Accounting Conservatism and Risk Taking Decisions

write up Conservatism and Risk Taking Decisions originationManager is in a position of Captain in shoot in ship of the Organization, so that to make institution more(prenominal) elegant Manager has duty to make an of import decision on incorpo stray Investment. These types of decisions create Agency Problems because of the time sake differences between director and stockholder. This look is carried out to understand how conservativism explanation system reduces agency problems, and examines the effect of conservativism on charabancs high risk thronement decision. This look alike examine that whether accounting conservativism solves the misalignment of interest between managers and organization through increasing hurdle rates used by managers during despatch selections, and sheds lights on literature attempting to identify the relation between accounting conservativism and managers posement decisions.MotivationA study was conducted by Givoly and Hayn (2000), Beatty et al. (2008), and Khan and Watts in 2009, to measure accounting conservativism and sign of the zodiacs characteristics such as size, leverage, and market-to-book proportion. They comprise evidences to support their hypothesis that accounting conservativism improves staunchs investment efficiency. fit to Khan and Watts managers investment hurdle rates and induces unprogressive investment decisions ar significantly increase under conservativism accounting, level off when the agency problems ar more severe this effect is more pronounced.According to the positive accounting theory accounting conservatism plays very hard-hitting role in the roll contracting process. Corporate investment is an important decision, nevertheless this decision be not always made in the best interest of shareholders, so many time manager invest in a risky and even off negative net face comfort exteriorises just because of their personal interest in of investment. news report conservatism is a reporting mechanism which reflects accountants trend to assume lower threshold to recognise bad news than good news. Accounting conservatism helps to improve corporate investment by preventing investment in high risk or unsuccessful investment abides by primal terminations of such projects. This early terminations of projects reduces managers compensation and increases managers interest of job turnover. If manager is judicious to predict the accelerated recognition of losings, and the timely termination of unsuccessful projects, they get out be more cautious to make the investment decisions. (Francis and Martin (2010) and Bushman et al. (2007)) The increased circumspection to invest will be reflected in the hurdle rate, which used to gauge an investment project. In theory, hurdle rate is as equals as the salute of capital managers should not take decision to invest in a project if the return is lower than the live of financing. Indeed hurdle rate is observed to be either low ers than the cost of capital in practice, because of managerial discretion.The result of the study state that Corporate governance role soak up established the roll of accounting conservatism in resolving knowledge asymme get wind, reducing agency cost, and improving debt contracting efficiency. (Ball (2001), Ball and Shivakumar (2005))Literature analyseThere are many research has been carried out in close the relation of the accounting conservatism and managers risk victorious decision. Ahmed and Zhang, 2009 tack that accounting conservatism reduces information imbalance between lenders and borrowers, and also reduces cost of capital for borrowers. They also found that if conservatism cause financially constrained firms to under investment than the relation between conservatism and firms future performance will negative. On the other extend to reduce overinvestment problem for financially constrained firms, than the relation will be sojourned positive.Another research carri ed out by Leuz (2001) and Guay and Vierrecchia (2006) and found that accounting conservatism force manager to void positive NPV projects, because Impaired incentives created for managers if gains not recognize timely untimely gain recognition, and manager force to avoid those types of positive projects. In particular, if gains are not recognize timely than manager will responsible for investment for those project, and may no longer be in the office by the time gains are realized. This is because always expect their future incentive rate higher(prenominal) in long term, than the firms mandatory rate of return. If gains recognise by timely than even positive NPV for shareholder became negative for manager.Accounting conservatism increases corporate investment efficiency in two ways. First is, by timelier incorporating bad news into earnings, accounting conservatism inform the boards investigation of the unsuccessful investment project that may lead to its early abandonment, saving sh areholders from unexpected future losses (Watts 2003). On the other hand, the expected personal costs related to project such as compensation, news report and career concerns would increase managers cautiousness in choosing investment projects at the outset.Extant studies by Ball and Shivakumar, 2005 Francis and Martin, 2010 believe that accounting conservatism can restrain managers to investing in negative NPV projects by accelerated loss recognition. In addition, if managers recognise ex ante about(predicate) failure of particular project, they should record losses timely, because it will affect to their reputation and income as well, so manager should postpone investing in those project.Furthermore, Roychowdhury (2010) found that risky projects are mostly become negative projects, therefor managers try to avoid risky projects due to timely loss recognition, because it creates also risk-averse, even if the projects have profitability to shareholders. If managers know that the p roject is have many risks of failure, manager have to write losses more timely before failure of project, because managers reputation income linked with compensation will be affected by it, so that manager avoid to involve to invest in those projects, even though projects are profitable.Smith and Watts 1992 Kwon and Yin 2006 found that, firms with higher growth opportunities prefer to assets have higher contracting costs, because growth opportunities are often intangible in nature, so that information related to them are likely less verifiable. Therefore, managers have greater unrestricted power, and are more likely to manage earnings through accruals, so that agency costs are higher in high-growth firms. Furthermore high growth firms are more likely to have more volatile returns and higher prospect of lawsuits, which creates a higher demand of accounting conservatism (Khan and Watts, 2009). Empirically, we use book-to-market ratio (an inverse measure of growth opportunity) to meas ure the growth opportunity of firms. driver and Temple (2010) found that, if the manager is aware of the embedded risk a hurdle rate that is higher than the cost of capital will be used by the irreversibility of the investment project. Corporate investment is efficient in the situation where internal funds flow gives the highest returns from investment project. However, managers deviate from the best level of investment, because of dysfunctional investment incentives (Stein et al. 2003). These dysfunctional incentives can be reflected in the hurdle rates used to select projects. Finance textbooks state that managers should bench mark the investment return to the cost of capital, so that with the project with lower returns than the cost of capital are rejected. In addition, managers use hurdle rates which sometimes higher or lower against the cost of capital, it depends on the managerial incentives invest. agreeable with Hayn (2000),andWatts (2003), They found that both not only fir m with goodwill purchased but also without goodwill have increasing trend in conservatism over time. Indeed He argue that lach of information will enclosure managers to random affect to recognize impairment losses agains their advantage timely.The pursuit hypotheses are proposed for this studyH1 Accounting conservatism improves firms investment efficiency.H2 Accounting conservatism helps manager to recognize bad news timely.H3 Accounting consarvitism accelerates terminations of successful projects.H4 Accounting conservatism can restrain managers to investing in negative NPV projects by accelerated loss recognition.To testing hypothisese Basus (1997) used measure of conditional conservatism, because of theverification standerds of the hypotheses of recognizing bad newsand good news assumsions. (Richardson, 2006 Denis and Sibikov, 2010) they also examine relation between accounting conservatism with the component of investments by ussing total investments and changes in firm capital .This study conclued that accounting conservatism is an important monitoring and contracting mechanism, and its helps gutter to recognize bad news timely,so that manager could increase their managerial interest regarding project. Indeed accounting conservatism accelerates terminations of unsuccessful projects, also study found that conservative accounting increases hurdle rates, in addition conservatism changes hurdle rate because it reducing the future financial cost rather than by increasing the efficiency of contracting with the managers. We also find conservatism adds value to firms. This study also sheds lights on relation between accounting conservatism and managers investment decisions. The study also show that the accounting conservatism negatively correlate investment and firms future operating performance.