How Conservative Accounting Helped Boost Investment during the Financial Crisis

Untitled-1A host of studies have examined the link between accounting and the 2007-2008 global financial crisis, most of them focusing on whether fair value accounting or accounting discretion at financial institutions helped skew valuations on bank balance sheets. In our recent article, “The Effect of Accounting Conservatism on Corporate Investment during the Global Financial Crisis,” available here, we examine how financial reporting at non-financial firms affected the economy during the crisis. Prior studies provide evidence that the financial crisis was a relatively exogenous shock to the supply of external finance (at least with respect to any individual firm) that significantly weakened firms’ ability to raise money (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 problems and ameliorated the negative impact of the crisis on corporate investment.

The theory underlying our hypotheses is based on standard models of investment (e.g., Jaffee and Russell 1976; Stiglitz and Weiss 1981; Holmstrom and Tirole 1997). This literature suggests that shocks to the supply of external finance, together with a firm’s information problems, can hamper firm-level investment. For example, firms may not be able to get financing because sources of capital don’t have enough accurate information about them (e.g., Jaffee and Russell 1976; Stiglitz and Weiss 1981) or capital providers are concerned that firms may misuse the financing proceeds (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 these information problems. 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 or cost of financing they receive and the economic activity they can engage in. Armstrong et al. (2010) provide an excellent discussion on information problems between firms and creditors, and how accounting conservatism can help resolve them (also see Holthausen and Watts 2001; Watts 2003a). The idea is that creditors 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 allows the loan to be called (Beneish and Press 1993) and to restrict managerial actions that reduce the value of net assets or otherwise reduce the value of the loan. Without such restrictions (i.e., debt covenants based on conservative accounting numbers), companies could not borrow, because management’s ability to distribute the assets, together with limited liability, make creditors wary of recovering their loans.

Based on the above discussions, we predict that accounting conservatism played an especially important role in mitigating underinvestment during the financial crisis. The crisis substantially limited a firm’s borrowing capacity, thus highlighting the importance of accounting conservatism in strengthening a firm’s funding ability. The global financial crisis was characterized by the drying-up of liquidity in the banking system (Ivashina and Scharfstein 2010). Such a “credit crunch” likely makes banks more careful about assessing loans to firms and a stringent assessment of a borrower’s financial condition requires verifiable accounting numbers (Watts 2003a). As a result, firms that embrace more conservative financial reporting are more likely to obtain funding (via better borrowing terms) from banks or other creditors, especially given the increased costs of external funds and intensified capital rationing in the crisis period.

In addition, the crisis period represents a situation in which most firms were likely to experience underinvestment (Campello et al. 2010; Duchin et al. 2010). During that period, accounting conservatism’s role in improving a firm’s borrowing capacity directly translated into value creation by mitigating underinvestment. In their survey paper, Armstrong et al. (2010) provide evidence that debt is the dominant source of capital in the United States. Hence we would expect that the global financial crisis had a major impact on corporate investment. Using survey evidence, Campello et al. (2010) find that the corporate sector was indeed adversely affected by the shortfall in bank lending during the crisis period, and that firms suffered from severe underinvestment. Duchin et al. (2010) provide corroborating empirical evidence that corporate investment declined significantly following the onset of the crisis, especially for firms with low cash reserves. In sum, the financial crisis made it much harder for firms to borrow and invest. Due to accounting conservatism’s role in enhancing borrowing capacity, firms with more conservative financial reporting would have suffered less from underinvestment during the crisis.

We examine the role of accounting conservatism on firm-level investment (capital expenditures) for non-financial firms around the 2007-2008 global financial crisis using a differences-in-differences design. Consistent with prior literature, we find that firms experienced a decline in their investment when hit by the financial crisis (Campello et al. 2010; Duchin et al. 2010). More importantly, consistent with our prediction, we find that firms with more conservative financial reporting experienced a smaller decline in investment activity following the onset of the financial crisis than did firms with less conservative financial reporting. Together, the results suggest that negative shocks to the supply of external finance hampers firm-level investment and that conservative financial reporting can ameliorate the sensitivity of firms’ investment to such negative shocks.

Next, we show that the magnitude of our findings is greater for firms that are financially constrained or have greater demand for external finance and, therefore, are more likely to experience underinvestment. These results strengthen the interpretation that conservative financial reporting mitigated underinvestment during the crisis. We also find that the role for conservatism is greater in more opaque firms, consistent with the notion that conservatism mitigates information problems.

Finally, we demonstrate that our conclusions are consistent with debt issuances and the stock return performance of firms during this period. A key mechanism by which conservatism affects underinvestment is by altering firms’ ability to raise debt financing. We find that firms with a higher level of conservatism found it less difficult to get debt financing during the crisis. Stock returns offer a distinct advantage in that stock prices capture the entire amount of relevant declines in economic activity. Consistent with our main conclusions, we find that firms with a higher level of accounting conservatism experienced a lower decline in stock performance. In sum, these findings are consistent with our predictions that conservatism improves borrowing capacity and mitigates underinvestment.

This post comes to us from Professor Karthik Balakrishnan at the London Business School, Professor Ross Watts at MIT’s Sloan School of Management, and Professor Luo Zuo at Cornell University’s Samuel Curtis Johnson Graduate School of Management. It is based on their article, “The Effect of Accounting Conservatism on Corporate Investment during the Global Financial Crisis,” which is available here.