Accounting Conservatism and Managerial Risk-Taking: Corporate Acquisitions

Abstract:     
Watts (2003) and Ball and Shivakumar (2005) argue that accounting conservatism decreases managerial incentives to make negative net present value investments. I develop and test a new hypothesis that posits accounting conservatism decreases managerial incentives to make riskier investments. I find evidence that under more conservative accounting managers make less risky acquisitions. This association is driven by firms with accounting-based debt covenants. These results are explained by debt holders’ concerns regarding risk-shifting which can occur quickly through acquisitions, and managers’ concerns regarding violating covenants. The implication of these results is that for shareholders the debt contracting benefits of conservatism outweigh the potential costs of conservatism. A potential cost of conservatism in this setting is if managers forgo riskier yet positive net present value acquisitions.

Number of Pages in PDF File: 60

Keywords: mergers and acquisitions, accounting conservatism, risk-taking, debt covenants

JEL Classification: G34, M40, M41

working papers series