Evidence on the Role of Accounting Conservatism in Monitoring Managers' Investment Decisions

Abstract:     
Watts (2003) and others argue that conservatism helps in corporate governance (specifically in monitoring firms' investment policies). We hypothesize that if conservatism reduces managers' ex ante incentives to take on negative NPV projects and improves the ex post monitoring of investments, firms with more conservative accounting ought to have higher future profitability and lower likelihood (and magnitude) of future special items charges. We find that firms with more conservative accounting have (i) higher future cash flows and gross margins, and (ii) lower likelihood and magnitude of special items charges than firms with less conservative accounting. Our results hold after controlling for industry, firm size, leverage, growth opportunities, prior special items charges, and stock returns. These findings are (i) consistent with conservatism mitigating agency problems associated with managers' investment decisions as predicted by Watts (2003) and Ball and Shivakumar (2005), and (ii) inconsistent with standard setters' view that conservatism is not a desirable characteristic in financial reporting.

Keywords: accounting conservatism, corporate governance, agency costs

JEL Classifications: G31, G34, M41, M43, M44

Working Paper Series