Timely Loss Recognition, Agency Costs and the Cash Flow Sensitivity of Firm Investment

Abstract

INTRODUCTION I examine whether timely loss recognition affects the sensitivity of firm investment to cash flows, a proxy for internal funds (see Hayashi, 1982). (1) Two related streams of literature motivate my analyses. First, timely loss recognition may arise not only out of a contracting need (Watts, 2003), but also out of the need to reduce information asymmetries between managers and investors (e.g. LaFond and Watts, 2008; Biddle et al., 2009). Where managers have significant information advantages over investors, timely loss recognition may act as a governance mechanism by resulting in a more conservative estimate of firm value. In line with this argument, timely loss recognition has been shown to be negatively related to cost of capital (e.g. Zhang, 2008; Lara et al., 2010), indicating investors consider conservative firms to be less risky. Second, financial reporting may have real effects in that managers take into account financial reporting practices when making operating and investment decisions (see Kanodia, 2007; McNichols and Stubben, 2009). Recent studies by Bushman et al. (2005), Ahmed and Duellman (2011), Francis and Martin (2009), and Lara et al. (2009) provide evidence that timely loss recognition improves capital allocation and investment profitability. Collectively, these findings support the argument by Ball (2001) and Ball and Shivakumar (2005) that conservative accounting forces managers to be mindful ex-ante of how they will report the outcomes of their investment decisions to investors ex-post. Given the potential for timely loss recognition to reduce external capital costs and affect managers' investment decisions, I examine its impact on one of the more established relations in the corporate finance literature, namely, the sensitivity of firm investment to cash flows. (2) Because of its ability to decrease external capital costs, timely loss recognition should be associated with a lower sensitivity of firm investment to cash flows. Furthermore, to the extent that timely loss recognition provides governance benefits, its impact on the investment-cash flow relation should be strongest in firms with a high agency costs (see LaFond and Watts, 2008; Francis and Martin, 2010). To test these predictions I expand the basic investment-cash flow model (e.g., Myers and Majluf, 1984; Gurgler et al., 2007; Chen et al., 2007) and examine whether the sensitivity of investment to cash flows is decreasing in timely loss recognition. I then introduce agency costs into the model to determine whether the impact of timely loss recognition on the investment-cash flow relation is dependent upon a firm's potential for agency problems. Results support my predictions; timely loss recognition is associated with a lower sensitivity of firm investment to cash flows, and this effect is strongest in firms with high agency costs. These findings are robust to both a changes specification of my primary empirical model and alternative measures of timely loss recognition. My study contributes to theory by Ball (2001) and Ball and Shivakumar (2005) that suggests conservative accounting has implications for corporate investment. I complement existing empirical studies by Ahmed and Duellman (2011) and Francis and Martin (2010) that find managers in firms with more timely loss recognition make better investments, and by Bushman et al. (2011) and Lara et al. (2010) which find that greater timely loss recognition improves capital allocation efficiency. My findings also add to the literature on the information benefits of conservative reporting. LaFond and Watts (2008) argue that timely loss recognition is most valuable in firms with high levels of information asymmetry. Francis and Martin (2010) lend empirical support to this argument by documenting that conservative firms make more profitable acquisitions, especially those firms with the potential for substantial agency problems. I provide additional support by documenting that firms with high agency costs benefit more from timely loss recognition in terms of their investment-cash flow sensitivity. …