Prior research has extensively studied the role of accounting conservatism in financial reporting. Researchers reason that accounting conservatism exists in response to economic demand for verifiable and timely information that mitigates agency problems in contracting, and in response to changes in the regulatory and litigation environments (Holthausen and Watts, 2001; Watts, 2003). Empirical studies generally find evidence in support of the contracting and governance role of conservatism in both equity (LaFond and Watts, 2008; LaFond and Roychowdhury, 2008) and debt markets (Zhang, 2008).
However, while prior work asserts the role and benefits of accounting conservatism to lenders and borrowers in external financial contracting, there is scant research examining how reporting conservatism shapes firms internal financial decisions; in particular, their liquidity management, their choice of debt or equity financing, the sensitivity of their investments to financing constraints and their payout policies. This omission in the literature is surprising given the close inter-relationship between accounting conservatism and financial contracting, and between financial contracting and corporate financial decisions.
This paper addresses this gap and investigates whether reporting conservatism is related to firms financial flexibility and their financial decisions. Financial flexibility is the ability of a firm to access and restructure its financing at a low cost. Financially flexible firms are able to avoid financial distress in the face of negative shocks and to fund investment readily when profitable opportunities arise (Gamba and Triantis, 2008, p.2263).
Existing literature reasons that accounting conservatism assists monitoring and governance by limiting managers ability to overstate financial performance opportunistically and thus facilitates the transfer of control rights to capital providers when covenant or performance thresholds are not satisfied (LaFond and Watts, 2008; Zhang, 2008). If conservatism assists monitoring and governance by capital providers, debt or equity providers should be more willing to extend financing and increase firms access to capital. If these conditions hold, I predict firms with greater reporting conservatism should exhibit greater financial flexibility ("Efficient Contracting View").
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The Role of Accounting Conservatism in Firms' Financial Decisions
