The Relationship between Accounting Conservatism and Efficient Investment

Journal of Accounting Advances (J.A.A)
Vol. 6, No. 2, 2014, Ser. 67/3
 
 
Extended Abstract
 
The Relationship between Accounting Conservatism and Efficient Investment
 
Dr. Seyed Ali Vaez                                        Mohsen Rashidi Baghi
Shahid Chamran University
 
Introduction
As an important course of corporate value creation, investment is deeply subject to information asymmetry and agency problems. What’s commonly believed is that information asymmetry adds to market friction and exerts influence on the cost of external financing, easily leading to insufficient investment for companies under liquidity constraint. On the one hand, listed companies are currently struggling against, due to agency problems, widespread over investment and serious abusive use of free cash flow and on the other hand, obvious financing constraints and severe shortage in investment attributable to information asymmetry. Both over investment and insufficient investment belong to inefficient investment behaviors which will cause tremendous losses to investors and waste of social resources (Xu et al, 2013). Also known as the cautious principle or the prudence principle, conservatism represents a prudent reaction to future uncertainties, serving as one of the most critical principles employed both by international accounting standards and China’s accounting standards, as well as a significant feature and practice of financial statements. Stemming from contract needs, accounting conservatism is clearly affected by institutional factors and managers’ motives (Watts, 2003). We believe the functions of accounting conservatism, market signaling and internal government, exert varying effects, according to different environment and conditions, on investment decision-making. When internal capital proves insufficient for current needs of investment and a firm is in need of external financing, the role of accounting conservatism as a market signaler dominates. However, accounting conservatism predominantly plays an internal governance role when internal capital is enough for investment, rooting out the need for external funding. Through internal governance, conservatism suppresses over investment and reduces agency cost, which ultimately shrinks firm investment.
 
Research Hypothesis
1.When a company needs external financing because its internal capital cannot meet the need of investment, conservatism functions to advance investment by removing information asymmetry and when external financing is unnecessary with thanks to sufficient internal capital, conservatism works to suppress the level of investment through reducing agency cost.
2. The promoting or suppressing effect of conservatism on investment weakens as agency and information problems become worse. Specifically, with other conditions fixed, enterprises whose ultimate controller is local governments or individuals react less obviously to the promoting or suppressing effect of conservatism on investment compared with other enterprises.
 
Methods
The data related to the companies listed in Tehran Stock Exchange for the period of 1384 to 1390 were extracted and the combination regression model was used to test the hypotheses.
1384-1390 data of all companies listed at Tehran Stock Exchange before 1384 is our research samples. Samples have undergone the following treatment in order to find out the influence of abnormal data and ensure company homogeneity and data effectiveness.
(1) Listed financial companies are removed
(2) Companies with absent audit report or with “reserved opinion”, “reservation with explanatory notes” or “disclaimer of opinion” are removed
(3) Some special abnormal samples are also removed, such as listed companies with negative or close to zero expenditure on investment and those with negative net assets
(4) Companies with incomplete seven-year data are also removed.
The remaining are 120 companies with 840 sample observation values.
 
Results
The results show that there is a significant relationship between accounting conservatism and investment efficiency in both larger and smaller than the net worth of internal capital but, relationship between accounting conservatism and investment efficiency with respect to the level of institutional ownership and managerial ownership has not been confirmed.
 
Discussion and Conclusion
With the 840 samples of the 120 companies listed at Tehran Stock Exchange from 1384 to 1390 as its object, this paper studied the relationship between investment and accounting conservatism. We have argued that the influence of conservatism on investment depends on whether external funds are needed. When investment exceeds the net worth of internal capital and external financing is needed, there is a positive correlation between investment and conservatism, indicating the promoting effect of conservatism on investment; but in this research, we can observe the negative correlation between investment and conservatism because of low level of specialty knowledge in our managers. When investment is smaller than the net worth of internal capital and no external funds are needed, however, there emerges a negative correlation between investment and conservatism, indicating the suppressing effect of conservatism on investment. This conclusion is true for the analysis of both total samples and individual samples. Moreover, we’ve found that the degree of seriousness of information and agency problems faced by a company, to some extent, affect the relationship between investment and conservatism and such relationship is weakened when the ultimate ownership is either institutional or managerial.
When the ultimate ownership is an institutional, there are more information problems resulting from multiple-agency and lack of strict restrictions and the inadequate supervision from major shareholders over the management adds to the risk of over investment. When the ultimate ownership is managerial, there emerge the problems of lack of restrict and consummate governance mechanism and strong personal pursuit of interest, leading to the implementation of radical accounting policies and ultimately more information and agency problems. Therefore, companies of both kinds face serious agency and information problems, greatly weakening the advancing effect of conservatism on investment as when external capital is needed and the suppressing effect of conservatism on investment as when external is not needed.