Accounting Conservatism & Earnings Management: An Australian View

This essay investigates the influence of accounting conservatism on earnings management practices within Australian firms. It begins by highlighting the differing interests of stockholders and debt providers, emphasizing how conservatism in financial reporting can protect creditors from excessive dividend payouts. The study examines the practical motivations for earnings management, driven by executive bonuses and stock options, and the theoretical gap in research regarding the relationship between earnings management and accounting conservatism in Australia. The literature review covers earnings management, agency theory, and the negative correlation between earnings management and accounting conservatism, alongside a review of existing research on the topic. The essay concludes by proposing a hypothesis that accounting conservatism at the organizational level significantly influences a corporation's earnings management.

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 1
INFLUENCE OF ACCOUNTING CONSERVATISM ON A FIRM’S EARNINGS
MANAGEMENT: AN AUSTRALIAN PERSPECTIVE
By:
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Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 2
Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective
Introduction
Different firms practice conservatism differently. Both the stockholders and the debt
providers do not have the same interests in the corporations. The shareholders try to take a
considerable amount of dividends at the expense of the creditors especially where the businesses
have a big executives’ ownership structure (Boyd and Solarino 2016). Due to this structure, the
managers decide to give the stockholders dividends in surplus. Therefore, the shareholders’
interest is to maximize on the dividends. On the other hand, the debt providers require that the
corporations secure their monies in order to get returns in the future. Therefore, the debt
providers require the companies to practice conservative financial reporting in order for them to
be safe from the stockholders who transfer the earnings that the firm makes by taking too much
dividends (Guay and Verrecchia 2018). According to Guay and Verrecchia (2018), conservatism
decelerates the recognition of income and increases the recognition of expenses, hence, it
triggers the accounting estimation. The present study is vital, since, it will assist both the
stockholders and the debt providers to understand the businesses that produce the reliable
financial reports in order to maximize their dividends and returns respectively in the future.
Practical Motivation
Firms’ executives get pressure when managing the earnings and through the accountants,
they manipulate the corporations’ accounting practices in order to realize what they expect
financially while keeping the share prices of the business up (Mao and Renneboog 2015). Most
of the managers obtain bonuses depending on how the earnings perform while some might

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 3
qualify for stock options, which create an income when their prices improve. Auditors do not
disclose several forms of earnings’ manipulation, therefore, shareholders remain in the dark.
Therefore, the executives who mind about the firms’ stockholders will find the current research
helpful because they will get its findings, which will suggest the methods to reduce the pressure
that they get when managing the earnings. By following the proposed ways, the firms will
produce true financial statements that the shareholders will rely on when making investment
decisions.
Theoretical Motivation
Scholars have carried out a lot of studies about the firms’ earnings management in
various parts of the globe but not many have studied the relationship between the firms’ earnings
management and accounting conservatism especially in Australia. Hence, the present research
will concentrate on that association in Australia. According to Akdogan and Ozturk (2015),
managers must explain any variation in the accounting principles to the users of the financial
accounts by disclosing in the footnotes of the statements. These disclosures would ensure that
there is consistency and the financial accounts become comparable, thereby, exposing any
manipulation of the earnings. The current study will improve on the prevailing theory because it
will demonstrate how the executives should manage the earnings of their firms in order to avoid
giving misstatements and help the financial accounts’ users to make prudent investment
decisions.
Literature Review
This section discusses the earnings management, agency theory, and the relationship
between a firm’s earnings management and accounting conservatism.

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 4
Firm’s Earnings Management and its Relationship with Accounting Conservatism
Earnings management is a situation where the managers of a firm use the accounting
methods to come up with financial accounts, which exaggerate a corporation's commercial
activities and financial position in a positive way. According to Ali and Zhang (2015), several
accounting rules and principles allow business managers to make their decisions by following
them. Ali and Zhang assert that the earnings management such benefits of the accounting and
principles to create financial reports, which inflate the income and assets of the firms, hence,
smooth out variations in earnings and show consistent returns either monthly or annually.
There is a negative relationship between the firm’s earnings management and accounting
conservatism. Conservatism is a principle, which tries to create the asset and income values,
hence, decelerates the recognition of revenue while accelerating the recognition of expenses.
According to Lara, Osma, and Penalva (2016), conservatism slows the future cash inflows
recognition and allows the accountants to report the highest liabilities’ values, and the lowest
assets and revenues’ values, therefore, producing the lowest equity book values. Conservatism
produces high profits, since, the principle does not allow companies to exaggerate their earnings,
thus, assists the accounting information users as they present earnings and assets that they do not
overstate (Guan 2014). Therefore, the organizations’ managers and accountants might require to
start using accounting conservatism when calculating the values of the assets and incomes in
order to enhance the revenues’ quality for the stakeholders to use when evaluating the business.
Agency Theory
The agency theory expounds on the association that exists between a business’s
principals and the agents. According to Pepper and Gore (2015), the purpose of agency theory is

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 5
to resolve the challenges that arise in agency relations because of the objectives that are not
aligned or when the levels of averting risk are different. Pepper and Gore assert that in finance
the commonest agency association happens between the shareholders who are the principals and
the corporation’s executives who are the agents. Agency problems might happen due to the
principal not being aware of the agent’s activities or the lack of funds prohibit him or her from
getting the information (Chari, David, Duru, and Zhao 2018). For instance, the firm’s managers
might wish to grow the corporation to other marketplaces, which will take much of the current
profits of the business as the executives prospect more incomes. On the other hand, the
shareholders who want more growth in the current capital might not be aware of the managers’
strategies.
According to Eisdorfer, Giaccotto, and White (2015), Jensen and Meckling are the ones
who proposed the agency theory in 1976 by defining the corporations' managers as the "agents"
and the shareholders as the "principals". Jensen and Meckling acknowledged that shareholders
are at odds with the directors because the shareholders delegate decision-making to the
managers. However, the challenge is that the directors do not make decisions in the favor of the
shareholders. Jensen and Meckling posited that agency theory assumes that the "agents" and the
"principals" have a conflict of interest. The views of the two were that what motivates the
managers is in their private interests, which conflicts with the interests of the shareholders to
maximize wealth. This opinion posits that the motivations, which include rewards, contracts,
political motivations, tax incentives, and changing the Chief Executive Officer (CEO), are some
of the major earnings management inducements.

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 6
The Review of Literature
Nahandi, Baghbani, and Bolouri (2012) undertook a study about the earnings
management and accounting conservatism with a case study of Iran. The scholars investigated,
“the relationship between earnings management and accounting conservatism in Iranian firms.”
Nahandi, Baghbani, and Bolouri measured the earnings management using the modified Jones
model while they measured conservatism using the Basu (1997) model. The scholars studied the
firms listed in Tehran Stock Exchange between 2001 and 2008, and used the systematic omission
method to get the sample and the ordinary least squares (OLS) regressions to test the relationship
between earnings management and accounting conservatism. Nahandi, Baghbani, and Bolouri
found out that the association between the earnings management and accounting conservatism is
negative. The organizations whose earnings management was at low levels appeared to possess
big asymmetric timeliness coefficients while the institutions whose earnings management was at
high levels had small asymmetric timeliness coefficients.
Zhang (2012), in his research about, “the empirical study of earnings management based
on Chinese listed companies” used the margin return on equity (ROE) and the Jones model in the
empirical examination on the selected manufacturing firms in China. From the results, Zhang
found out that changing of accounting principles does not escalate the earnings management
although sometimes it can go up slightly, hence, not statistically significant.
Martin and Roychowdhury (2015), in their study about, “Do financial market
developments influence accounting practices? Credit default swaps and borrowers׳ reporting
conservatism” studied how conservatism relates to both the accrual and real earnings
management. The authors used a large sample of the banks from1991 to 2010. From the results,

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 7
Martin and Roychowdhury found out that there is a positive relationship between conservatism
and the real earnings’ management and a negative relationship between conservatism and the
accruals interference’s measures.
Abbasiazadeh and Zamanpour (2016) studied about, “Investigation of the Effect of Audit
Size on Earnings Management in Tehran Stock Exchange.” The authors investigated the effect of
audit size on the earnings management in the 116 corporations registered with the Tehran stock
market from 1387 to 1392. Abbasiazadeh and Zamanpour tested earning management using
multiple regressions. The authors used a sample of 5 corporations that are listed on the stock
market and utilized the Excel statistical tool for analysis. From the findings, Abbasiazadeh and
Zamanpour established that the audit size and tenure are significantly correlated to the earning
management.
Hosseini, Chalestori, Hi, and Ebrahimi (2016), in their study about, “the relationship
between earnings management incentives and earnings response coefficient” used a sample of
100 firms listed in Tehran Stock Exchange. The authors studied the firms from 2007 to 2013 and
statistically analyzed the data collected at a 95% confidence level using the coefficient of
correlation. Hosseini, Chalestori, Hi, and Ebrahimi used the multivariate linear regression model
to test the hypothesis of the study. From the findings, the authors established that there is no
relationship between the earnings management incentives and the earnings response coefficient.
Saghafi (2016) studied about, “examining the relationship between disclosure levels,
ownership structure, and earning management in the Tehran stock exchange.” The author studied
143 companies that are registered with Tehran stock market from 2005 to 2014 with an aim of
examining the effect of the various disclosure levels and methods on the firms’ earnings

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 8
management. From the findings, Saghafi established that there is a positive and significant effect
of the ownership of organizations on earnings management. In addition, Saghafi established that
there is a negative and significant effect of disclosure on the firm’s earnings management. The
size of the organization also has a positive correlation with the earnings management while
financial leverage has a negative effect. Therefore, from these findings, it is prudent that the
investors and key shareholders take part in supervision in order to enhance the company’s
performance. Their supervision will also assist in aligning their interests with those of the
executives in order to reduce the agency problems.
In his research about, “the effect of accounting conservatism on earning quality”, Asri
(2017), studied the corporations registered with the Indonesian stock exchange from 2010 to
2015 using the purposive sampling technique to get the representative sample of the population.
Asri found out that conservatism positively affects the earning quality and, therefore, the
managers positively show the accounting conservatism’s use in the firm, hence, enhancing the
earnings’ quality. The investors get high values by offering high premiums on the business's
price of shares. From the literature reviewed above, it is established that there is a negative
relationship between firms’ earnings management and accounting conservatism. Some studies
show that there is a slight escalation in the earnings management when the firms change their
accounting principles.
Hypotheses
The accounting conservatism at the level of the organization influences the corporation's
earnings’ management.

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 9
Reference List
Abbasiazadeh, L. and Zamanpour, A., 2016. Investigation of the Effect of Audit Size on
Earnings Management in Tehran Stock Exchange. International Journal of Humanities
and Cultural Studies.
Akdogan, N. and Ozturk, C., 2015. A Country Specific Approach to IFRS Accounting Policy
Choice in the European, Australian, and Turkish Context. EMAJ: Emerging Markets
Journal, 5(1).
Boyd, B.K. and Solarino, A.M., 2016. Ownership of Corporations: A Review, Synthesis, and
Research Agenda. Journal of Management, 42(5).
Ali, A. and Zhang, W., 2015. CEO Tenure and Earnings Management. Journal of Accounting
and Economics, 59(1).
Asri, M., 2017. The Effect of Accounting Conservatism on Earning Quality, SSRN Electronic
Journal
Chari, M.D., David, P., Duru, A. and Zhao, Y., 2018. Bowman's Risk-Return Paradox: An
Agency Theory Perspective. Journal of Business Research.
Eisdorfer, A., Giaccotto, C. and White, R., 2015. Do Corporate Managers Skimp on
Shareholders' Dividends to Protect their Own Retirement Funds? Journal of Corporate
Finance, 30.
Guan, K., 2014. Corporate Growth, Audit Quality and Accounting Conservatism: Empirical
Evidence from Public Companies in China. Journal of Accounting and
Economics, 5(005).
Guay, W. and Verrecchia, R.E., 2018. Conservative Disclosure. Journal of Financial Reporting.

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 10
Hosseini, M., Chalestori, K.N., Hi, S.R. and Ebrahimi, E., 2016. A Study on the Relationship
between Earnings Management Incentives and Earnings Response Coefficient. Procedia
Economics and Finance, 36.
Lara, J.M.G., Osma, B.G. and Penalva, F., 2016. Accounting Conservatism and Firm Investment
Efficiency. Journal of Accounting and Economics, 61(1).
Mao, Y. and Renneboog, L., 2015. Do Managers Manipulate Earnings Prior to Management
Buyouts? Journal of Corporate Finance, 35.
Martin, X. and Roychowdhury, S., 2015. Do Financial Market Developments Influence
Accounting Practices? Credit Default Swaps and Borrowers׳ Reporting
Conservatism. Journal of Accounting and Economics, 59(1).
Nahandi, Y. B., Baghbani, S. M., and Bolouri, A., 2012. Earnings Management and Accounting
Conservatism: The Case of Iran. African Journal of Business Management, 6(19).
Saghafi, S., 2016. Examining the Relationship between Disclosure Level, Ownership Structure,
and Earning Management in the Tehran Stock Exchange. The Turkish Online Journal of
Design, Art, and Communication.
Pepper, A. and Gore, J., 2015. Behavioral Agency Theory: New Foundations for Theorizing
about Executive Compensation. Journal of Management, 41(4).
Zhang, Y., 2012. The Empirical Study of Earnings Management Based on Chinese Listed
Companies. Lingnan Journal of Banking, Finance, and Economics, 3(1).

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
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Appendix
Table – Annotated Bibliography for Selected Articles
Author Dat
e
Title Journal Type of
Paper
(Theoretic
al or
Empirical)
If empirical,
dependent and
independent
variables
100 word
summary of
contribution
to the
research
question
Abbasiazad
eh and
Zamanpour
201
6
Investigatio
n of the
Effect of
Audit Size
on Earnings
Managemen
t in Tehran
Stock
Exchange
International
Journal of
Humanities
and Cultural
Studies
Theoretica
l
Altering the
earnings
figures of a
firm helps
the managers
to cheat the
investors as
they give
positive
views on the
financial
reports to the
shareholders.
Such views

Influence of Accounting Conservatism on a Firm’s Earnings Management: An Australian
Perspective 12
are
important to
managers
but affect the
investors as
they depend
on the data
that
corporations
publish,
hence, invest
in them. The
conflicting
interests
arise because
of the
separation of
ownership
from the
executives,
thus,
motivating