The Effect of Accounting Conservatism on Corporate Investment during the Global Financial Crisis

• Date: 01 May 2016
• Author: Luo Zuo,Karthik Balakrishnan,Ross Watts
• DOI: http://doi.org/10.1111/jbfa.12206
• Published date: 01 May 2016

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(5) & (6), 513–542, May/June 2016, 0306-686X

doi: 10.1111/jbfa.12206

The Effect of Accounting Conservatism on

Corporate Investment during the Global

Financial Crisis

KARTHIK BALAKRISHNAN,ROSS WATTS AND LUO ZUO∗

Abstract: This paper examines the effect of accounting conservatism on firm-level investment

during the 2007–2008 global financial crisis. Using a differences-in-differences design, we find

that firms with less conservative financial reporting experienced a sharper decline in investment

activity following the onset of the crisis compared to firms with more conservative financial

reporting. This relationship was stronger for firms that were financially constrained, faced

greater external financing needs, or had higher information asymmetry. We also find that

more conservative firms experienced lower declines in both debt-raising activity and stock

performance. The evidence suggests that accounting conservatism reduces underinvestment

in the presence of information frictions.

Keywords: accounting conservatism, investment, information frictions, financing constraints,

crisis

∗The first author is at the London Business School, London, UK. The second author is at the Sloan

School of Management, MIT, Cambridge, MA, USA. The third author is at the Johnson Graduate School

of Management, Cornell University, Ithaca, NY, USA. This paper integrates two working papers: ‘Credit

supply, financial reporting quality and investments: Evidence from the subprime mortgage credit crisis’

by Balakrishnan, and ‘Accounting conservatism and firm value: Evidence from the global financial crisis’

by Watts and Zuo. The authors appreciate the helpful comments of Martin Walker (the Editor), an

anonymous referee, Anwer Ahmed, Bill Baber, Eli Bartov, Anne Beatty, Mary Billings, Douglas Breeden,

Robert Bushman, Richard Carrizosa, Daniel Cohen, John Core, Anna Costello, Andre de Souza, Jamie Diaz,

Vicki Dickinson, Lucile Faurel, Pingyang Gao, Mark Gertler,William Greene, Wayne Guay, Michelle Hanlon,

Shane Heitzman, Kose John, JaeWoo Kim, Yongtae Kim, Kalin Kolev, S.P. Kothari, Wayne Landsman, Alina

Lerman, Baruch Lev, Dongmei Li, Siqi Li, Xiumin Martin, Lorenzo Naranjo, Jeffrey Ng, Edward Owens,

Seda Oz, Carrie Pan, Sorah Park, Reining Petacchi, Christine Petrovits, Sugata Roychowdhury, Rik Sen,

Aimee Shih, Nemit Shroff, Mohan Venkatachalam, Rodrigo Verdi, Charles Wasley, Joseph Weber, Toni

Whited, Joanna Wu, Eric Yeung, Haiwen Zhang, Liandong Zhang, Jerry Zimmerman, and Emanuel Zur,

as well as the seminar participants at Columbia University, CUNY-Baruch College, Emory University, the

London Business School, the Massachusetts Institute of Technology, New York University, Northwestern

University, the Ohio State University, the University of Arizona, the University of British Columbia, the

University of Chicago, the University of Florida, the University of Michigan, the University of Pennsylvania,

the University of Rochester,the University of Southern California, the 2011 UNC/Duke Fall Camp, the 2012

American Accounting Association Annual Meeting, and the 2013 National Taiwan University Accounting

Research Symposium.

Address for correspondence: Luo Zuo, Johnson Graduate School of Management, Cornell University,

Ithaca, NY 14853, USA.

e-mail: luozuo@cornell.edu

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1. INTRODUCTION

A growing literature studies the causes and consequences of the global financial

crisis of 2007–2008 (e.g., Campello et al., 2010; Duchin et al., 2010; Ivashina and

Scharfstein, 2010; Vyas, 2011; Huizinga and Laeven, 2012). Most of the accounting-

related work in this area focuses on financial institutions and seeks to understand

whether fair value accounting or accounting discretion contributed to the systematic

biases in valuations on bank balance sheets (e.g., Huizinga and Laeven, 2012). In this

study, we examine the role non-financial firms’ financial reporting played in affecting

the real economy during the crisis. Prior studies provide evidence that the financial

crisis of 2007–2008 represents a relatively exogenous shock to the supply of external

finance (at least with respect to any individual firm) that significantly weakened

firms’ funding abilities (Ivashina and Scharfstein, 2010) and caused underinvestment

(Campello et al., 2010; Duchin et al., 2010). We build on those studies and predict that

conservative financial reporting reduces potential underinvestment in the presence of

information frictions and ameliorates the negative impact of the crisis on corporate

investment.1

The theory underlying the hypotheses examined in this study is based on standard

models of investment with financing frictions (e.g., Jaffee and Russell, 1976; Stiglitz

and Weiss, 1981; Holmstrom and Tirole, 1997). This literature suggests that negative

shocks to the supply of external finance, together with a firm’s information frictions,

can hamper firm-level investment. For example, firms may face capital rationing

because of either adverse selection concerns arising from information asymmetry

between firms and capital suppliers (e.g., Jaffee and Russell, 1976; Stiglitz and Weiss,

1981) or moral hazard concerns arising from the private benefits of control (e.g.,

Holmstrom and Tirole, 1997). Suppliers of capital, when hit with a negative shock, may

be unwilling to provide financing to firms in the presence of information frictions. As

a result, some projects with positive net present values (NPVs) will not be financed.

The above concepts of financial market imperfections provide a theoretical link

between firms’ financial reporting and the amount/cost of financing they receive and

the economic activity in which they are hence able to engage. Armstrong et al. (2010)

provide an excellent discussion on information problems between firms and creditors,

and how accounting conservatism can help address them (also see Holthausen and

Watts, 2001; Watts, 2003a). The intuition is as follows. Debt holders of a firm have an

asymmetric pay-off with respect to net assets. As a result, they are concerned with the

lower ends of the earnings and net assets distributions. In assessing a potential loan,

lenders require verifiable lower bound measures of the current value of net assets

and use those as inputs in the loan decision. Further, they use those lower bound

measures to monitor the borrower’s ability to pay during the life of the loan. Debt

contracts use the lower bound measures of net assets to trigger technical default that

1 Accounting conservatism is a long-run equilibrium response to various institutional factors and firm

characteristics. The financial crisis provides us with a “shock” that helps to break this “equilibrium” and

as a result, we are able to document the effects of conservative financial reporting on firm investment in

this situation. The increase in uncertainty leads to the “unexpected” drying up of liquidity in the banking

system and unexpectedly increases conservative financial reporting’s relative benefits. Following the same

logic, several papers exploit the exogenous nature of financial crises and examine the effect of certain

corporate governance characteristics on firm performance during the Asian financial crisis of 1997–1998

(e.g., Johnson et al., 2000; Mitton, 2002; Lemmon and Lins, 2003; Baek et al., 2004). See Goldstein and

Razin (2015) for a thorough discussion of the theoretical literature on financial crises.

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