The Effect of Accounting Conservatism on Corporate Investment Behavior

• In Event: Investment Behavior

Abstract

We examine how two types of conservatism―conditional conservatism and unconditional conservatism―affect corporate investment behavior. Conditional conservatism forces managers to timely recognize their losses resulting from an investment project. When risk-averse managers are aware that their reputation and compensation are affected adversely by timely recognizing the loss resulting from project failure, they are less likely to undertake the project ex ante despite its positive NPV. Thus, conditional conservatism is likely to inhibit corporate investment behavior. In contrast, unconditional conservatism mitigates a firm’s earning volatility, especially downward, by providing an accounting slack. Thus, unconditional conservatism is likely to promote corporate investment behavior. Using a large sample of Japanese companies, we empirically analyze how conditional conservatism and unconditional conservatism affect corporate investment behavior.
　This study provides two empirical findings. The conditional conservatism measurement relates negatively to the corporate investment behavior measurement, while the unconditional conservatism measurement relates positively to it. These results are robust to (i) including variables relating to capital investment as control variables, (ii) including lagged capital investment as an independent variable, (iii) using the non-standardized raw data as proxies for conditional conservatism and unconditional conservatism, (iv) using the abnormal depreciation rate of tangible fixed assets as a proxy for unconditional conservatism, and (v) using Basu’s [1997] model to examine the relationship between conditional conservatism and corporate investment behavior. Our findings suggest that firms with higher conditional conservatism take more negative investment initiatives, whereas firms with higher unconditional conservatism take more positive investment initiatives.
This study contributes to the literature on conservatism by providing new insight into the economic consequences of conservatism. Although many previous studies examine the relationship between conservatism and contracting or litigation risk, we provide evidence suggesting that conservatism affects corporate investment behavior. This study has implications for regulators and standard setters. In recent years, standard setters have excluded unconditional conservatism. If this trend continues, firms will probably take more negative investment initiatives.

Author

• Souhei Ishida, Hitotsubashi University