How to model accounting robustness

Basu's accounting robustness model is: EPS/P = β1 + β2*DR + β3*R + β4*DR*R + ε ? Equation ① ? (Note: where P represents the closing price of the company in the previous year; R represents the stock return; DR=0 when R>0; DR=1 when R<0.)

G-Score=β3=μ1+μ2*Size+μ3*Lever+μ4*MB ? Equation ②.

C-Score=β4=λ1+λ2*Size+λ3*Lever+λ4*MB Equation (iii).

Substituting Eqs. ② and ③ into Eq. ① yields μ1μ2μ3μ4, and λ1λ2λ3λ4. Then substituting λ1λ2λ3λ4 into Eq. ③ yields the C-Score, which is the degree of firm-level accounting robustness.

Accounting robustness refers to the principle of robustness in financial accounting, also known as the principle of prudence or the principle of caution. For the income statement, the usual meaning of the principle of soundness is to anticipate expenses but not revenues, and for the balance sheet, the principle of soundness is not to overestimate assets and not to underestimate liabilities, which results in not overestimating profits and not overestimating net assets. Accounting robustness indicators can be measured by accounting indicators or market indicators.

Accounting indicators. Over the life of any business, realized profits and net cash received are equal. Due to accrual requirements, businesses report profits in installments, and if profits are reported high in earlier periods, they will be reported lower in later periods. The level of profit can be measured by cash flow.

Anticipating expenses without anticipating revenues means recognizing expenses before cash is paid and recognizing revenues after cash is received, or delaying revenue recognition until uncertainty is removed. Thus, the robustness of accounting is demonstrated by the fact that current profits are lower than net cash. If profits are consistently higher than net cash for a given time period, the firm may be systematically overestimating profits, which are aggressive.

The reverse is true for robust profits. Accounting robustness can be demonstrated by specific accruals, such as accounts receivable, advance receipts, projected liabilities, and asset impairments, and by accounting policies, such as depreciation lives and bad debt ratios.

It is worth noting that payable items actually become a means of financing for the enterprise and do not have an impact on current profit and loss. Therefore, the increase in items payable should be deducted when measuring accounting soundness.

Through the above analysis, we can use the following indicators to measure accounting robustness: accounting robustness = net profit - net cash flow from operating activities - increase in operating payables. Anticipating expenses without anticipating revenues often manifests itself in early recognition of expenses and delayed recognition of revenues, but this is merely a record on the accounting books, and no actual cash receipts or payments occur. The opposite can have a negative impact on the business.

Accounting information is of predictive value, and if aggressive accounting policies are adopted and investors use them as a basis for predictions, and losses occur in the future, investors or the market will revalue the company, which will obviously hurt investors' interests.

A robust accounting policy will automatically avoid such losses to investors. In reality, company directors and accounting firms are often sued for overestimating assets and profits, but rarely for underestimating assets and profits.

Creditors are at an informational disadvantage relative to the company's shareholders; suppliers and customers, small and medium-sized shareholders, and government agencies are at an informational disadvantage relative to the company's management and majority shareholders. Uncertainty about future profitability implies business risk, and current higher dividends transfer too many resources to shareholders.

Creditors will therefore demand more robust accounting information, which will reduce excessive dividend payments. Similarly, suppliers and customers do not want to expose themselves to losses due to the company's business risks, and robust accounting information helps to protect their interests.

It is because of the various benefits of robust accounting information that accounting standard-setting bodies also tend to favor accounting standards that conform to the characteristics of robustness and protect the party at an information disadvantage. For example, the Circular of the Ministry of Finance on Improving the 2007 Annual Reports of Listed Companies requires that listed companies should adopt the principle of robustness in preparing their annual reports.

Robustness has become one of the typical features of accounting information reflecting differences in institutional background and differences in accounting standards. Timely recognition of losses is not only an important feature of the quality of financial reporting, but also gradually improves the usefulness of financial reporting and affects the development and implementation of accounting standards.