Conservative Accounting, IFRS Convergence and Cash Dividend Payments: Evidence from China

• DOI: http://doi.org/10.1111/eufm.12114
• Date: 01 June 2017
• Published date: 01 June 2017

Conservative Accounting, IFRS

Convergence and Cash Dividend

Payments: Evidence from

China

William Bradford

Foster School of Business, University of Washington, Seattle, Washington 98195-3226 USA; and

Faculty Fellow, China Academy of Financial Research, Shanghai, China

E-mail: bradford@uw.edu

Chao Chen

School of Management, Fudan University, 670 Guoshun Road, Siyuan Building #314, Shanghai, China

200433

E-mail: chen_chao@fudan.edu.cn

Song Zhu

Business School, Beijing Normal University, 19# Xinjiekouwai Street, Beijing, China 100875

E-mail: zhusong@bnu.edu.cn

ABSTRACT

We investigate the governance role of conservative accounting in mitigating the

creditor–stockholder conflict by affecting firms’dividend policies, and how

the convergence to International Financial Reporting Standards (IFRS) affects the

governance role of conservative accounting as it relates to dividend policy. We

analyze data on Chinese listed firms from 2000 through 2011. The use of

conservative accounting reduced cash dividend payouts, thereby playing a

governance role by mitigating the firm’s creditor–stockholder agency conflict.

However, China’s convergence to IFRS reduced the governance role of

conservative accounting on dividend policy by reducing the accounting

conservatism of listed firms in China.

Keywords: accounting conservatism, mandatory IFRS adoption, cash dividend

policy

JEL classification: G32,G35,G38

The authors thank Terry Shevlin, Lloyd Tanlu and two anonymous referees for helpful comments

on earlier versions of this paper. We acknowledge the support of the National Natural Science

Foundation of China (Chao Chen, Project No. 71472048 and Song Zhu, Grant No. 71302023).

European Financial Management, Vol. 23, No. 3, 2017, 376–414

doi: 10.1111/eufm.12114

© 2017 John Wiley & Sons, Ltd.

1. Introduction

Accounting Conservatism, an important aspect of the quality of accounting information,

affects the information asymmetry between stakeholders (LaFond and Roychowdhury,

2008; LaFond and Watts, 2008) and related agency problems (Watts, 2003), thus

significantly influencing the efficiency of a firm’sfinancing and investing activities

(Biddle and Hilary, 2006; Liang and Wen, 2007; Zhang, 2008b; Garc

ıa Lara et al., 2011).

Scholars have investigated the governance role of accounting conservatism in reducing

agency costs between creditors and shareholders in cash dividend payouts and found that

in Western countries, accounting conservatism can effectively reduce the cash payment

to shareholders (Zhang, 2008b; Louis and Urcan, 2015).

We use firms listed on Chinese stock exchanges to explore the relationship between a

firm’s cash dividend policy and its use of accounting conservatism. On 1 January 2007,

China adopted a new set of Chinese accounting standards (CAS) that substantially

converge with the International Financial Reporting Standards (IFRS; Deloitte Touche

Tohmatsu, 2006; DeFond et al., 2011; Ke et al., 2012).

1

This study also investigates how

the IFRS affect the information quality and, thereafter, cash dividend payments of firms

that are listed on Chinese stock exchanges.

Since China is the world’s largest developing economy and the second largest

economy overall, there is justifiable interest in the dividend policy of Chinese listed

firms. More importantly, China’s unique institutional setting provides a rich backdrop to

examine how conservative accounting under domestic and international accounting

standards affects firms’financial decisions. Dividend policy is a major financial decision

of China’s publicly listed firms because, among other reasons, from 1999 through 2012,

nearly half of the total return of the MSCI China Index came from dividends paid to

stockholders (Levisohn, 2013).

The institutional setting in China is different from that in the US and other developed

countries, and we highlight four institutional traits that distinguish China. First, publicly

traded firms in China include state-owned firms (SOEs). It is important to understand

how government ownership affects the use and efficacy of accounting conservatism and

firms’dividend policies. This study compares the differences in accounting conservatism

between SOEs and non-state-owned enterprises (NSOEs), the differences between SOEs

and NSOEs on the impact of accounting conservatism on dividend policy, and how these

relationships changed after China’s convergence to IFRS.

Second, China is considered to have a weak judicial system as it relates to business

transactions, but its judicial system has been developing along with its economy. In

countries with strong judicial systems, accounting reports are more conservative; firms in

these countries tend to reflect bad news in earnings more quickly than firms in countries

with weak judicial systems (Ball et al., 2000; Ball et al., 2003; Holthausen, 2003;

Bushman and Piotroski, 2006). However, Xia and Zhu (2009) show that with the

1

Deloitte Touche Tohmatsu (2006) provides a detailed comparison of the old Chinese GAAP

and the IFRS standards that were adopted. In this publication, Sir David Tweedie, then

Chairman of the International Accounting Standards Boards states (p.1): ‘The adoption of the

new Chinese accounting standards system brings about substantial convergence between

Chinese standards and International Financial Reporting Standards (IFRSs), as set by the

International Accounting Standards Board (IASB)’.

© 2017 John Wiley & Sons, Ltd.

Conservative Accounting, IFRS Convergence and Cash Dividend Payments 377

implementation of more conservative accounting standards and the enforcement of

regulations, the financial reporting of firms in China has been more conservative since

2001. In addition, Chen et al. (2010) provide evidence that China’s legal system enforces

debt provisions and debt covenants of listed firms in China including restrictions that

limit dividends.

With regard to the effect of IFRS on accounting quality, Ahmed et al. (2013) –who did

not include China in their study –conclude that the convergence to IFRS does not affect

accounting quality in weak enforcement countries. We note that judiciary systems are

multifaceted and the ‘weakness’of laws and law enforcement can vary across the

business spectrum, thus affecting some decisions less than others. Our study considers

how, in China’s transitioning weak judicial system setting, accounting conservatism

impacts dividend policy and how that impact has changed after the adoption of the IFRS.

Third, until 2004, government entities in China that owned common stock of listed

firms could not easily sell their shares at the current market price. A dominant method for

getting cash from holding shares was through the firm paying dividends. Subsequent to

2004, the shares held by government entities became saleable (via the Chinese

government’s‘split share structure reform’), and thus the pressure on SOEs to pay

dividends was reduced. We include controls for the pre- and post-split share structure

reform periods and thus explore the role of accounting conservatism on dividend policy

both before and after the split share structure reform in China.

Fourth, unlike the US, in China, both the government and private investors control a

large number of listed firms through pyramid structures (Fan et al., 2005; Zhu, 2006).

Corporate ownership through pyramid structures is popular around the world (the US

and UK excluded) due to the private benefits of control rights (Attig et al., 2003).

Pyramid structure ownership is more prevalent in countries and regions with weaker

laws and undeveloped economies (La Porta et al., 1999; Claessens et al., 2000). Ultimate

owners (those at the apex) of the pyramid can control multiple resources relative to their

investment through a corporate pyramid structure. We explore how the ownership of the

ultimate shareholder affects the conservatism of firms’accounting before and after the

adoption of IFRS in China. We also examine how ultimate shareholder ownership

interacts with conservative accounting to affect the dividend payout of firms in China.

The determinants of firms’dividend policies have long been the source of interest and

inquiry for business scholars (Lintner, 1956; Miller and Modigliani, 1961; Black, 1976).

Agency theory suggests that dividend policy affects the stockholder–creditor conflict

because paying cash dividends to stockholders reduces the funds available to pay

creditors’claims (Jensen and Meckling, 1976). Overpayment of cash dividends to

shareholders will damage the interests of creditors and may lead to the inefficiency of

debt contracts. Accounting scholars propose that conservatism can enhance the

efficiency of debt contracting (Watts and Zimmerman, 1986; Watts, 2003) and protect

creditors because conservative accounting dampens the reported net income and retained

earnings, which can reduce cash dividends (Watts and Zimmerman, 1986). There is,

however, little evidence on the debt-contracting benefits of conservatism (Ahmed et al.,

2002; Moerman, 2008; Zhang, 2008b; Nikolaev, 2010), and even less research in

emerging markets with weak investor protections on whether conservative accounting

can mitigate the creditor–stockholder agency conflict by reducing cash dividends

(Frankel et al., 2008).

The accounting literature devoted to assessing the consequences of mandatory IFRS

adoption around the world is abundant and growing, but the related research is

© 2017 John Wiley & Sons, Ltd.

378 William Bradford, Chao Chen and Song Zhu