Ebook Accounting Conservatism and Corporate Investment
This paper examines the effects of accounting conservatism on managers’ investment incentives. Accounting literature on the relationship between these two factors is mixed. One strand of accounting literature argues that accounting conservatism can discipline managers and reduce agency costs related to over investment (Ball, 2001; Ball and Shivakumar, 2005). The other strand of literature suggests that accounting conservatism cause dysfunctional investment incentives for managers and induce them to forego positive net present value (NPV) projects resulting in underinvestment (Leuz, 2001; Watts, 2003a; Guay and Vierrecchia, 2006; Roychowdhury, 2010). Despite the debate, empirical studies examining the role of conservatism on firm investment are limited and only focus on how conservatism constrains over investment tendency. For example, Francis and Martin (2010) and Bushman et al. (2007) find that timely loss recognition constrains over investment incentives in merger and acquisition and cross-country settings. No studies so far investigate whether conservatism can also cause dysfunctional investment incentives. This study fills this gap and makes initial efforts to examine whether accounting conservatism can distort managers’ investment incentives.
One empirical challenge to distinguish the two competing but non-exclusive hypotheses is that both theories predict a negative correlation between conservatism and firm investments. To overcome this problem, I partition the sample into financially constrained and unconstrained firms. In particular, I focus on financially constrained firms and examine how accounting conservatism can affect investment incentives for those firms. The empirical strategy builds on two important findings from extent financial and accounting studies. First, finance literature show that financially constrained firms are more likely to forego positive NPV projects due to limited access to external capitals (Almeida, Campello, and Weisbach, 2004; Faulkender and Wang, 2006; Denis and Sibikov, 2010). Hence, ex ante, financially constrained firms are more likely to suffer underinvestment. Second, accounting literature argues that accounting conservatism can reduce information asymmetry between lenders and borrowers and consequently reduce borrowers’ cost of capital (Ahmed et al, 2006; Zhang, 2009; Garcia Lara, Garcia Osma, and Penalva, 2010a).
If accounting conservatism doesn’t distort managers’ investment incentives, then we should expect accounting conservatism mitigate the adverse effects of financial constraints on firm investments. Ceteris paribus, firms with high conservatism will invest more for financially constrained firms, and we expect a positive correlation between conservatism and firm investments. However, if accounting conservatism distorts managers’ investment incentives as argued by the literature, then managers may decide not to borrow external capital and forego NPV projects. In this case, a negative correlation between conservatism and firm investments is expected after controlling for all the other factors that can affect a firm’s investment policy. In contrast, because financially unconstrained firms can suffer both under and overinvestment simultaneously, a negative correlation between conservatism and firm investment is consistent with both the underinvestment hypothesis and constraining of overinvestment hypothesis and further tests as discussed later are used to disentangle these two competitive hypotheses.
To provide further evidence on the under and overinvestment hypothesis, I also examine the relationship between conservatism and ex post firm accounting performance conditional on firm financial status. Although the under and overinvestment hypotheses both predict a negative correlation between firm investments and accounting conservatism, the two hypotheses yield different predictions regarding the relationship between conservatism and firm future operating performance. If conservatism can cause a firm to under invest, then the firm’s future performance will deteriorate. A negative correlation between conservatism and future performance is expected. On the other hand, if conservatism can constrain overinvestment, then we should expect a positive correlation between accounting conservatism and future operating performance. Hence, if conservatism can cause financially constrained firms to under invest, then we should observe a negative correlation between conservatism and firm future performance for those firms. Likewise, if conservatism can reduce (cause) overinvestment problem for financially unconstrained firms, then a positive (negative) correlation between conservatism and future performance is expected.
I use Basu’s (1997) conditional conservatism as the measure of accounting conservatism because the hypotheses are based on the asymmetric verification standards imposed for recognizing bad news versus good news. Following the literature (Richardson, 2006; Denis and Sibikov, 2010), firm investment is measured as firm capital expenditures net of depreciation expenses obtained from cash flow statements. To reduce the concerns of omitted correlated variable problems, I model firm investment as a function of a vector of explanatory factors that shown by literature can affect firm investment behavior. Then I examine whether accounting conservatism is correlated with the component of investments that cannot be explained by those factors in the predicted way. In the robustness section, I also use total investments and changes in firm capital expenditures as alternative measures of investments and examine the relationship between conservatism and these two alternative investment measures conditional on firm financial constraints.
Download
PDF Ebook Accounting Conservatism and Corporate Investment
Posted in :
