentives to overstate financial performance through strategically withholding (or selectively disclosing) bad news and accelerating the release of good news. If managers are able to withhold and accumulate bad news for an extended period, negative information is likely to be stockpiled within a firm. However, there is an upper limit to the amount of bad news that managers can absorb or accumulate: Once the amount of accumulated bad news reaches a tipping point, it will come out at once, leading to large, negative, firm-specific returns, i.e., stock price crashes.Accounting conservatism requires a higher degree of verification to recognize good news as gains than to recognize bad news as losses. The proposed research first predicts, and aims to provide evidence, that accounting conservatism reduces stock price crash risk for the following reason: Conservatism curbs managers’ incentives and ability to accelerate good news recognition, because unverifiable good news cannot be recognized as gains under conservative accounting. On the other hand, conservative accounting accelerates the recognition of (unverifiable) bad news into reported earnings by applying a lower verification standard for losses. Therefore, accounting conservatism deters unfavorable, negative information from being accumulated within a firm. Viewed this way, the more conservative is a firm’s accounting practices, the lower is the probability that firm-specific bad news is hidden and accumulated within a firm. As such, firms with conservative accounting practices are less likely to cross a tipping point or are more likely to reach such a point in a delayed manner, compared with firms with aggressive accounting practices. The primary research objective is to test the hypothesis that ceteris paribus, accounting conservatism reduces not only the likelihood of future crash occurrences, but also delays the timing of such occurrences. In addition, we also aim to provide evidence on whether the ability of conservatism to predict the likelihood and timing of future crash occurrences is accentuated for firms with concentrated ownership and less effective external monitoring.Given the scarcity of evidence on the issue, the results of the proposed research should provide useful insights into whether the lack of accounting conservatism plays a role in recent stock market crashes around the world, and are expected to offer important policy implications for accounting regulations in China and other emerging economies.