The effect of accounting conservatism on measures of financial constraints

• Published date: 01 April 2023
• Author: Taewoo Kim,Brandon Byunghwan Lee,Bo Meng,Daniel Gyung Paik
• Date: 01 April 2023
• DOI: http://doi.org/10.1002/jcaf.22602

Received:  August  Accepted:  October 

DOI: ./jcaf.

RESEARCH ARTICLE

The effect of accounting conservatism on measures

of financial constraints

Taewoo Kim1Brandon Byunghwan Lee2Bo Meng3Daniel Gyung Paik4

College of Business and Public

Administration, California State

University, San Bernardino, California,

USA

School of Business and Economics,

Indiana University Northwest, Gary,

Indiana, USA

College of Business & Economics,

Longwood University, Farmville, Virginia,

USA

Department of Accounting, Robins

School of Business, University of

Richmond, Richmond, Virginia, USA

Correspondence

Daniel Gyung Paik, Robins School of

Business, Q RSB,  UR Drive,

Richmond,VA,,USA.

Email: daniel.paik@richmond.edu

Abstract

This study examines the relationship between accounting conservatism and

measures of financial status. Wefind that, in g eneral,a higher level of accounting

conservatism is associated with a lower level of financial constraints – thereby

making external funds less costly. The results also show that for a firm with a

higher bid-ask spread or a higher likelihood of bankruptcy, this negative rela-

tionship between conservative financial reporting and financial constraints is

intensified. In other words, a higher level of accounting conservatism is likely

to make external funds less costly especially for those firms with a higher level

of bid-ask spread or a higher level of bankruptcy risk.

KEYWORDS

accounting conservatism, financial constraints, financial reporting

1 INTRODUCTION

In this study, we are the first to investigate the direct rela-

tionship between accounting conservatism and financial

constraints by developing composite measures of these

constructs. A firm’s constrained financial status restricts

its course of economic actions, and results from informa-

tion asymmetries that make external funds costly. In debt

contracting practice, creditors have an informational dis-

advantage compared to borrowers. One type of problem

related to asymmetric information is the agency problem.

Holthausen and Watts ()andWatts() claim that

accounting conservatism helps to reduce agency problems.

Numerous studies examine whether the degree of account-

ing conservatism in a firm is associated with the extent

of the agency problem that results from debt financing

(see, for example, Armstrong et al., ; Christensen et al.,

;Zhong&Li,). Our results show that, in general, a

high level of accounting conservatism is negatively associ-

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©  The Authors. Journalof Corporate Accounting & Finance published by Wiley Periodicals LLC.

ated with constrained financial status – an association that

results in less costly external funding.

Prior studies provide evidence of a positive relationship

between the level of information asymmetry and the extent

of the bid-ask spread (see, for example, Glosten & Harris,

; Gregoriou et al., ). Our results show that a high

bid-ask spread intensifies the negative association between

conservative financial reporting and firm-level constrained

financial status.

In addition, prior studies document significant posi-

tive associations between accounting conservatism and

cash holdings (Hui et al., ; Kirschenheiter & Ramakr-

ishnan, ). Also, Louis and Urcan ()findthat

accounting conservatism reduces dividend payouts. These

findings regarding conservatism and cash holdings sup-

port the notion that accounting conservatism is likely to

reduce bankruptcy risk by easing debt contracting (see, for

example, Ball et al., ; Kothari et al., ). More specif-

ically,accounting conservatism helps to set lower net-asset

166 wileyonlinelibrary.com/journal/jcaf JCorp Account Finance. ;:–.

KIM  . 167

bounds in lending decisions (Sunder et al., ), and it

signals financial distress more quickly to facilitate lending

(Christensen & Nikolaev, ;Zhang,).

In this study, we also examine whether the relation

between accounting conservatism and constrained finan-

cial status is influenced by firms’ level of bankruptcy

risk. We predict that the role of accounting conservatism

in reducing financial constraints is more (less) promi-

nent in firms with high (low) bankruptcy likelihood. Our

results show that greater likelihood of bankruptcy indeed

intensifies the negative association between conservative

financial reporting and financial constraints.

In summary,we find that accounting conservatism helps

lower constrained financial status in general, and this

relationship is more pronounced for firms with higher bid-

ask spread and for firms with high bankruptcy risk. As

such, our study makes four contributions to the account-

ing and finance literature. First, we are the first to examine

the direct relationship between accounting conservatism

and constrained financial status. While prior account-

ing research posits that accounting conservatism plays

an important role in efficient debt contracting (Ahmed

et al., ;Watts,), our study provides direct empir-

ical evidence to substantiate this claim by examining the

broader benefits of accounting conservatism with respect

to financial constraints.

Second, we develop a composite measure of financial

constraints that mitigates the limitations of previously

developed measures (Buehlmaier & White, ; Farre-

Mensa & Ljungqvist, ). Third, similarly, we develop

a composite measure of accounting conservatism to over-

come the various restrictions of prior measures of conser-

vatism (Ball et al., ; Givoly & Hayn,;Qiang,).

Fourth, due to the increasing emphasis on the fair value

approach in accounting standards, regulators have been

moving away from conservatism as an accounting princi-

ple in their conceptual framework. However,conservatism

remains widespread in practice. By documenting the ben-

efits of conservatism related to the reduction of financial

constraints, we help explain why conservatism remains

widespread despite the reduced emphasis from regulators.

The remainder of the paper is organized as follows. The

next section discusses the background literatureand devel-

ops hypothesis development. Section provides details of

the data and methodology used. Section examines the

empirical results. Conclusions are offered in Section .

2BACKGROUND LITERATURE AND

HYPOTHESIS DEVELOPMENT

Information asymmetry is a circumstance under which,

when two parties are dealing with one another, one party

has more information than the other. Information asym-

metry can result in imbalance and even exploitation in

business transactions. Information asymmetry may also

increase a firm’s financial constraints, thereby making

external funds more costly. For example, an article pub-

lished by the National Bureau of Economic Research

(NBER) states that “ percent of (financially) constrained

firms reported that they bypassed attractive investments

because of concerns over raising money from outside the

company...,comparedwith...percentofunconstrained

firms.”

One type of problem related to asymmetric information

is the agency problem. An agency problem arises when

one party is more likely to take risks because any poten-

tial resultant costs will not be borne by that party. The

agency problem arises from a conflict of interest intrin-

sic to any relationship wherein one party is expected to

behave in a way that maximizes benefit to another. Prior

accounting studies have found that accounting conser-

vatism helps to reduce agency problems (for example, see

Holthausen & Watts, ;Watts,). Accounting con-

servatism requires that any probable losses be recognized

instantly upon discovery, while gains can be recognized

only once they are fully realized, resulting in a down-

ward bias in accounting net asset value. Numerous studies

examine whether the degree of a firm’s accounting conser-

vatism is associated with the extent of the agency problem

that results from debt financing (see, for example, Guay &

Verrecchia,, ; Armstrong et al., ; Christensen

et al., ;Zhong&Li,).

2.1 Financial constraints

Financial constraints arising from information asymme-

tries make external funds more costly than internal funds,

sometimes prohibitively so (see, for example, Kaplan &

Zingales, ;Whited&Wu,). Over the past decade,

several studies have investigated the role of financial con-

straints on corporate investment, but the results are mixed

(see, for example, Cleary,; Farre-Mensa & Ljungqvist,

).

Nini et al. () show that financing frictions (i.e., con-

flicts of interest) between borrowers and creditors have

a substantial impact on companies’ investment decisions.

They show that creditors often impose restrictions on the

capital expenditures of the companies who borrow money

from them. They further find that capital spending restric-

tions are likely to result in a reduction in firms’ invest-

ment. Similarly, Chava and Roberts () also find that

The Real Effects of Financial Constraints (The Digest by NBER, April

), retrieved from https://www.nber.org/digest/apr/real-effects-

financial-constraints