We study the association between conditional accounting conservatism and firm investment efficiency. Classic agency theory shows that managers have superior information about the expected profitability and the timing of the payoffs of undertaken projects and investments (Lambert 2001) and can therefore make investment or operating decisions that are harmful to the interests of the providers of finance (Jensen and Meckling 1976). Accounting research argues that increased disclosure and higher quality financial reporting mitigates information asymmetry problems and agency costs (Healy and Palepu 2001).
In particular, Bushman and Smith (2001) argue that the use of high quality accounting information in corporate governance is bound to improve firm's investment decisions. Even in the absence of agency problems, Lambert, Leuz and Verrecchia (2007) show that if accounting quality leads to decreases in cost of capital, this will change the investments viewed as optimal by the firm.
These arguments about the link between improved accounting information and investment efficiency are supported by recent empirical work by Biddle and Hilary (2006), McNichols and Stubben (2008) and Biddle, Hilary and Verdi (2008), who provide evidence on the positive association between efficient investment and accounting quality as measured by accruals quality. Regarding the relation between conservatism and investment efficiency, Bushman, Piotroski and Smith (2007) and Ahmed and Duellman (2007a) provide some initial evidence.
Bushman et al. (2007) show that investment efficiency varies internationally with aggregate conservatism at the country-level, while Ahmed and Duellman (2007a) study the relation between conservatism and future outcomes of firms investment policies. In this paper, we more directly address the issue of whether more conditionally conservative firms invest more efficiently by analysing if conditional conservative accounting constrains managerial tendencies to under-and over-invest. This analysis is of particular interest in light of the ongoing FASB debate on whether to eliminate conservatism.
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Conditional Conservatism and Firm Investment Efficiency
