Do Conservative Auditors Induce Myopic Underinvestment in R&D?

61 Pages Posted: 27 Jun 2016 Last revised: 15 Apr 2017

Mahfuz Chy

University of Toronto, Rotman School of Management, Students

Ole-Kristian Hope

University of Toronto - Rotman School of Management

Date Written: April 14, 2017

Abstract

In this study, we exploit exogenous variations in auditor conservatism arising from staggered changes in state-level auditor legal liability and examine whether an increase in auditor conservatism induces managerial myopia as manifested in R&D underinvestment. We hypothesize that conservative auditors constrain managerial ability to meet earnings thresholds and that managers in turn resort to real earnings management by cutting R&D investments. Consequently, auditor conservatism could induce myopic underinvestment in R&D and lead to a decline in client innovation as measured by patent-based metrics. Using a difference-in-differences regression approach with firm fixed effects, we find evidence consistent with this hypothesis. Cross-sectional analyses further reveal that the effect of auditor conservatism on myopic R&D underinvestment is greater when the incentives to meet earnings thresholds by R&D underinvestment are stronger. Our findings are robust to alternative explanations, changes in sample periods, alternative measures of innovation, and a battery of other sensitivity tests. Collectively, the evidence suggests that regulation-induced auditor conservatism leads to an important negative externality in the form of managerial myopia.

Keywords: Auditor conservatism; Auditor litigation; Innovation; Research design; Real effects; State liability laws; Patents; R&D; Going-concern opinions; Earnings management; Real earnings management

JEL Classification: M41, O31, O32, G31, G38

Suggested Citation

Chy, Mahfuz and Hope, Ole-Kristian, Do Conservative Auditors Induce Myopic Underinvestment in R&D? (April 14, 2017). Rotman School of Management Working Paper No. 2801183. Available at SSRN: https://ssrn.com/abstract=2801183 or http://dx.doi.org/10.2139/ssrn.2801183

Mahfuz R Chy

University of Toronto, Rotman School of Management, Students ( email )

Toronto, ON
Canada

Ole-Kristian Hope (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6
Canada

HOME PAGE: http://www.rotman.utoronto.ca/FacultyAndResearch/Faculty/FacultyBios/Hope.aspx

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