Does Financial Reporting Conservatism Mitigate Underinvestment?

Journal of Accounting, Auditing and Finance, Volume 34, Issue 2, pp. 258-283, 2019

39 Pages Posted: 26 Jun 2017 Last revised: 1 Jul 2019

See all articles by Hyun A. Hong

Hyun A. Hong

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management

Yongtae Kim

Santa Clara University - Leavey School of Business

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business

Date Written: June 24, 2017

Abstract

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

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

Hyun A. Hong

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management ( email )

Riverside, CA 92521
United States

Yongtae Kim

Santa Clara University - Leavey School of Business ( email )

500 El Camino Real
Santa Clara, CA California 95053
United States
(408) 554-4667 (Phone)
(408) 554-2331 (Fax)

Gerald J. Lobo (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States
713-743-4838 (Phone)
713-743-4828 (Fax)

HOME PAGE: http://www.bauer.uh.edu/acct/acctprofile.asp?search=Gerald%20Lobo

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