Accounting conservatism and banking expertise on board of directors

Abstract

Previous studies show mixed evidence of the role of banking expertise on the board of directors on accounting conservatism. In this paper, we add to this growing literature by providing an innovative way to measure banking expertise based on life-time working history in banks of all individual directors on the board. We find that accounting conservatism is negatively affected by banking expertise on the board. Also, the results indicate that banking expertise on the board has a more pronounced impact on accounting conservatism when firms have high bankruptcy risk and when firms have high financial leverage. The evidence has some implications for boards of directors.

Appendix: Variable definitions

Variable	Definitions
Accounting conservatism measures
CONS_RANK	Annual fractional rank of the three-year average of total accounting conservatism (García Lara et al. 2016), where total accounting conservatism is the sum of the timeliness of good news (GSCORE) and the asymmetric timeliness of bad news over good news (CSCORE) estimated by the model of Khan and Watts (2009), which is based on Basu (1997). We calculate the average of total accounting conservatism across years t − 2, t − 1, and t (denoted $aCONS_{i,t}$); then rank $aCONS_{i,t}$ of all firms for each year; and divide the rank values by N + 1, where N is the total observations in each rank group. We refer to the new variable as the annual fractional rank of total accounting conservatism
CSCORE_RANK	Annual fractional rank of the three-year average of CSCORE (Basu 1997; Khan and Watts 2009)
NOACC_RANK	Annual fractional rank of the three-year average of the negative accumulation of non-operating accruals (Givoly and Hayn 2000). The calculation of negative non-operating accruals is as follows: $NOACC_{i,t} = - 1*\left\{ {TABD_{i,t} - OA_{i,t} } \right\} = - 1*\left\{ {\left[ {\left( {NI_{i,t} + DEP_{i,t} } \right) - CFO_{i,t} } \right] - \left[ {\Delta REC_{i,t} + \Delta INV_{i,t} + \Delta PREPAID_{i,t} - \Delta PAY_{i,t} - \Delta TAX_{i,t} } \right]} \right\}$ where $NOACC_{i,t}$ is negative non-operating accruals at the end of year t; $TABD_{i,t}$ is total accruals before depreciation and amortisation at the end of year t; $OA_{i,t}$ is operating accruals at the end of year t; $NI_{i,t}$ is net income in year t; $DEP_{i,t}$ is depreciation and amortisation in year t; $CFO_{i,t}$ is cash flows from operations in year t; $\Delta REC_{i,t}$ is change in account receivables from the end of year t − 1 to the end of year t; $\Delta INV_{i,t}$ is change in inventories from the end of year t − 1 to the end of year t; $\Delta PREPAID_{i,t}$ is change in prepaid expenses from the end of year t − 1 to the end of year t; $\Delta PAY_{i,t}$ is change in account payables from the end of year t − 1 to the end of year t; $\Delta TAX_{i,t}$ is change in tax payables from the end of year t − 1 to the end of year t. All variables are scaled by total assets at the end of year t. i represents company i and t represents fiscal year t
Banking expertise measures
yEXPERTISE	Total number of years all directors on the board have worked as executives in banks
aEXPERTISE	Total number of banks for which all directors on the board have worked as executives
EXPERTISE	The presence of banking expertise on the board, which is equal one if a company has at least one director on board who has worked as an executive in a bank, zero otherwise
mEXPERTISE	Average number of years all directors on the board have worked as executives in banks, which is equal yEXPERTISE divided by the number of board members
Other variables
$\Delta SALE$	Sale growth, which is equal change in sales from year t − 1 to year t, scaled by total assets at the end of year t
ACC	Accruals which are calculated as follows: $ACC = \Delta INV + \Delta REC + \Delta OCA - \Delta PAY - \Delta OCL - DEP$, where $\Delta INV$ is change in inventories from the end of year t − 1 to year the end of year t, $\Delta REC$ is change in receivables from the end of year t − 1 to year the end of year t, $\Delta OCA$ is change in other current assets from the end of year t − 1 to year the end of year t, $\Delta PAY$ is change in payables from the end of year t − 1 to year the end of year t, $\Delta OCL$ is change in other current liabilities the end of year t − 1 to year the end of year t, $DEP$ is depreciation and amortisation in year t
AT	Total assets
CASH	Ratio of cash to total asset at the end of year t
CFO	Cash flow from operations, which equals to net income before extraordinary items ($IB$) minus accruals ($ACC$) in year t, scaled by assets at the end of year t
CYCLE	Business life cycle (Dickinson 2011), which is a dummy variable is equal one if firms are classified based on cash flows as at mature stage (positive cash flows from operating activities, negative cash flows from investing activities, and negative cash flows from financing activities), and zero if firms are classified as at young stage (negative cash flows from operating activities, negative cash flows from investing activities, and positive cash flows from financing activities), or growth stage (positive cash flows from operating activities, negative cash flows from investing activities, and positive cash flows from financing activities)
D	A dummy variable that equals one if $RET$ < 0, and zero otherwise
DCFO	A dummy variable which equals to one if $CFO$ < 0, and zero otherwise
DEBTISSUE	Debt issue, which is a dummy variable with the value of one if the change in short-term and long-term debts from the end of year t − 1 to the end of year t
EARN	Net income before extraordinary items in year t, scaled by market value of equity at the end of year t − 1
IB	Net income before extraordinary items
LEV	Financial leverage, which is the sum of long-term and short-term debts at the end of year t, scaled by the market value of equity at the end of year t
MTB	Market to book ratio, which is equal to market value of equity divided by book value of equity at the end of year t
PPE	Ratio of property plant and equipment (gross) to total assets at the end of year t
RET	Buy-and-hold stock returns for the period from the beginning to the end of fiscal year t
SALE	Sales
SEO	Equity issue, which is a dummy variable with the value of one if a firm increases outstanding shares in year t at least 5% with positive proceeds from equity issuance, zero otherwise
SIZE	Firm size, which is the log of the market value of equity at the end of year t
ZSCORE	Financial distress at the end of year t, measured by $ZSCORE$ following (Taffler 1983) as follows: ${\text{ZSCORE}} = 3.2 + 12.18 *\frac{\text{Profit before tax}}{\text{current liabilities}} + 2.50 *\frac{\text{Current assets}}{\text{Total liabilities}} - 10.68 *\frac{\text{Current liabilities}}{\text{Total assets}} + 0.029 *\frac{{\left( {{\text{Quick assets}} - {\text{Current liabilities}}} \right)}}{{\left( {{\text{Sales}} - {\text{Pretax income}} - {\text{Depreciation}}} \right)/365}}$