Accounting Conservatism, Financial Constraints, and Corporate Investment

Abstract:
This paper documents negative associations between conservatism and both firm
investments and future operating performance for financially constrained firms. The
negative correlations are consistent with accounting literature’s predictions that
accounting conservatism can cause dysfunctional investment incentives for managers andmotivate them to forego positive NPV projects (Leuz, 2001; Watts, 2003a; Guay andVerrecchia, 2006). Further, consistent with literature, empirical evidence show that thenegative correlation between conservatism and firm investments is more pronounced forfirms with high return volatility and for firms with short CEO tenure horizon. Last, thenegative correlation between conservatism and future investments is mitigated by CEOs’equity ownership, suggesting that equity ownership mitigates agency conflicts (Jensen andMeckling, 1976). The results are robust to alternative empirical strategy, variable
specifications, and sample selection criteria.

JEL Classification: G31; M41
Keywords: Accounting conservatism, Underinvestment, Investment efficiency.

11. Introduction
This paper examines the effects of accounting conservatism on managers’ investment incentives.
The predicted relationship between these two factors based on accounting literature is mixed.
One strand of accounting literature argues that timely loss recognition, one important componentof accounting conservatism, can discipline managers and reduce agency costs related tooverinvestment (Ball, 2001; Ball and Shivakumar, 2005). The other strand of literature suggeststhat untimely gain recognition distorts managers’ investment incentives and induce them toforego 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 overinvestment tendency (Francis and Martin, 2010;
Bushman et al., 2007). 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.1 2
One empirical challenge to distinguish the two competing but non-exclusive hypothesesis that both theories predict a negative (positive) correlation between timely loss (gain)
recognition and firm investments. It is difficult to infer whether timely loss (gain) recognition
constrain(induce)overinvestment(underinvestment)

or

cause

underinvestment(overinvestment). To overcome this problem, I examine the relationship between investment andthe timeliness of accounting recognition for financially constrained and unconstrained firms. In
1

The term accounting conservatism is used to refer to three components of accounting conservatism: asymmetrictimeliness of earnings, timely loss recognition, and untimely gain recognition. In the empirical tests, I examine therelationship between firm investment and these three components of accounting conservatism jointly.
2
Consistent with Ball (2001), Ball and Shivakumar (2005), LaFond and Watts (2008), and Francis and Martin(2010), I assume in this paper that accounting conservatism is exogenously imposed on managers either as part ofcorporate governance mechanism or by external forces.

2particular, I focus on financially constrained firms and examine how the timeliness of gain andloss recognition affects managers’ investment incentives. The empirical strategy builds on thefindings from extent finance literature that financially constrained firms are more likely to forego
positive NPV projects due to limited access to external capitals (Almeida, Campello, andWeisbach, 2004; Faulkender and Wang, 2006; Denis and Sibikov, 2010). Hence, ex ante,
financially constrained firms are more (least) likely to suffer underinvestment (overinvestment).
In this case, a negative (positive) correlation between timely loss (gain) recognition andinvestment would suggest that timely loss (gain) recognition can cause (mitigate)
underinvestment for financially constrained firms. In contrast, because financially unconstrained
firms can suffer both under and overinvestment simultaneously, a negative (positive) relationshipbetween timely loss (gain) recognition is consistent with both constraining (inducing)overinvestment and inducing (mitigating) underinvestment. Further tests as discussed in next
paragraph are used to disentangle these two competitive hypotheses.3
To further shed light on the effect of conservatism on firm investments, I also examine
the relationship between conservatism and ex post firm accounting performance conditional on
firm financial constraints. Although the under and overinvestment hypotheses both predict a
negative (positive) correlation between firm investments and timely loss (gain) recognition, thetwo hypotheses yield different predictions regarding the relationship between timeliness of loss
(gain) recognition and firm future operating performance. Examining the relationship between
recognition timeliness and future operating performance can help further distinguish the twocompeting hypotheses. Specifically, if TLR (TGR) can cause a firm to under invest, then thefirm’s future performance will deteriorate. A negative correlation between TLR and future3

The under and overinvestment hypotheses are not mutually exclusively and can exist at the same time. The
empirical tests only document the dominant forces for financially constrained and unconstrained firms.

3performance is expected. On the other hand, if TLR can constrain overinvestment, then weshould expect a positive correlation between accounting conservatism and future operating
performance because firms are less likely to invest in value-destroying projects. Likewise, if
TGR can cause (mitigate) financially constrained firms to under invest, then we should observe anegative (positive) correlation between conservatism and firm future performance. 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 forrecognizing bad news versus good news. Following the literature (Richardson, 2006; Denis andSibikov, 2010), firm investment is measured as firm capital expenditures net of depreciation
expenses obtained from cash flow statements. 4 To reduce the concerns of omitted correlated
variable problems, I model firm investment as a function of a vector of explanatory factors thatshown 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 thosefactors in the predicted way. In the robustness section, I also use total investments and changes infirm capital expenditures as alternative measures of investments and examine the relationshipbetween conservatism and these two alternative investment measures conditional on firm
financial constraints.
Empirical results show that accounting conservatism is negatively correlated with bothinvestments and future operating performance for financially constrained firms, providing
consistent results supporting the underinvestment hypothesis. In contrast, for financially4

The results are qualitatively same if I use total capital expenditure instead of net capital expenditures. Please see
additional discussions in the robustness test section.

4

unconstrained firms, accounting conservatism is negatively correlated with firm investments andpositively correlated with future operating performance, suggesting that financiallyunconstrained firms are more likely to suffer overinvestment and accounting conservatism canconstrain managers’ incentive to invest in negative NPV projects. Combined together, the results
are consistent with both under and overinvestment arguments as predicted by accounting
literature. After documenting the negative correlation between conservatism and firm investment
for financially constrained firms, I also examine cross sectional variations in the negative
correlation based on the literature’s predictions. Consistent with the literature, I find that for
financially constrained firms the negative correlation between conservatism and investments ismore pronounced for firms with high stock return volatility and for firms with short-termoriented CEOs. Hence, the documented cross sectional variations lend further support to theunderinvestment hypothesis. Lastly, the empirical results also show that the underinvestment
problem is mitigated by CEO equity ownership, indicating that equity ownership can reduce
agency conflicts related to firm investment policy (Jensen and Meckling, 1976).
Firm investment and accounting policy are likely to be determined by unobservable firm
characteristics. Although several steps are taken in the empirical design to address the potential
endogeneity problems, to further alleviate any residual concern, I explore the regulation of the
Sarbanes and Oxley Act (SOX) of year 2002 and investigate the underinvestment hypothesis byidentifying an exogenous shock to firm accounting conservatism. The passage of SOX increases
managers’ and auditors’ legal liability, and they have responded by increasing the conservatismof financial reporting (Lobo and Zhou, 2006; Iliev 2010). Consistent with the underinvestment
hypothesis, I find that firm investments decrease significantly in the post SOX period after
controlling for investment opportunities and the decrease is larger for financially constrained5

firms. Further, the results show that the negative correlation between accounting conservatism
and investment becomes stronger in the post SOX period and this enhanced negative correlation
is mostly attributable to financially constrained firms.
This paper contributes to the literature examining the economic impacts of accounting
conservatism.5 Extant studies argue that accounting conservatism can mitigate agency conflicts
between lenders and borrowers (Watts, 2001; LaFond and Watts, 2008; LaFond andRoychowdhury, 2008). Based on this argument, studies show that accounting conservatism canreduce cost of capital (Ahmed et al., 2002; Moerman, 2008; Zhang, 2008; Garcia Lara et al,2009). However, none of the studies investigate whether the reduced costs of capital willtranslate into increased capital investments, especially for financially constrained firms. 6 Given
that accounting literature also argues that accounting conservatism can distort managers’
investment incentives, it is possible that managers may decide not to take advantage of the
reduced cost of capital and forego positive NPV projects. The contribution of this paper is toshow early evidence that accounting conservatism can cause dysfunctional incentives and induce
underinvestment.
The remainder of the paper is organized as follows. I develop the testable hypotheses in
section 2, and section 3 discusses the sample selection criteria and research methodology.

5

Please refer to Watts (2003a, 2003b) for a detailed survey of empirical papers examining the demands and supplyof accounting conservatism prior to the year of 2003.
6
In a concurrent working paper, Garcia Lara et al. (2010b) find that conditional conservatism can alleviate rather
than aggravate underinvestment as predicted in this paper. The authors use C-score as the measure of conditional
conservatism based on Khan and Watts (2010). Khan and Watts (2010) measure accounting conservatism as afunction of firm market to book value, leverage, and firm size. All three variables have been documented by priorliterature as important factors that affect firm investment policies. Hence, using C-score as the measure ofconservatism can cause serious endogneity problem because firm market to book value, size, or firm leverage candetermine simultaneously firm accounting conservatism and investment policy rather than accounting conservatism
affecting firm investments. In addition, Garcia Lara et al. (2010b) assume perfect interest alignment between
shareholders and managers; whereas, the assumption underlying this paper’s arguments is that there exists agency
problem and managers are not acting for the best interests of shareholders.

6Section 4, 5 and 6 presents the empirical results and is followed by the robustness test in section
7. The paper concludes in section 8.
2.

Accounting Conservatism, Corporate Investment, and Hypotheses Development
Separation of ownership and control causes agency problems (Jensen and Meckling,1976), and one such agency problem concerns firm investment decisions. Shareholders wantmanagers to undertake every positive NPV project to maximize firm value. However, managers
whose utility closely tied to accounting earnings also compare their personal gains and costs
associated with undertaking a project. Managers may decide to forego positive NPV projects orundertake negative NPV projects if the benefits of undertaking or foregoing the projects are
greater than the costs, resulting in both over and underinvestment.
Prior literature argues that timely loss recognition is an important governance mechanism
in deterring managers from undertaking negative NPV projects by accelerating future investment
losses into current earnings. Please refer to Watts (2003a), Shivakumar and Watts (2005), andFrancis and Martin (2010) for a thorough discussions on how conservatism can constrain
overinvestment.7
Another strand of accounting literature however argues that untimely gain recognition
can cause managers to abandon positive NPV projects. Leuz (2001) and Guay and Vierrecchia(2006) argue that untimely gain recognition can cause dysfunctional incentives for managers toabandon positive NPV projects. In particular, if gains are not timely recognized, then executives
responsible for designing long-run investment policy may no longer be in office by the time
gains are realized. Even if managers have long enough tenure horizons to benefit the gains, they
may still find the benefits of undertaking the projects cannot offset the efforts of implementing
7

Briefly, the authors argue that timely loss recognition can accelerate future losses into current earnings, in turnaffecting managers’ earnings based compensation and reputation. In addition, timely loss recognition can also timely
alert corporate boards to investigate the causes of losses and threaten managers’ job security.

7

the projects. This is so because managers are risk averse, and they require a higher discount rate
on future gains in deriving the expected payoffs (Reichelstein, 2000). A positive NPV project toshareholders may become a negative NPV to the manager if gains are not recognized on a timely
basis.

Watts (2003a) also argue that both timely gain and loss recognition can “avoid

dysfunctional outcomes related to limited tenure horizon.” Watts’ argument can be clearly
conveyed by the following excerpts (Watts, 2003a, p. 211):“Ceteris paribus, managerial performance measures in compensation contracts, such as earnings,
are more effective when they are timely and reflect the effects of the managers’ actions on firm
value in the period in which the actions are taken. Timeliness avoids dysfunctional outcomes
associated with managers’ limited tenure with the firm, often referred to as the manager’s limited
horizon. For example, a manager may forego positive net present value projects with near-term
negative earnings because future earnings will reflect the benefits of the project after the manager
has retired or left the firm.”

Extant studies argue that accounting conservatism can restrain managers from investingin negative NPV projects through accelerated loss recognition (Ball and Shivakumar, 2005;
Francis and Martin, 2010). In particular, the authors argue that if managers know ex ante thatupon failure in pursuing a project, they have to book losses more timely and consequently theirreputation and income linked compensation will be affected adversely, then ex ante, managers
will choose not to invest in negative NPV projects. However, Roychowdhury (2010) argues thatsince risky projects are more likely to become negative projects, timely loss recognition can also
cause risk-averse managers to avoid risky projects even though the projects have positive NPV toshareholders. Specifically, if managers know that in pursuing risky projects, they have to booklosses more timely upon project failure and their reputation and income linked compensation will8

be affected adversely, then they are less likely to undertake these investments ex ante eventhough those projects have positive NPV.
In sum, prior literature argues and shows that timely economic loss recognition can
restrain managers from undertaking negative NPV projects.

In addition, untimely gain

recognition can aggravate managers’ concerns over firm performance and motivate managers toforgo positive NPV projects, resulting in underinvestment. Despite the debate on the roleaccounting conservatism plays in executive’s investment incentives, extant empirical studies
only focus on accounting conservatism’s role in constraining overinvestment incentives and noneof the studies investigate whether accounting conservatism can also cause underinvestment. This
paper tries to fill this gap and shed light on the debate. Further, the accounting literature argues
that the underinvestment problem induced by accounting conservatism is more pronounced forfirms whose CEOs have limited tenure horizon (Watts, 2003a) and for firms with high return
variances in future payoff (Roychowdhury, 2010). I empirically test the cross-sectional variationand examine whether the underinvestment problem is more severe for firms whose managers
have short tenure horizon and for firms that are likely to have risky projects in their investment
opportunity set.
Jensen and Meckling (1976) argue that equity ownership can alleviate agency problem andalign managers’ interests with those of shareholders. In particular, since equity ownership can
extend CEOs’ horizons and provide incentives for managers to undertake positive NPV projects
that create value for the firm in the long run, I also test whether equity ownership can alleviate
the positive correlation between accounting conservatism and underinvestment.
The documented underinvestment for financially constrained firms due to conservatism
doesn’t necessarily mean that those firms are behaving irrationally in setting up accounting

9

conservatism policy. On the contrary, it is likely that conservatism is optimally chosen to
maximize firm value. Given that managers’ opportunistic behavior cannot be completely
eliminated, this paper documents a residual loss in the equilibrium. For example, it is very costly
for financially constrained firms to waste limited resources in negative NPV projects, and thebenefits of imposing accounting conservatism will outweigh the potential costs of forgoingcertain positive NPV projects. Alternatively, because the demands for conservatism comes frommultiple sources such as creditors, auditors and managers’ legal liability concerns etc.,
conservative reporting is not completely at the discretion of managers or corporate boards.
Given that firm conservative reporting can be exogenously imposed upon managers by otherforces (such as legal liability or regulations), it is possible that conservatism may not be
optimally set for some firms, such as financially constrained firms. Please see section 5 forfurther discussion on this issue. (given the concern for legal liability, firms impose conservatism
can still optimal and rational to avoid big losses in the future. The only one not optimal is the one
due to regulation and demand from auditors, and firms have to use conservatism even though it
is not optimal)
Additional concern is why managers cannot voluntarily disclose good news and potentially
offset the negative impact of untimely gain recognition in earnings. Kothari, Shu and Wysocki(2009) document that firms’ voluntary disclosure appears to favor the release of good news in atimely manner than bad news and the authors suggest that managers use voluntary disclosure ofgood news to offset the timely loss recognition in earnings. However, there are two reasons why
voluntary disclosure of good news cannot completely solve the underinvestment problem
induced by accounting conservatism. First, voluntary disclosure of good news is less credible
and investors tend to discount the economic value of the disclosed good news.

10

More

importantly, the underinvestment documented in this paper is related to managers’ earningsbased incentives rather than stock-based incentives. Although prices can fully incorporate future
good news, the impacts of conservatism on earnings are unchanged by voluntary disclosure ofgood news.
3.

Sample selection and empirical design

3.1. Sample selection
The initial sample is drawn from the intersection of COMPUSTAT and CRSP from 1987
to 2007. All observations included in the sample are required to have sufficient data to calculate
accounting conservatism and investments. CEO equity ownership and tenure horizon
information is obtained from EXECUCOMP data file.
Firms investing heavily in R&D expenditure are excluded from the sample observations.
Specifically, firms investing more than 70% of their total investments in R&D expenditures are
excluded from empirical analyses.8 This sample restriction is imposed for two reasons. First,
firms with heavy R&D expenditures are likely in a business that requires less tangible capital
investments and hence decisions over capital investments are insignificant to those firms.
Second, because R&D expenditures are expensed as they incur, firms with high R&D
expenditures will have relatively lower earnings. In contrast, firms with high R&D expenditure
enjoy higher stock returns because capital market rationally price in the future benefits of current
R&D expenditures (Chan et al., 1990). Hence, high R&D expenditures can cause a negative
relation between earnings and return and affect the measure of conditional accounting

8

Specifically, I calculate annually the ratio of R&D expenditures over the sum of capital expenditures and R&D
expenditures. If the ratio is over 70%, then the observation is excluded from the sample observations for that year.
9,029 firm-years are deleted from the sample due to this procedure (about 21% of the final sample observations).
The results are not sensitive to other cutoff points. In the robustness test, I restrict the sample firms to those with nopositive R&D expenditures and the results are qualitatively the same.

11

conservatism.9 More importantly, firms investing heavily in R&D expenditures will have lessavailable resources devoted to capital expenditures, confounding the relationship between themeasure of accounting conservatism and investment.
The final sample for the empirical analyses consists of a total of 42,665 firm-year
observations from 7,084 individual firms. After merging with the EXECUCOMP, the sample
observation is reduced to 11,421 CEO-years with available data to measure CEO ownership and
4,410 CEO years with valid data to measure CEO tenure information. The exact number ofobservations used in empirical analysis varies with specific empirical testing. Following priorliterature, I also delete all the financial firms and firms in regulated industries. All the variables
are trimmed at the 1st and 99th percentile values in order to reduce the influence of extreme
observations.
3.2. Investment model
To alleviate the concerns that some omitted correlated variables may simultaneously
determine firm investment and accounting reporting, I regress firm net capital expenditure on
variables that identified by prior literature to affect firm investments and use the residuals as mymeasure of firm investments. Specifically, I estimate the following equation each year:
Investi,t+1 = α0 + α1 Qi, t + α2 Ri, t + α3 SaleGrthi, t + α4 Cashi, t+ α5 Leveragei, t + ei,t+1(1)

The variable Investi,t+1 is the net capital expenditure for firm i in year t+1 calculated as thedifference between capital expenditures (CAPX) and depreciation expenses (XDP) scaled by the
beginning year book value of asset (AT). Consistent with prior literature, I use firms’ average q,

9

To show the impact of R&D expenditures on the measure of conservatism, all the firms with positive R&D
expenditures are sorted into quintiles based on the level of R&D expenditures, and Basu baseline model (equation 2)
is estimated for each quintile. Unreported results show that the measure of accounting conservatism (β3, as discussed
in section 3.3) increases monotonically from 0.06 for the top quintile (highest R&D expenditure) to 0.13 for thebottom quintile (lowest R&D expenditure).

12Q, to measure firm marginal q, a proxy for growth opportunity (Tobin 1969; Hayashi, 1982).
Firm average q is calculated as the sum of the market value of equity (PRCC_F*CSHO) and total
debt (DLC + DLTT) scaled by the beginning year assets (AT). Prior studies show that average q
is a noisy measure of firm marginal q, and to alleviate the measurement error problems, othervariables that are used by literature to proxy for firm investment opportunities are included in themodel.

Specifically, following Biddle et al (2009), Barro (1990), I include sales growth(SaleGrth) and stock return (R) as additional proxies for firm investment opportunity. SaleGrth iscalculated as the percentage change in sales (SALE) in a given year, R is the twelve-monthcompounded returns beginning nine months prior to fiscal year and ending three months after theannouncement of fiscal year earnings.
Farrazi et al. (1988) and Denis and Sibikov (2010) show that firm cash holdings canaffect investments for financially constrained firms, and the variable Cash is added to control fordifferences in internal financing capability. Following Richardson (2006), Cash is measured as
the cash flow from operation (OANCF) scaled by beginning year assets (AT). I also include firm
leverage (leverage) to control for underinvestment due to debt overhang problems (Myers,1977). Firm leverage is calculated as the book value of debt over the book value of assets (DLC
+ DLTT) / (AT). The residual ei,t+1 captures the portion of investments that cannot be explainedby those firm specific factors and is the main measure of firm investments, denoted as RInvest.
3.3.

Measure of accounting conservatism
Accounting conservatism is measured using Basu’s (1997) conditional conservatismspecification. Basu (1997) estimates the following model:
Xi,t = β0 + β1 Di, t + β2 Ri, t + β3 Di, t * Ri, t + ei,t

13

(2)

where X is earnings before extraordinary item (IB), scaled by the market value of equity at the
beginning of the year (PRCC_F*CSHO); R is the twelve month compounded returns as definedin previous section. D is a dummy variable equal to 1 if return is negative and 0 otherwise. The
coefficient β2 measures earnings’ timeliness of gain recognition and β3 captures the incremental
timeliness of loss recognition in earnings. In this paper, I interpret β3 as the degree of accounting
conservatism. In the empirical tests, I jointly test whether firm investment is 1) positively
correlated with timely gain recognition (β2) 2) negatively correlated with timely loss recognition(β2 + β3 ) and 3) negatively correlated with accounting conservatism (β3).
3.4. Empirical procedure
One empirical challenge to investigate the underinvestment hypothesis is that both theunderinvestment and overinvestment hypothesis predict a negative correlation between
conservatism and firm investments. Based on prior studies’ finding (as discussed later) that
financially constrained firms are more (least) likely to suffer underinvestment (overinvestment), I
partition the sample into financially constrained and unconstrained firms. If I observe a negative
correlation between accounting conservatism and firm investments, then the negative correlation
will suggest that conservatism can cause underinvestment rather constraining overinvestment for
financially constrained firms. On the other hand, the interpretation of a negative correlation
between conservatism and firm investment for financially unconstrained firms is ambiguous andcan be consistent with both the under and overinvestment hypothesis.
Myer and Majluf (1984) show that information asymmetry can cause firms to turn downsome positive investments opportunity due to increased external financing costs. Consistent withthe theoretical argument, empirical studies show financially constrained firms are more likely tohold cash (Almeida et al, 2004) and the market perceives the value of cash holdings more

14

valuable for financially constrained firms (Faulkender and Wang, 2006). In a recently study,
Denis and Sibikov (2010) show that greater holdings of cash are associated with higher levels ofinvestments for constrained firms, and, more importantly, they find firm investments increase
firm value significantly for financially constrained firms. Taken together, the results suggest that
financially constrained firms suffer underinvestment due to limited access to external financing.
Following the literature (Almeida et al, 2004; Faulkender and Wang, 2006; Denis andSibikov, 2010), I classify firms as financially constrained and unconstrained based on annual
payout ratio, firm size, and S&P long term debt and domestic paper rating. Specifically, for eachyear, firms in the bottom (top) three deciles of the annual cash payout ratio distribution areclassified as financially constrained (unconstrained) firms. Cash payout ratio is calculated as theratio of dividends adjusted for repurchase of common shares over operation income ((DVC +PRSTKC)/OIBDP). Firms that fall in the bottom (top) three deciles of the firm size (AT)
distribution is classified as constrained (unconstrained). Firms are classified as constrained ifthey have debt (both long term and short term) outstanding but never had their debts rated before(no S&P long-term debt or short-term debt rating).
The empirical strategy to investigate the under and overinvestment hypothesis relies on
the predicted different relationship between conservatism and firm investment and futureaccounting performance for financially constrained and unconstrained firms. In particular, if
accounting conservatism can reduce information asymmetry between lenders and borrowers andconsequently reduce borrowers’ cost of capital (Ahmed et al., 2006; Zhang, 2008; Garcia Lara etal., 2010a), then accounting conservatism can mitigate the adverse effects of financial constraints
on firm investments. Hence, we should expect a positive correlation between conservatism andfirm investment for financially constrained firms. However, if we still observe a negative15

correlation between accounting conservatism and firm investment after controlling for firm
investment opportunity, then this negative correlation is consistent with the argument that
accounting conservatism can cause underinvestment. In addition, if conservatism can aggravate
underinvestment problem for financially constrained firms, then we should also expect anegativecorrelation

betweenconservatism

and

firm

futureperformance

becauseunderinvestment will have a negative effect on firm future performance. In contrast, a negative
correlation between conservatism and investment for financially unconstrained firms are
consistent with both the under and overinvestment hypothesis. However, if we observe a positive(negative) correlation between conservatism and future firm performance, then we can say that
accounting conservatism can constrain (cause) underinvestment (underinvestment) for
financially unconstrained firms since firms’ future performance will improve (deteriorate) due toaccounting conservatism.
The empirical model is based on the expanded Basu’s model by interacting RInvest
measured at time t+1 with D, R, and D * R separately.10 LaFond and Watts (2008) and Francis
and Martin (2010) also use the similar model specification when examine whether accounting
conservatism measured at time period t can lead to reduced information asymmetry or higher
acquisition returns at time t+1. Specifically, I estimate the following pooled and cross-sectionalmodel separately for financially constrained and financially unconstrained firms:
Xi,t = β0 + β1 Di,t + β2 Ri,,t + β3 Di,t * Ri,t + β4 RInvest i,t+1 + β5 RInvest i,t+1 * Di,t+ β6 RInvesti,t+1 * Ri,,t+ β7 RInvest i,t+1 *Di,t * Ri,t + β8 Leverage i,t+ β9 leverage i,t * Di,t+ β10 Leverage i,t * Ri,,t+ β11 Leverage i,t * Di,t* Ri,t+ β12 Size i,t+ β13 Sizei,t * Di,t+ β14 Sizei,t * Ri,,t + β15 Size i,t *Di,t * Ri,t+ β16 MTB i,t + β17 MTBi,t * Di,t + β18 MTBi,t * Ri,,t+ β19 MTB i,t *Di,t * Ri,t+ β20 LIT i,t+ β21 LITi,t * Di,t + β22 LITi,t * Ri,,t+ β23 LIT i,t *Di,t * Ri,t
+ ut+ vj +ei,t(3)

10

I measure firm investment at time t+1 to alleviate the concern of endogneity problem and enhance the causality
inference. Unreported results show that the inferences remain same if investments are measured at time t.

16

where RInvest is the residuals from equation (1). Both under and overinvestment hypotheses
predict that the coefficient on RInvest * R (β6) will be positive, suggesting that timely gain
recognition is positively correlated with firm investment, and the coefficient on RInvest * D * R(β7) and the sum of β6 + β7will be negative and significant, suggesting that both aymmetry timelyof earnings and timely loss recognition is negatively correlated with firm investment.
To alleviate the correlated omitted variable problem, I also control for variables
documented by prior studies that can affect firm accounting conservatism. Specifically, I include
firm leverage (Leverage), market to book value of equity (MTB), firm size (Size), litigation risk
(LIT), and their interactions with dummy D, return (R), and negative returns (D * R). Leverage
is firm leverage as defined in previous section. Prior studies show that firm leverage is positively
correlated with accounting conservatism due to the demand by creditors (e.g., Kahn and Watts,
2009) and I expect β11 to be positive and significant. Size is the natural log of the book value of
assets (AT), and a negative and significant β15 is consistent with literature’s findings that large
firms are less conservative. MTB is the ratio of market value of equity over the book value ofequity (PRCC_F * CSHO / CEQ). The literature (e.g., LaFond and Roychowdhury, 2008) has
shown a negative correlation between accounting conservatism and market to book value; 11
hence, β19 is expected to be negative. LIT is a dummy variable equal to one if a firm is in a highlitigation risk industries as identified in Francis et al. (1994) and zero otherwise. A positive andsignificant coefficient estimate of β23 is expected because firms in high litigation industry will be
more conservative. Lastly, I also include two-digit SIC industry dummy and year dummy
variables to control for year and industry effects on accounting earnings.

11

Roychowdhury and Watts (2007) provide explanations why firms with a high growth option (MTB) have lower
accounting conservatism.

17

Likewise, to test the relationship between conservatism and firm future performance, I
replace the variable RInvest with changes in operating performance (ΔPeform) measured bychange in return on assets (ΔROA) and change in cash from operation (ΔCFO). ΔROA is
calculated as the difference in net income (IB) scaled by total assets (AT) from year t-1 to yeart+2. ΔCFO is calculated as the difference in cash flow from operations (OANCF) scaled by total
assets (AT) from year t-1 to t+2. This modified equation is also estimated separately for
financially constrained and unconstrained firms.
Standard errors of coefficient estimates are adjusted for heteroskedasticity and clusteredat the firm level. Statistical significance of coefficient estimates reported in the paper is based on
two-tailed tests.
4.

Empirical results

4.1. Descriptive statistics and univariate analysis
Panel A, table 1 reports summary statistics for the dependent and independent variables
used in the empirical analyses. The mean ratio of net capital expenditures to firm assets (Net
Capex) is 2.7% and median ratio is 1%. The mean of the residual capital expenditures (RInvest)
from the investment model is 0 by construction, and the median value is -0.009. The mean valueof earnings (X) is 0.026 with a median value of 0.05. The mean (median) value of return (R) is
13.3% (4.6%). On average, firms pay out 10.3% of the total earnings to shareholders, and there
are total of 25% (10%) firms have available bond rating (paper rating), which is consistent withthose found in Faulkender and Wang (2006). The percentage of equity ownership including
options (CEO_Own) is 4% and 2% for the mean and median respectively, similar to thosereported by LaFond and Roychowdhury (2008). Standard deviation of daily return volatility(RetVol) is comparable to those reported by Kahn and Watts (2009). Return on assets decrease18

by 1.4% on average from t-1 to t+2 (ΔROA) but cash flow from operations barely changes overthe same time period (ΔCFO).

The mean and median values for the other control variables,

namely market to book value (MTB), leverage (Leverage), and firm size (Size) are similar to
those reported by prior studies.
Panel B of table 1 reports the Pearson correlation matrix between selected variables. As
expected, firm investments are significantly and positively correlated with prior year’s stock
returns, average q and sales growth, all of which are used as proxies for firm investment
opportunity set by prior studies. Not surprisingly, these variables are positively correlated witheach other, and the highest correlation is between stock returns and average q (0.167) and thelowest correlation is between sales growth and return (0.077). Hence, these variables capture
different aspects of firm investment opportunity. As expected, firm investments is negatively
correlated with firm leverage, consistent with the notion of debt overhang problems. Overall, thesummary statistics show that the distributions of variables and the correlation are consistent withthe findings of prior studies.
Table 2 provides results of univariate analysis on the relationship between accounting
conservatism and residuals from investment model (RInvest) in panel A and net capital
expenditures (Net Capex) in panel B. To conduct the test, I first sort sample observations into
quintiles based either on RInvest or Net Capex and then estimate Basu model of accounting
conservatism separately for each quintile. Panel A shows that there is a monotonic positive
correlation between β2 and RInvest (β2 estimates increase from 0.01 in the bottom RInvest
quintile to 0.039 in the top Rinvest quintile) and a monotonic negative correlaiton between β3 andRinvest (β3 decrease from 0.152 in the botton quintile to 0.082 in the top quintile) suggesting thatinvestments positively correated with timely gain recongition and negatively correlated with firm

19

asymmetric timliness of earnings. Panel B provides results on the relaitonship between net
capital expenditure and the measure of accounting conservatism. Consistent with the results inpanel A, net capital expenditure and conservatism are also negatively correlated. In sum, theunivariate analysis provides evidence that firm invesment is negatively correlated withaccounting conservatism. However, as argued before, this negative monotonic correlation does
not answer the question whether conservatism constrain overinvestment or cause
underinvestment. In next section, I will provide results shed light on this issue.
4.2. Multivariate analyses
Table 3 provides results from multivariate analyses testing the relationship between
conservatism and firm investments conditional on firm financial status. Column (1) provides
results estimating equation (3) based on the whole sample. As shown in column (1), theestimated coefficient on RInvest * R (β6) and RInvest * D * R (β7) are 0.057 and -0.199
respectively, and both are statistically significant at the 5% level. Further, the sum of β6 + β7 issignificantly negative at the 5% level. Consistent with results from the univariate analysis,
results based on multivariate tests also show that firm investment is positively correlated withtimely gain recognition and negatively correlated with timely loss recognition and asymmetrictimeliness of earnings. As discussed before, this negative correlation is consistent with bothunderinvestment and constraining-overinvestment hypotheses.

To investigate whether

accounting conservatism can cause underinvestment, column (2) to column (8) report estimation
results based on firm financial status, a proxy for the likelihood that a firm suffers
underinvestment ex ante. As shown in the table, the coefficient estimates of β6 and β7 are
statistically significant at the 10% level or better with expected signs across all four groups offinancially constrained firms. Further the F-tests indicate that the sums of the two coefficients are20

negative and significant at the 5% level for all the groups as well. As discussed before, because
financially constrained firms are less likely to suffer underinvestment, the results from this tableshow that rather than mitigating the adverse impacts of financial constraints on firm investments(suggesting a positive correlation between conservatism and firm investment), accounting
conservatism is associated with less investment for financially constrained firms after controllingfor firm investment opportunity. This negative correlation is consistent with the underinvestment
hypothesis. For the financially unconstrained firms, the majority estimates of the coefficient β6
and β7 are statistically significant with the same signs as for financially constrained firms.
However, as discussed before, the negative (positive) coefficient of β7 (β6) is consistent with boththe under and overinvestment hypothesis. My next empirical test sets to disentangle these twocompeting hypotheses. The coefficient estimates on the control variables are all loaded withexpected signs and statistically significant at 10% level or better. To save space, those estimates
are not reported.
To provide further evidence on the role conservatism plays in managers’ investment
incentives, table 4 provides estimation results testing the relationship between conservatism andchanges in future firm performance. Panel A of table 4 reports results based on ΔROA as themeasure of operating performance and panel B reports results based on ΔCFO as the measure ofoperating performance.

Consistent with the underinvestment hypothesis, the coefficientestimates on ΔROA * R are positive and significant at the 10% level for two of the four groups ofthe financially constrained firms and the coefficient estimates on ΔROA * R * D is negative andsignificantly different from zero for three of the four financially constrained groups. The sums ofthe two coefficients are significantly negative at the 10% level or better for all the financiallyconstrained groups except for the paper-rating group. Consistent with the underinvestment

21

hypothesis, the results suggest that accounting conservatism can cause future performance todeteriorate for financially constrained firms because under invest in positive NPV projects.
For financially unconstrained firms, the coefficient estimates on ΔROA * R are negativeacross all four group classifications but significant only for two groups. The coefficient estimateson ΔROA * R * D are mixed. It is positive and significant (β7 = 0.038, p = 0.057) for the payoutgroup and negative and significant (β7 = -0.175, p = 0.087) for the bond rating group. For theother two groups, it is positive but not significant. Hence, results for financially unconstrained
firms are not as clear as those for financially constrained firms. Nevertheless, since all thecoefficient estimates of β6 are negative and three of the estimates of β7 are positive, the results
suggest that overinvestment is a dominant factor for financially unconstrained firms andaccounting conservatism can constrain overinvestment and improve firm future performances.
Panel B based on ΔROA provides qualitatively similar results.
Taken together, results from table 3 and 4 provide consistent and strong evidence that
accounting conservatism can cause financially constrained firms to under invest. But the results
provide consistent but statistically weak evidence that accounting conservatism can also
constrain overinvestment for financially unconstrained firms.
5. Endogenous choices of conservatism and firm investment
It is expected that firms make decisions regarding corporate reporting policies andinvestment policies jointly. A firm’s operating environment, legal risk and nature of agency
problem it faces can influence both investment behavior and accounting reporting. In theprevious empirical tests, several steps are taken to alleviate the endogeneity problem. For
example, I measure firm investment at time t+1 and accounting conservatism at t, which reduces
the extent of endogeneity problem arising out of simultaneous determination of these variables.

22Second, I use residuals of the investment model as the main measure of investments to alleviate
the concern that variables determine firm investments may also simultaneously affect firm
accounting reporting policy. Lastly, I also include other variables in the expanded Basu’s model
to control for other factors that can affect firm accounting conservatism.
To further alleviate the endogeneity concern, I exploit the passage of SOX in 2002. The
passage of SOX increases legal liability and fines for managers for issuing false statements. One
implication of this increased fines and regulatory scrutiny is that managers have greater
incentives to avoid using their discretion to overstate earnings and to be more conservative when
faced with uncertainty and increased legal liability. For example, Browning (2002) notes that“requiring chief executives at the nation’s largest companies to personally endorse thecompany’s financial filings and face punishment if the filings are false, could make somecompanies file unexpectedly conservative number.”
Empirical studies provide supporting evidence that managers indeed become moreconservative in reporting accounting information after SOX. Lobo and Zhou (2006) find thatfirms report lower discretionary accruals after SOX than in the period preceding SOX. Using aquasi natural experiment setting, Iliev (2010) also document that firm discretional accruals
decrease significantly after the passage of SOX. Further, using Basu’s measure of conservatism,
Lobo and Zhou (2006) also document that firms incorporate losses more quickly than gains when
they report income in the post-SOX period. The key assumption in this section’s empirical tests
is that this change in firm conservative reporting after the passage of SOX, which occurred in
response to a change in the regulation rule, is exogenous to the firm’s investment decisions.12

12Bargeron, Lehn, and Zutter (2010) show that capital investments by U.S. publicly traded firms declined after thepassage of SOX because increased legal liability and enhanced internal controls cause managers to take on less risk.
Hence, it is possible that increased legal liability cause managers to report conservative accounting and reduce firm
investment simultaneously. However, this explanation is unlikely because firm investment opportunities are only23

To empirically test whether the measure of conservatism increases in the period of post
SOX for my sample firms, I estimate an expanded Basu’s model by interacting a dummy
variable Post, which takes the value 1 if the fiscal year is after 2002 and 0 otherwise. I interact
the variable Post with variable R, D, and R * D separately. In addition, I also include firm
leverage, market to book, litigation dummy variable and two-digit SIC industry indictors asadditional controls. Specifically, I estimate the following model:
Xi,t = β0 + β1 Di,t + β2 Ri,,t + β3 Di,t * Ri,t + β4 Post i,t+1 + β5 Post i,t+1 * Di,t+ β6 Posti,t+1 * Ri,,t+ β7 Post i,t+1 *Di,t * Ri, + βi Control Variables + vj +ei,t(4)

Results are reported in table 5. As shown the table, the coefficient on Post * R * D ispositive and significant (0.039 with p-value of 0.000) without adding additional control
variables.

After controlling for other factors that affect firm conservatism, the coefficientdecreases to 0.037 and significant at the 1% level. Likewise, the coefficient on Post * D isnegative and significantly different from zero for both model specifications. Overall, results inthis table are consistent with the findings of prior studies that firms are become more timely inincorporating bad news and less timely in incorporating good news into earnings after thepassage of SOX.
Next, I examine how the passage of SOX affects firm investment behaviors. Empirically,
I estimate a modified equation (1) by adding two additional variables Post and FC and theinteractive variable, Post * FC. FC is an indicator variable equal to 1 if the firm is classified as
financially constrained and 0 if the firm is classified as financially unconstrained. The

observable to managers and corporate boards or internal control system cannot directly affect managers’ investment
behavior, contradicting Bargeron et al.’s assumption. Instead, corporate boards can affect firm investment behavior
indirectly through executive compensation contracts (Dechow and Sloan, 1991; Gibbon and Murphy, 1992). I argue
in this paper that because managers are personally responsible for the reliability of reported accounting information,
the legal liability for misreporting increased. To reduce the potential legal liability, managers will reportconservatively. Consequently, because managers’ compensation, reputation and career security is tied to accounting
earnings, they decide to invest in less risky asset in the period after SOX. Hence, the argument in this paper
provides an explanation for Bargeron et al’s findings.

24

classification of financially constrained and unconstrained is same as those discussed in previous
section. Using the dummy variable Post as an instrument for firm conservatism, I examine
whether firm investments decrease significantly after the passage of SOX and whether thedecrease is more pronounced for financially constrained firms relative to unconstrained firms.
The particular interest is the coefficient on the variable Post * FC. A negative coefficient on thevariable Post * FC would suggest that the passage of SOX (increased conservatism) can cause
financially constrained firms to reduce investment in the periods after SOX, aggravating
underinvestment problem.
Table 6 reports estimation results. Column (1) presents results based on full sample.
Consistent with the predictions and the findings by Bargeron, Lehn, and Zutter (2010), thecoefficient on Post is significantly negative, suggesting that firm investments decreasesignificantly after the passage of SOX. More importantly, the results from column (2) to (5)show that the coefficients on Post * FC are significantly negative for all four financial constraintclassifications. Hence, the passage of SOX (the increase in conservatism) causes financiallyconstrained firms to decrease their investments significantly more. Therefore, the exogenous
increase in conservatism aggravates the underinvestment problem faced by financiallyconstrained firms. Interestingly, the coefficient on FC is positive and significant suggesting that
financially constrained firms invest more than unconstrained firms. This finding is same as thefindings in Faulkender and Wang (2006) and Denis and Sibikov (2010).
I also re-examine equation (3) and investigate the changes in the relationship between
conservatism and firm investment pre and post the passage of SOX for financially constrained
firms. Specifically, I compare the coefficient changes (β6, β7 and β6 + β7) pre and post the passage

25

of SOX for financially constrained firms.13 Table 7 provides results. As shown in the table, thecoefficient estimates of β6 increase significantly and coefficients of β7 decrease significantly post
SOX. The results hold for both the whole sample and the four financial constraint groups. All thedifference are significantly at the 5% level. Hence, the results provide further evidence that thepassage of the SOX increases the level of conservatism. Consequently firms reduce theirinvestmetns after the exogenous increase in conservatism.
6. Cross sectional tests
In this section, I explore the cross-sectional implications of the underinvestment
hypothesis for the financially constrained firms. As discussed in section 2, I expect the negative
correlation between investment and accounting conservatism be more pronounced for firms withshort-tenured CEOs and for firms with risky operating environment. In addition, since thedocumented underinvestment is a part of agency costs, I also explore whether CEO equity
ownership can alleviate this underinvestment problem.

That is, I expect that the negative

correlation between conservatism and firm investment is more pronounced for firms with low
CEO equity ownership.
To test these conjectures, I limit my sample firms only to the financially constrained
firms. I further partition the financially constrained firms into two subgroups with high and low
underinvestment incentives. And then I estimate equation (3) separately for the two subgroups.
Following Dechow and Sloan (1991) and Gibbon and Murphy (1992), the measure of CEO
tenure horizon is based on the number of years before a CEO leaves office (Horizon). Firms
with CEOs leaving office within two years are sorted into the short-horizon subgroup (highunderinvestment incentive group). If CEOs are at least three years away from leaving office,then those firms are sorted into the long-horizon subgroup (low underinvestment incentive
13

Results for financially unconstrained firms are qualitatively same.

26

group). Following Kahn and Watts (2009), I use the standard deviation of daily stock return tomeasure the volatility of firm operating environment, denoted as RetVol. Firms with high return
volatility are arguably to have more risky projects in their investment opportunity set, and firmyears with RetVol higher than the median of the subsample are sorted into high risk subgroup(high underinvestment incentive group). Likewise, RetVol lowers than the median is labeledsorted into low risk subgroup (low underinvestment incentive group). To test whether CEO
equity ownership can alleviate the underinvestment problem induced by conservatism, firm-year
observations are sorted into high and low ownership subgroup based on CEOs’ total equity
ownership. Prior studies (Jensen and Murphy, 1990; Arggarwal and Samwick, 1999) show thatthe vast majority of incentive alignment provided by compensation is due to a CEO’s ownershipof stocks and options. Hence, I use the percentage of CEOs’ equity holding in the form of bothstocks and options over the total number of outstanding common stocks (CEO_Own) to proxy
for the degree of incentive alignment. Firm-years with CEOs’ equity ownership higher (lower)
than the median ownership of the subsample are sorted into the high (low) equity ownershipsubgroup (High ownership corresponds to lower underinvestment incentive). Because data on
CEO equity ownership and tenure horizon is obtained from ExecComp, which are available after
1992 for relatively large firms, the sample size for this section’s tests are decreased significantly.
Table 8 provides results on testing the cross sectional variation. To save space, I only
tabulate the results for financial constrained firms measured by payout ratio. Results based onother measures of financial constraint are qualitatively same and are not reported. Further, toincrease the sample size, I use the median payout ratio of the sample as the cutoff point andclassify firms with payout ratio less than sample median as financially constrained rather thanbottom 30 percentile. Columns labeled Horizon, RetVol and CEO_Own report results for testing27

the relationship between conservatism and firm investment conditional CEO tenure horizon, firmrisk, and CEO equity ownership respectively. As predicted, the estimated coefficients of β6 on
RInvest * R are positive and significant (except for the short Horizon column) and β7 on RInvest* R * D are negative and significant for the short horizon, high risk, and low equity ownershipsubgroups, but not significant for the other subgroups. The differences of β6 and β7 across threesets of partitioned subgroups are significant at the 1% level except for the difference of β6 in the
Horizon column. Coefficient estimates on control variables are not reported to save space, butthey are all significant and loaded with expected signs.
7. Robustness check7.1. The effect of R&D expenditure on the relationship between accounting conservatism andinvestment.
As discussed in prior section, firms invest relatively heavily in research and development
costs are excluded from the sample because large research and development costs can cause anegative relation between earnings and returns, and this negative correlation can affect themeasurement of conservatism and confound the association between accounting conservatism
and firm investment. Excluding firms investing more than 70% of their total investment in R&D
can alleviate this problem, but not totally eliminate the problem.

To further alleviate theconcerns over the possible confounding effect, I rerun all the empirical tests by excluding firmyears with positive research and development costs.
The sample size is reduced by almost half after excluding firm-years with positive R&D
expenditures.

Consistent with the first hypothesis, the untabulated results show that thecoefficient estimates on RInvest i,t+1 * Di,t * Ri,t are significantly negative across both all
specifications (-0.392 and -0.262 respectively for financially constrained and unconstrained firms
based on payout classification).

Therefore, the negative correlation between accounting
28

conservatism and investment for financially constrained firms is robust after excluding firms
with positive R&D expenditures.
7.2. Alternative measure of firm investments
In this section, I use two alternative measures of firm investments to show the robustnessof the documented relationship between conservatism and firm investments. First, I use changes
in investments from year t to t+1 scaled by book value of asset at year t and firm total
investments as the measure of investments. Following Richardson (2006), the total investment iscalculated as the sum of all outlays on capital and acquisition expenditures less receipts from thesale of property, plant and equipment (CAPX + AQC – SPPE) scaled by the beginning year bookvalue of assets (AT).

Specifically, I replace variable RInvest with changes in investment inequation (3) and estimate equation (3) separately for financially constrained and unconstrained
firms. When investment is measured as total investment, I first replace variable Invest inequation (1) with the measure of total investment and then use the residuals as the measure ofinvestment and estimate equation (3) for financially constrained and unconstrained firms.
Untabulated results show qualitatively same results as shown in table 3 and table 4.
7.3. Firm investment opportunity, accounting conservatism and firm investment
LaFond and Roychowdhury (2008) and Kahn and Watts (2009) show that conditional
conservatism is positively correlated with firm investment opportunity set (measured as market
to book value of equity). This is so because high growth firms may need more external financing
to realize future growth opportunity. Because conservative accounting policy reduces
information asymmetry and enhances contracting efficiency, we should expect firms with highinvestment opportunity set will be more conservative. Hence, investment opportunity set may
drive both conservatism and future investment policy (a positive correlation between investment

29

and accounting conservatism). But this positive correlation is the opposite of my prediction (anegative correlation between conservatism and investment). Roychowdhury and Watts (2007)
argue and find that Basu’s accounting conservatism measured over short time interval can causea negative correlation between conservatism and firm market to book value because short-time
interval measure of conservatism contains some measurement errors. Hence, it is likely that themeasurement error of conservatism can drive the negative correlation between conservatism andinvestment, which are determined simultaneously by investment opportunity set. Although I
have controlled firm investment opportunity in the empirical tests, to further reduce any concern,
following Roychowdhury and Watts (2007), I measure accounting conservatism over a long timeinterval to reduce the measurement error problem. Untabulated results show that the negative
correlation between conservatism and firm investments for both financially constrained andunconstrained firms are not changed.
8. Conclusion and discussion
Accounting literature has debated over the role of accounting conservatism on managers’
investment incentives.

However, extent empirical studies only focus on how accounting

conservatism can reduce managers’ overinvestment tendency and none of them have investigatedwhether accounting conservatism can also cause underinvestment. This study provides initial
empirical evidence whether accounting conservatism can cause dysfunctional investment
incentives for managers. Based on an expected investment model, I use the residuals of themodel as the main measure of firm investments and document that accounting conservatism isnegatively correlated with firm investments for financially constrained firms.

Becausefinancially constrained firms are more likely to suffer underinvestment ex ante, the negative
correlation between conservatism and investment indicates that conservatism can cause30underinvestment for financially constrained firms.

Further evidence show that accounting

conservatism is also negatively correlated with firm future performance for financiallyconstrained firms, lending additional support that accounting conservatism can cause
dysfunctional investment incentives. Lastly, consistent with literature’s arguments, I also findthat the negative correlation between conservatism and investment is more pronounced for risky
firms and for firms with short-horizon CEOs. Consistent with Jensen and Meckling (1976), I
also find that CEOs’ equity ownership can alleviate this negative correlation, suggesting that
equity ownership can align managers’ interests with those of stockholders and reduce the agency
costs related to firm investment policy. Using the passage of SOX as an exogenous shock tofirm conservatism, I document that firm investments decrease significantly in the period post
SOX and the decrease is more significant for financially constrained firms. Taken together,empirical results provide consistent and robust results suggest that conservatism can cause
underinvestment for financially constrained firms.
Prior literature documents ample evidence regarding the benefits of accounting
conservatism, and this paper contributes to this line of literature by providing a more complete
picture on the economic impacts of accounting conservatism. Nevertheless, the results of thepaper do not suggest that financially constrained firms behave irrationally and adopt accounting
conservatism at a suboptimal level. On the contrary, financially constrained firms optimallytrade off costs and benefits of accounting conservatism and are willing to bear the costs ofaccounting conservatism given the benefits they enjoy as long as the benefits outweigh the costs.
Alternatively, it is also likely that external forces (like regulation and legal liability) cause firms
to adopt conservatism at an suboptimal level and cause underinvestment problems.

31This study also contributes to the literature examining managers’ earnings related
investment incentives. In particular, this paper documents the exact property of accounting
earnings that incentivizes managers to behave myopically when their welfare is tied toaccounting earnings.

32

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Appendix – Variable Definitions
Dependent Variables:
Net Capex:

Capital expenditure from cash flow statement (CAPX) net of depreciation
expenses (XDP) scaled by assets scaled by beginning year book value of
asset (AT);RInvest:Residual values from estimating the investment model equation (1);Total Investments:

Sum of all outlays on capital and acquisition expenditure less receipts
from the sale of property, plant and equipment (CAPX + AQC – SPPE)
scaled by beginning year book value of asset (AT);ΔCapex:Change in capital expenditures from year t to year t+1 scaled by assets atyear t;X:

Earnings before extroadinary item (IB) scaled by the market value ofequity at the beginning of the year (PRCC_F * CSHO);

Independent Variables:R:

Twelve month compounded returns beginning nine month prior to fiscal
year and ending three month after the announcement of fiscal year
earnings;

D:

Dummy variable equal to 1 if return is negative and 0 otherwise;Q:

Tobin’s q, calculated as sum of market value of equity and total debt
(PRCC_F * CSHO + DLC + DLTT) scaled by the beginning year assets(AT);

Leverage:

Firm’s leverage is calculated as the book value of debt over book value of
assets (DLC + DLTT) / (AT);Size:

The log value of assets (AT);MTB:

Market to book value of equity, calculated as the ratio of market value ofequity over book value of equity (PRCC_F * CSHO /CEQ);

SaleGrth:

The percentage changes in sales (SALE) in a given year;

LIT:

a dummy variable equal to one if a firm falls in high litigation risk
industry as identified in Roychowdhury and Watts (2008) and zerootherwise;36

Cash:Cash flow from operation (OANCF) scaled by beginning year assets (AT);Own_WO:

The total number of stocks, options owned by the CEO over the total
stocks outstanding;Debt Rating:

S&P LT domestic issuer credit rating (SPLTICM);

Paper Rating:

S&P short term debt rating (SPSTICM);

Payout:Total dividends adjusted for repurchase of common shares over operation
income ((DVC + PRSTKC)/OIBDP);

Post:

Dummy variable equal 1 if fiscal year is after 2002 and 0 otherwise;

RetVol:Standard deviation of firm daily stock return for year t;

Horizon:Number of years before a CEO leaves office;

ΔROA:

Difference in net income (IB) scaled by total assets (AT) from year t-1 toyear t+2;

ΔCFO:

Difference in cash flow from operations (OANCF) scaled by total assets(AT) from year t-1 to year t+2;u:Year indicator variable;v:

Two-digit SIC code industry indicator variable.

37

Table 1
Descriptive Statistics
Panel A: Summary Statistics
Firm Characteristics
Xt
Rt
Qt
Net Capext+1
RInvestt+1
Leveraget
MTBt
Sizet
LITt
Casht
Payoutt
Bond Ratingt
Paper Ratingt
SaleGrtht
RetVolt
CEO_Ownt
ΔROAt-1,t+2
ΔCFOt-1,t+2

N
42,65542,65542,65542,65542,65542,65542,65542,65542,65542,65540,14042,65542,65542,65542,655
11,42135,07435,074

Mean
0.026
0.133
1.665
0.027
0
0.195
2.691
5.256
0.280
0.051
0.103
0.252
0.100
0.189
0.032
0.043
-0.0140.001

Median
0.048
0.046
1.182
0.010
-0.009
0.174
1.933
5.053
0.000
0.067
0.053
0
0
0.104
0.029
0.019
-0.006
0

38

25th
0.115
0.535
0.829
-0.007-0.028
0.169
2.434
1.877
0.000
0.009
0
0
0
0.011
0.021
0.008
-0.044-0.00375th
0.001-0.210
1.924
0.042
0.014
0.301
1.218
3.842
1.000
0.125
0.203
1
0
0.275
0.040
0.044
0.026
0.002

Std. Dev.
0.083
0.355
1.405
0.061
0.055
0.316
3.224
6.525
0.449
0.127
1.071
0.434
0.300
0.569
0.016
0.070
0.115
0.599

Table 1 (Continued)
Panel B: Pearson Correlation
X
0.138

Q
0.167
-0.075

Capital
Exp.
0.132
0.119
0.110

Leverage-0.055-0.006-0.304-0.034

MTB
0.191
0.017
0.824
0.115
-0.097Size-0.0490.105-0.119-0.092
0.362
0.056

CEO_Own
R
0.031
X
0.049
Q
0.097
Capital Exp.
0.029
Leverage-0.132
0.015
MTB
Size
-0.278
LIT
0.046
0.007
Cash
SaleGrth
0.093
0.001
Payout
RetVol0.132This table provides summary statistics and Pearson correlation between variables. The bold number of correlation indicates that the correlation is
statistically significant at the 5% level or better, all the variables are defined in Appendix.

39

LIT
0.016
-0.0930.156
0.115-0.181
0.062-0.066

Cash
0.120
0.419
-0.1050.186-0.005-0.0670.264-0.098

SaleGrth
0.077
0.155
0.128
0.078
0.003
0.137
-0.0470.025-0.001

Payout
0.007
0.027
0.009
-0.027-0.0120.015
0.033-0.0020.029
0.001

RetVol-0.233-0.0060.031-0.007-0.023-0.014-0.4820.095-0.2090.060-0.033

Table 2: Univariate Analysis – accounting conservatism and firm investment:
Panel A: Investment = RInvest
Investi,t+1 = α0 + α1 Qi, t + α2 Cashi, t + α3 Ri, t + α4 Leveragei, t + α5 SaleGrthi, t + ei,t+1
Xi,t = β0 + β1 Di, t + β2 Ri, t + β3 Di, t * Ri, t + ei,t
1 (Bottom)-0.0562-0.0243-0.00940.009

5 (Top)
0.049

β2

0.010

0.012

0.018

0.026

0.039

β3

0.152

0.131

0.109

0.081

0.082

N

8,531

8,531

8,531

8,531

8,531

Panel B: Investment = Net Capital Expenditures
Xi,t = β0 + β1 Di, t + β2 Ri, t + β3 Di, t * Ri, t + ei,t
1 (Bottom)-0.0272-0.004

3
0.010

4
0.034

5 (Top)
0.128

β2

0.004

0.010

0.012

0.012

0.014

β3

0.131

0.104

0.083

0.088

0.081

8,531
8,531
8,531
8,531
8,531
N
This table reports OLS estimations of Basu’s conservatism model. All the variables are definedin Appendix.

40

Table 3: Multivariate Analysis –Accounting Conservatism and Underinvestment Based on Underinvestment Incentives
Xi,t = β0 + β1 Di,t + β2 Ri,,t + β3 Di,t * Ri,t + β4 RInvest i,t+1 + β5 RInvest i,t+1 * Di,t+ β6 RInvesti,t+1 * Ri,,t+ β7 RInvest i,t+1 *Di,t * Ri,t + βi Control Variables+ ut+ vj +ei,t
Whole
SamplePayoutConstr. Uncon.

Size
Constr. Uncon

Bond Rating
Constr. Uncon

Paper Rating
Constr. Uncon.

0.045
0.000
-0.013
0.001
0.046
0.000

-0.0590.007-0.0130.209
0.049<.0001

0.074
0.001-0.0170.008
0.044<.0001-0.0750.014-0.004
0.741
0.056
0.000

0.028
0.074
0.010
0.453
0.083
<.0001

0.032
0.021
0.002
0.983
0.029
0.213

-0.0240.158-0.023
0.065
0.033
0.001

-0.0110.455-0.0160.006
0.039<.0001

0.062
0.000
0.028
0.075
0.079
0.049

0.029
0.031
0.129
< .0001

0.061
0.016
0.023
0.519
0.173
0.155
<.0001 <.0001

0.075
0.062
0.021
0.532

0.055
0.435
0.206
<.0001

0.182
0.023
0.216
<.0001

0.098
0.000
0.119
<.00010.092<.00010.138<.0001

0.007
0.945
0.198
<.0001

Control Variables
Industry & Year Dummy

0.023
0.305
0.025
0.050
-0.199
0.004
Yes
Yes

0.007
0.842
0.091
0.034
-0.228
0.003
Yes
Yes

-0.019
0.622
0.074
0.065
-0.168
0.092
Yes
Yes

0.065
0.057
0.065
0.043
-0.301
0.012
Yes
Yes

-0.038
0.452
0.036
0.204
-0.878<.0001
Yes
Yes-0.062
0.366
0.081
0.032
-0.678
0.005
Yes
Yes

0.004
0.839
0.045
0.064
-0.269
0.002
Yes
Yes

-0.007
0.792
0.057
0.047
-0.302
0.000
Yes
Yes

-0.064
0.423
0.042
0.288
-0.723
0.103
Yes
Yes

Adjusted R-squre

13.02

14.65

14.35

16.34

12.75

13.40

15.45

12.83

20.32

Intercept
DR
R *D
RInvestRInvest * D
RInvest * RRInvest * R * D

42,655
16,200 11,695
12,602 12,707
31,549 11,106
37,966
4,689
NThis table reports OLS estimation of running equation (3) conditional firm financial status. Reported p-values are based on twotailed tests. All the variables are defined in Appendix.

41

Table 4: Multivariate Analysis –Accounting Conservatism and Future Performance
Xi,t = β0 + β1 Di,t + β2 Ri,,t + β3 Di,t * Ri,t + β4 ΔPerform i,t+1 + β5 ΔPerform i,t+1 * Di,t+ β6 ΔPerform i,t+1 * Ri,,t+ β7 ΔPerform i,t+1 *Di,t * Ri,t + βi Control Variables+ ut+ vj +ei,tPanel A: Δperform = ΔROA
PayoutConstr. Uncon.

Size
Constr. Uncon

Bond Rating
Constr. Uncon

Paper Rating
Constr. Uncon.

0.048
0.004
-0.0780.376
0.058<.0001

0.072
0.000-0.0190.007
0.040<.00010.038
0.102-0.0020.903
0.049<..000

0.048
0.001
0.001
0.932
0.087
<.0001

0.055
0.000-0.0200.000
0.042<.0001

0.054
0.002
0.023
0.209
0.063
0.046

0.059
<.0001-0.0170.000
0.050<.0001

0.072
0.000
0.021
0.204
0.074
0.108

0.014
0.556
-0.057
0.018

0.019
0.517
-0.556<.00010.053
0.042-0.0250.021-0.0340.635-0.089
0.001

0.027
0.137
-0.038
0.004

0.078
0.335
-0.091
0.046

0.020
0.221
-0.0380.003-0.0680.385-0.016
0.499

Control Variables
Industry & Year Dummy-0.027
0.968
0.017
0.115
-0.082
0.043
Yes
Yes

-0.0020.948-0.017
0.185
0.038
0.057
Yes
Yes

-0.052
0.053
0.007
0.237
-0.062
0.061
Yes
Yes

0.026
0.585
-0.029
0.033
0.086
0.160
Yes
Yes

-0.018
0.336
0.017
0.062
-0.052
0.049
Yes
Yes

-0.0820.839-0.082
0.042-0.175
0.087
Yes
Yes

-0.025
0.162
0.011
0.071
-0.038
0.110
Yes
Yes

-0.0480.243-0.054
0.311
0.139
0.134
Yes
Yes

Adjusted R-squre

14.26

14.78

15484

13.57

14.40

15.58

13.03

21.02

N

13,141

9,924

10,50010,50125,896

9,362

31,126

3,948Intercept
DR
R *D
ΔPerformance
ΔPerformance * D
ΔPerform * R
ΔPerform * R * D

42

Panel B: Δperform = ΔCFO
PayoutConstr. Uncon.

Size
Constr. Uncon

Bond Rating
Constr. Uncon

Paper Rating
Constr. Uncon.

0.048
0.003
-0.0090.315
0.060<.0001

0.072
0.000-0.0210.003
0.040<.00010.039
0.087-0.0040.748
0.051<..0000.047
0.001-0.001
0.944
0.086
0.000

0.054
0.000
-0.0180.000
0.042<.0001

0.055
0.002
0.021
0.253
0.052
0.115

0.058
<.0001-0.0160.002
0.050<.0001

0.071
0.000
0.020
0.228
0.074
0.105

0.010
0.692
-0.051
0.018

0.020
0.520
-0.056
0.102

0.042
0.203
-0.0350.028-0.086
0.203-3.214
0.025

0.023
0.217
-0.0490.002-0.041
0.958-0.091
0.046

0.013
0.421
-0.0480.003-0.0830.294-5.602
0.011

Control Variables
Industry & Year Dummy-0.002
0.947
0.019
0.065
-0.121
0.034
Yes
Yes

0.052
0.544
-0.047
0.055
0.098
0.073
Yes
Yes

0.005
0.872
0.013
0.072
-0.125
0.085
Yes
Yes

-1.2240.626-4.065
0.003
6.553
0.000
Yes
Yes

-0.011
0.713
0.019
0.102
-0.044
0.249
Yes
Yes

-0.0820.839-1.3090.142-2.727
0.187
Yes
Yes

0.010
0.736
0.021
0.100
-0.048
0.241
Yes
Yes

-3.280
0.303
2.394
0.311
-8.739
0.254
Yes
Yes

Adjusted R-squre

13.74

13.89

15.98

13.82

12.84

16.21

13.24

19.85

N

13,125

9,926

10,50010,50125,896

9,362

31,126

3,948Intercept
DR
R *D
ΔPerformance
ΔPerformance * D
ΔPerform * R
ΔPerform * R * DThis table reports OLS estimations examining the relationship between accounting conservatism and firm future operating
performance. Reported p-values are based on two-tailed tests. All the variables are defined in Appendix.

43

Table 5: SOX and Accounting Conservatism
Xi,t = β0 + β1 Di,t + β2 Ri,,t + β3 Di,t * Ri,t + β4 Post i,t+1 + β5 Post i,t+1 * Di,t+ β6 Posti,t+1 * Ri,,t+ β7 Post i,t+1 *Di,t * Ri,+ βi Control Variables + vj +ei,tExpected
Sign

Coeff.

P -Value

Coeff

P-Value

Intercept

0.057<.0001

0.028

0.085

D
R

-0.0060.022

0.000<.0001-0.0150.034

0.002<.0001

R *D

0.061

<.00010.101<.0001

Post-0.0060.000-0.006<.0001

Post * D

0.003

0.401

-0.001

0.672

Post * R--0.0130.000-0.014

0.000

Post * R * D

+

0.039

0.005

0.037

0.003

Control Variables
Industry Dummy
Adjusted R-Square

No

Yes

Yes

Yes

8.34

10.57

42,65542,655N
This table reports estimation results running equation (4). Reported p-values are based on twotailed tests. All the variables are defined in Appendix.

44

Table 6: SOX, Accounting Conservatism and Financial Constraints
Investi,t+1 = β0 + β1 Post + β2 FC + β3 Post * FC + β4 Qi, t + β5 Ri, t + β6 SaleGrthi, t+ β7 Cashi, t + β8 Leveragei, t + vi, t + ei,t+1
Expected
Sign
Intercept

Whole
SampleSize

Bond
Rating

Paper
RatingPayout

0.068
0.102

-0.000
0.949

0.009
0.157

0.009
0.071

0.00830.093-0.017<.0001-0.016<.00010.013<.0001-0.017<.00010.005
0.000-0.017<.00010.005<.0001-0.017<.0001
0.007<.0001-0.0020.024-0.0020.058-0.0020.036-0.003
0.091

Post

-

FC

?

Post * FC

-

Q

+

0.010
<.00010.009<.00010.009<.00010.010<.00010.010<.0001R+

0.011<.00010.011<.00010.011<.00010.011<.00010.011<.0001

SaleGrth+

0.00010.086

0.0001
0.042

0.0001
0.055

0.00010.085

0.0001
0.082

Cash

+

0.015
0.011

0.019
0.002

0.015
0.025

0.014
0.017

0.014
0.010

Leverage--0.018<.0001-0.022<.0001-0.019<.0001-0.014<.0001-0.018<.0001

Industry Dummy

Yes

Yes

Yes

Yes

Yes

Adjusted R-Square

28.34

30.57

30.05

30.86

30.42

N

46,25527,89525,30942,65542,655This table provides the OLS estimation results examining firm investment behavior pre and post Sox.
Reported p-values are based on two-tailed tests. All the variables are defined in Appendix.

45

Table 7: Relationship between accounting conservatism and firm investment around SOX for financially constrained firms
Xi,t = β0 + β1 Di,t + β2 Ri,,t + β3 Di,t * Ri,t + β4 RInvest i,t+1 + β5 RInvest i,t+1 * Di,t+ β6 RInvesti,t+1 * Ri,,t+ β7 RInvest i,t+1 *Di,t * Ri,t + βi Control Variables+ ut+ vj +ei,t
Size

Payout
Pre
Post

Pre

Post

0.045
0.001
-0.0150.006
0.045<.0001

0.038
0.065
0.006
0.598
0.041
0.002

0.031
0.104
-0.017
0.064
0.049
0.000

0.027
0.274
0.019
0.418
0.039
0.121

-0.077
0.025
0.014
0.452
0.057
0.000

-0.1060.000-0.039
0.459
0.052
0.112

0.065
<.0001-0.019
0.004
0.034
0.004

0.064
0.008
-0.012
0.493
0.067
0.001

-0.0070.623-0.015
0.015
0.037
0.000

-0.0120.578-0.004
0.838
0.033
0.033

0.032
0.023
0.123
<.0001

0.083
0.077
0.094
0.015

0.025
0.322
0.140
<.0001

0.150
0.065
0.076
0.247

0.108
0.0.14
0.098
0.008

0.148
0.301
0.058
0.369

0.040
0.101
0.141
<.0001-0.052
0.515
0.134
0.098

0.102
0.000
0.155
0.000

0.199
0.002
0.087
0.030

Control Variables
Industry & Year Dummy

0.012
0.602
0.041
0.054
-0.172
0.018
Yes
Yes

0.051
0.472
0.124
0.021
-0.338
0.062
Yes
Yes

0.034
0.339
0.043
0.112
-0.049
0.312
Yes
Yes

0.048
0.682
0.173
0.002
-0.467
0.041
Yes
Yes

0.046
0.392
0.076
0.102
-0.206
0.082
Yes
Yes

-0.272
0.094
0.097
0.092
-1.132
0.002
Yes
Yes

-0.017
0.742
0.104
0.004
-0.131
0.182
Yes
Yes

0.071
0.589
0.082
0.051
-0.296
0.091
Yes
Yes

0.008
0.798
0.062
0.084
-0.221
0.022
Yes
Yes

-0.071
0.416
0.103
0.056
-0.652
0.005
Yes
Yes

Adjusted R-squre

14.19

16.18

11.78

11.90

13.92

14.59

13.89

14.27

13.30

14.82

N

35,262

7,393

12,932

2,368

26,3695,180

26,3595,187

29,883

7,083

Intercept
DR
R *D
RInvestRInvest * D
RInvest * RRInvest * R * D

Bond Rating
Pre
Post

PaperRating
Pre
Post

Whole Sample
Pre
Post

This table reports OLS estimation results of running equation (3) separately for pre and post SOX for financially constrained firms. Reported pvalues are based on two-tailed tests. All the variables are defined in Appendix.

46

Table 8: Cross sectional tests –accounting conservatism and firm investments
Xi,t = β0 + β1 Di,t + β2 Ri,,t + β3 Di,t * Ri,t + β4 RInvest i,t+1 + β5 RInvest i,t+1 * Di,t+ β6 RInvesti,t+1 * Ri,,t+ β7 RInvest i,t+1 *Di,t * Ri,t + β8 Leverage i,t + βi Control Variables+ ut+ vj +ei,tHorizon
Short
Long

RetVolHigh
Low

CEO_Own
Low
High

0.055
0.264
0.054
0.174
-0.046
0.368

0.058
0.237
0.017
0.550
0.028
0.188

0.035
0.116
0.007
0.972
0.052
<.0001

0.042
0.001-0.0170.063
0.057<.00010.038
0.101-0.0890.063-0.092
0.006

0.037
0.085
0.034
0.365
0.066
0.275

-0.012
0.932
0.311
0.132

0.055
0.485
0.134
0.317

0.067
0.006
0.163
0.000

0.018
0.642
0.106
0.000

0.320
0.003
0.142
0.006

0.113
0.274
0.062
0.185

Control Variables
Industry & Year Dummy

0.431
0.247
0.057
0.432
-2.721
0.032
Yes
Yes

-0.108
0.710
0.069
0.204
-1.562
0.125
Yes
Yes

0.029
0.552
0.051
0.034
-0.715
0.038
Yes
Yes

0.032
0.382
0.027
0.315
-0.214
0.117
Yes
Yes

0.094
0.466
0.315
0.032
-0.928
0.001
Yes
Yes

-0.015
0.891
0.176
0.024
-0.243
0.375
Yes
Yes

Adjusted R-squre

29.35

27.80

17.20

15.87

25.34

27.23

N

909

1,776

13,947

13,948

2,280

2,258

Intercept
DR
R *D
RInvestRInvest * D
RInvest * RRInvest * R * DThis table reports estimation results of running equation (3) conditional on firm investment incentives for financially constrained firms measured
by dividend payout ratio. Reported p-values are based on two-tailed tests. All the variables are defined in Appendix.

47