Accounting Conservatism and Corporate Investment Decisions: Evidence from a Structural Assessment

We investigate whether accounting conservatism solves the misalignment of interest between managers and shareholders by increasing hurdle rates used by managers during project selections. We argue that accounting conservatism raises managerial cautiousness in project screening. By incorporating bad news timely into earnings, conservative accounting system increases the likelihood of early termination of unsuccessful projects, increasing personal costs of the manager and thus deterring managers from investing in projects merely to enjoy private benefits. Using a structural model and GMM estimation, we find that conservative accounting increases hurdle rates and such increases are more pronounced for firms that exhibit higher degree of agency problem. We also find conservatism adds value to firms when investment is under consideration. Our work sheds lights on the literature attempting to identify the relation between accounting conservatism and managers' investment decisions.