Accounting Conservatism and Capital Investments: Real Options Models and Evidence

Project Details

Description

This study investigates how accounting conservatism affects managers’ capital allocation decisions through altering their hurdle rates, which may incorporate managers’ attitude towards risk and their ex ante incentives. In the first year two real options models with different focuses will be derived. In the former model where no agency conflict between shareholders and manager is considered, instead it is stressed that the adoption of accounting conservatism raises the firm’s perception on both the growth rate and volatility of project returns on prospective investments. These changes will then induce the firm to employ a higher hurdle rate so as to achieve the goal to optimally choose the timing of investment.In the second theoretical model where the agency costs of equity are emerged, three strategies of investment will be derived. The reference strategy is the first-best (FB) one; under which the manager truthfully reports her private information to shareholders regarding the expected growth rate of returns on prospective investments. However, FB strategy is not achievable since the manager tends to over-report the probability that the growth rate of returns of prospective investment is low so that she can get the variable compensation based on the investment returns since the firm will then invest early according to her report. This second-best (SB) strategy which induces “underinvestment” can be alleviated after the firm adopts conservative accounting rules. This is because, the investors’ short-termism for the firm’s performance will force the manager to conduct an adjusted-second-best strategy (ASB) under which the firm chooses a timing later than the one under the SB strategy so that the investment returns on the accounting books remain the same as the time before the firm adopts accounting conservatism.In the second year empirical tests will be conducted by employing data of the U. S. firms listed on the NYSE, AMEX, and NASDAQ exchanges during the period from 1982 to 2013/2014. The main hypothesis is that firms adopting accounting conservatism have higher hurdle rates. The generalized method of moment (GMM) will be used so as to simultaneously estimate two equations, i.e., the Euler pricing kernel of intertemporal investment based on a structural model derived from maximizing the manager’s compensation, and a reduced-form asset pricing relation stressing on the link between hurdle rates and the extent of accounting conservatism of firms.Additional empirical tests will be conducted to support the results of the main hypothesis; Under the more restricted theoretical model where there is no agency conflict between the shareholders and the manager of a firm, although in general accounting conservatism increases the hurdle rates of firms, the increases in hurdle rates are expected to be less pronounced for multi-segment firms and firms whose organizational structure are more stable. By contrast, a firm is financially constrained or not may not be a key factor when considering the impact of the adoption of conservative accounting rules on investment behavior of the firm. Similarly, when the agency costs of equity are emphasized, accounting conservatism is expect to have higher impact on firms used to have higher agency costs such as the ones with smaller size, the less-opaque firms, and firms with high free cash-flow levels.
StatusFinished
Effective start/end date1/03/1631/07/17

UN Sustainable Development Goals

In 2015, UN member states agreed to 17 global Sustainable Development Goals (SDGs) to end poverty, protect the planet and ensure prosperity for all. This project contributes towards the following SDG(s):

  • SDG 13 - Climate Action
  • SDG 16 - Peace, Justice and Strong Institutions
  • SDG 17 - Partnerships for the Goals

Keywords

  • Accounting Conservatism
  • Capital Investment
  • hurdle rate
  • Real Options

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