Bank-Firm Relationships and Accounting Conservatism: Evidence from Japan

Abstract

Banks play a central role in corporate governance in many economies around the world. We compare the extent of conditional and unconditional conservatism between firms with and without close working relationships with their banks in order to gain insights into how bank-firm relationships affect the conservatism of financial reports. When bank-firm relationships are strong, we posit that investors will be less concerned about the timely recognition of economic losses (i.e., conditional conservatism should be weaker) because these investors can rely on the banks to monitor management. However, Japanese banks have incentives to direct managers to report lower earnings (i.e., to be unconditionally conservative) so that managers can benefit when negotiating payouts to the other takeholders. As predicted, empirical analyses reveal that firms with close bank-firm relationships recognize economic losses in a less timely manner, consistent with less conditional conservatism. and that these firms' accruals are more income-decreasing, consistent with greater unconditional conservatism.