Does Financial Reporting Conservatism Mitigate Underinvestment?

This study examines the role of financial reporting conservatism in mitigating under-investment problems. Recognizing that volatile cash flows increase the need to access external capital markets, and that agency conflicts and information asymmetry make external capital costlier than internal capital, which leads managers to forgo valuable investment projects, Minton and Schrand (1999) document a negative relation between cash flow volatility and investment. We draw on Minton and Schrand’s (1999) framework to isolate under-investment problems, and hypothesize and document that conservatism mitigates the negative relation between cash flow volatility and investment, and that this mitigative effect is more pronounced for firms with ex ante more severe agency conflicts. We also document that conservatism mitigates the sensitivity of investment to cash flow volatility by facilitating access to external capital.

Keywords: Financial Reporting Conservatism, Underinvestment, Cash Flow Volatility, Agency Conflicts, Information Asymmetry

JEL Classification: G31, M41

Suggested Citation: Suggested Citation

Hong, Hyun A. and Kim, Yongtae and Lobo, Gerald J., Does Financial Reporting Conservatism Mitigate Underinvestment? (June 24, 2017). Journal of Accounting, Auditing and Finance, Volume 34, Issue 2, pp. 258-283, 2019, Available at SSRN: https://ssrn.com/abstract=2992109 or http://dx.doi.org/10.2139/ssrn.2992109