S&P 500 Membership and Managers’ Supply of Conservative Financial Reports

• Published date: 01 May 2016
• DOI: http://doi.org/10.1111/jbfa.12200
• Date: 01 May 2016

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(5) & (6), 543–571, May/June 2016, 0306-686X

doi: 10.1111/jbfa.12200

S&P 500 Membership and Managers’

Supply of Conservative Financial Reports

GREGORY W. MARTIN,∗WAYNE B. THOMAS AND MATTHEW M. WIELAND

Abstract: Our study is motivated by economic theory and the debate among practitioners,

standard setters, and academics on the role of conditional conservatism in financial reporting.

We find that managers provide less conditionally conservative financial reports after their

firms are added to the Standard and Poor’s (S&P) 500 index. S&P 500 membership is

expected to reduce information asymmetry between managers and outside stakeholders due

to an increased flow of public and private information. As a result, the contracting benefits

of conservative accounting choices are reduced, and managers are less willing to provide

conditionally conservative reports. In contrast, we find that managers provide more conditionally

conservative financial reports after their firms are deleted from the index. Firms being deleted

from the S&P 500 index probably incur an increase in information asymmetry. Overall, our

results provide evidence consistent with conditional conservatism being a response by managers

to the information needs of financial statements users.

Keywords: conservatism, S&P 500, information asymmetry, earnings quality, agency theory

1. INTRODUCTION

In this study we examine the change in firms’ conservatism around addition to

or deletion from the Standard and Poor’s (S&P) 500 index. Changes in S&P 500

membership are expected to have a significant effect on the firm’s information

asymmetry and therefore affect the contracting benefits of conservative accounting.

Our study is motivated by the current debate over the role of conservatism (prudence)

in financial reporting (Andr´

e et al., 2015; Mora and Walker, 2015; Ruch and Taylor,

2015).

The FASB’s conceptual framework (SFAC 8) rejects unconditional conservatism

based on the notion that it compromises neutrality, even though conditional

∗The first author is from the University of North Carolina-Charlotte; the second author is from the University

of Oklahoma; the third author is from Miami University.The authors thank Brad Badertscher, Brian Burnett,

Daniel Beneish, Joe Fisher, John Hassell, Nathan Stuart, Jim Wahlen, and workshop participants at Indiana

University,University of Notre Dame, and Purdue University for their helpful comments on this manuscript.

The authors wish to thank an anonymous referee and Martin Walker (Editor) for helpful comments and

suggestions on earlier versions of this paper. (Paper received July 2015, revised revision accepted February

2016).

Address for correspondence: Gregory W. Martin University of North Carolina-Charlotte, 9201 University

City Blvd. Charlotte, NC 28223.

e-mail: gmarti44@uncc.edu

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conservatism is mandated in many recent standards (e.g., SFAS 121, 142, 144).1While

the IASB’s conceptual framework retains the term prudence (IASB ED-2015-3), the

Basis for Conclusion notes the view by some that prudence could lead to greater

subjectivity and lack of neutrality in financial statements, making it difficult to assess

an entity’s financial performance.2Some academic research corroborates this view by

finding that conditional conservatism reduces the usefulness of accounting information

(Dichev and Tang, 2008; Gigler et al., 2009; Chen et al., 2014). There is also concern

that conservatism allows for the creation of hidden reserves or excessive provisions

in the current period which can be used to strategically manage earnings upward in

future periods (Paton, 1932, pp. 421–422; CAP, 1939; Levitt, 1998 (unconditional);

Jackson and Liu, 2010 (conditional)).

In contrast, the IASB also discusses the views by others that prudence may increase

the usefulness of accounting information to the firm’s stakeholders. The Basis for

Conclusions suggests that prudence can reduce moral hazard by better aligning the

interests of managers and shareholders, is needed to counteract management’s natural

bias towards optimism, and is consistent with investors’ greater concern for downside

risk. These benefits suggest that the existence of conservatism can be explained by

its contracting role in the presence of information asymmetry (Watts, 2003).3These

views are also confirmed in prior research that documents an association between debt

contracting and conservative accounting (e.g., Wittenberg-Moerman, 2008; Zhang,

2008; Nikolaev, 2010; Tan, 2013; Khurana and Wang, 2015). Creditors are more

likely to use their bargaining power (through cost of debt) to demand timelier

recognition of losses because they face downside risk. Other stakeholders are also

likely to use their bargaining power to demand conservative accounting, such as strong

boards of directors (Beekes et al., 2004; Ahmed and Duellman, 2007), large investors

(Ramalingegowda and Yu, 2012; Cheng et al., 2015), big auditors (Krishnan, 2005;

2007; Cano-Rodriguez, 2010), and material customers and suppliers (Hui et al., 2012).

The literature argues that these parties demand conservatism, and managers respond

because the contracting benefits outweigh the costs of doing so.

We examine the link between conservative accounting and information asymmetry

using a sample of firms that are added to and deleted from the Standard and

Poor’s (S&P) 500 index. This setting for investigating whether managers’ supply of

conservatism is affected by information asymmetry is useful for several reasons. First,

managers and board members cannot select their own firm for membership, nor are

they likely to be able to predict such an event far in advance. Instead, our research

setting allows us to test the extent to which managers adjust their level of conservatism

in response to membership announcement. Our setting includes an exogenous shock

to a firm’s information environment, which allows us to infer a causal link between a

change in information asymmetry and conditional conservatism.

1 Beaver and Ryan (2005) adopt the term “conditional conservatism” to distinguish the asymmetric

timeliness of gain/loss recognition from “unconditional conservatism”, the predetermined understatement

of the book value of net assets. In this paper, we focus exclusively on conditional conservatism but for

expediency often refer to it simply as “conservatism”.

2 The Basis for Conclusion discusses both “cautious prudence” and “asymmetric prudence”, where the latter

relates more closely to the concept of conditional conservatism.

3 The existence of conservatism may also be explained by the firm avoiding litigation, income taxes, political

costs and reducing the cost of debt and equity capital (Basu, 1997; Watts, 2003; Qiang, 2007).

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