Effects of Accounting Conservatism on Investment Efficiency and Innovation

Volker Laux
University of Texas at Austin - Department of Accounting

Korok Ray
Texas A&M University - Mays Business School
May 17, 2016

Abstract:
We study how biases in financial reporting affect managers' incentives to spend effort searching for
innovative projects, and to make appropriate investment decisions once they have uncovered a new
project. Holding the manager's earnings-based payoffs exogenously fixed, a move to more
conservative accounting (i) reduces the manager's temptation to invest in risky projects, which can
either reduce overinvestment or increase underinvestment, and (ii) weakens his incentive to search
for innovative ideas ex ante. These effects are broadly consistent with informal arguments developed
in the extant literature. When incentive contracts are endogenous, however, more conservative
accounting (i) always reduces overinvestment incentives (and does not create underinvestment
incentives) and (ii) leads to stronger, not weaker, managerial incentives to search for innovative
projects.
Number of Pages in PDF File: 37

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Date posted: May 19, 2016