Does Financial Reporting Conservatism Mitigate Underinvestment?

Abstract

This study examines the role of financial reporting conservatism in mitigating underinvestment problems. Recognizing that volatile cash flows increase the need to access external capital markets and that agency conflicts and information asymmetry make external capital costlier than internal capital, which leads managers to forgo valuable investment projects, Minton and Schrand document a negative relation between cash flow volatility and investment. We draw on Minton and Schrand’s framework to isolate underinvestment problems and hypothesize and document that conservatism mitigates the negative relation between cash flow volatility and investment and that this mitigative effect is more pronounced for firms with ex ante more severe agency conflicts. We also document that conservatism mitigates the sensitivity of investment to cash flow volatility by facilitating access to external capital.

The Effect of Accounting Conservatism on Investment Efficiency and Debt Financing: Evidence From Egyptian Listed Companies

“…This result agrees with the findings of prior literature that found that accounting conservatism reduced cost of debt and facilitated debt contracting process (Karthik, Watts and Zuo, 2016;Razzaq, Riu and Donghua, 2016;Lara, Osma and Penalva, 2016;Hong, Kim andLobo, 2017, Yasir, 2018). However, this result contradicts with other studies which found that conservatism might discourage managers to invest in high risk projects even with a positive net present value (Liu, 2014;Brockman, Liu and Ma, 2015;Ashfaq et al, 2016).…”

“…The second view argues that accounting conservatism may increase risk aversion, thus, rejecting risky projects even if with a positive net present value and increasing underinvestment problem (Guay andVierrecchia, 2006, Liu, 2014;Ashfaq et al, 2016). In contrast, the third view argues that accounting conservatism may mitigate managers' underinvestment incentives by encouraging prudent investments (Ahmed et al, 2002;Karthik, Watts, and Zuo, 2016;Razzaq, Riu and Donghua, 2016;Hong, Kim and Lobo, 2017).…”

Mitigating Underinvestment through Accounting Conservatism: A Comparative Study of Family and Non-Family Firms in Taiwan

“…The coefficient for cash flow volatility (OCFVOL) is -0.005, significant at the 1% level, suggesting that greater volatility in cash flows, which may lead to inadequate internal funds for investment projects and increased external financing costs due to information asymmetry, results in underinvestment. These findings align with Minton and Schrand (1999) and Hong et al (2019). The interaction term between conservatism and cash flow volatility (Conser×OCFVOL) has a coefficient of 0.021, significant at the 1% level, showing that under high cash flow volatility, conservatism helps mitigate the negative relationship between cash flow volatility and investment, likely because conservatism reduces information asymmetry between the firm and external stakeholders, making it easier to obtain funds at lower costs, thus increasing investment expenditures.…”

“…To examine the role of accounting conservatism in mitigating underinvestment due to cash flow volatility in family and non-family businesses, this paper follows the approach of Hong et al (2019). It calculates cash flow volatility using cash flows from operations and incorporates a conservatism variable, and the model shows as follows:…”

“…Furthermore, accounting conservatism, characterized by the prompt recognition of bad news (Basu, 1997), effectively supervises and restrains managerial self-interest behavior, thereby reducing information asymmetry with external stakeholders. Hong, Kim, and Lobo (2019) used the Basu model and Givoly and Hayn's (2000) measures of earnings distribution variability and non-operating accruals to assess conservatism and its role in underinvestment. Their empirical results showed that higher conservatism mitigates underinvestment phenomena, consistent with previous studies on the relationship between investment efficiency and conservatism (Ahmed and Duellman, 2007;Ball and Shivaumar, 2005;LaFond and Watts, 2008).…”