Accounting conservatism and firm investment efficiency

Abstract

a b s t r a c tWe argue that conservatism improves investment efficiency. In particular, we predict that it resolves debt equity conflicts, facilitating a firm's access to debt financing and limiting underinvestment. This permits the financing of prudent investments that otherwise might not be pursued. Our empirical results confirm these predictions. We find that more conservative firms invest more and issue more debt in settings prone to underinvestment and that these effects are more pronounced in firms characterized by greater information asymmetries. We also find that conservatism is associated with reduced overinvestment, even for opaque investments such as research and development.

Macroeconomic effects of aggregate accounting conservatism: A cross‐country analysis

“…García Lara et al. (), in their study of conservatism and investment efficiency, include two alternative measures that capture both conditional and unconditional conservatism, but they are unable to replicate all results obtained with their primary conditional conservatism measure . Conversely, Biddle et al.…”

“…They conclude that conservatism alleviates weakness in governance. García Lara, García Osma, and Penalva () find evidence that accounting conservatism improves firm investing efficiency by allowing easier access to capital and limiting overinvestment. On the equity side, Kim and Zhang () find that firms with a higher level of conservatism have lower stock price crash risk because conservatism limits managers’ ability to make risky decisions.…”

“… García Lara et al. () state “we are interested in conditional conservatism, as it is the only one with contracting value.” In fact, they consider the unconditional conservatism component of their measures “noise.” …”

International Mergers and Acquisitions Laws, the Market for Corporate Control, and Accounting Conservatism

“…[], Ball and Shivakumar [], Nikolaev [], Aier, Chen, and Pevzner []). The extant research also shows that, by requiring timelier recognition of economic losses relative to gains, accounting conservatism constrains managers’ ability to overinvest (Francis and Martin [], Garcia Lara, Garcia Osama, and Penalva []). Conceivably, as firms ratchet up financial leverage and cut excessive capital investment to thwart takeover attempts, a concomitant increase in firm financial‐reporting conservatism will occur.…”

“…In addition to boosting the proportion of debt in the firm's capital structure, the incumbent management is positioned to cut inefficient capital investments, preempting the bidder's wealth gain potentially arising from the takeover (Hendershott [], Safieddine and Titman [], Servaes and Tamayo []). Increases in leverage and reductions in wasteful capital spending often accompany timelier loss recognition, because accounting conservatism reduces informational friction and agency conflict underlying corporate restructuring (Bushman, Piotroski, and Smith [], Garcia Lara, Garcia Osama, and Penalva []).…”