CFA Institute Journal Review summarizes "Effects of Accounting Conservatism on Investment Efficiency and Innovation," by Volker Laux and Korok Ray, from the Journal of Accounting and Economics, August 2020.
Managers decide whether to invest in innovative projects based on financial reporting and incentives. By implementing more-stringent verification standards for recognizing good news, conservative reporting practices may lower the probability that risky innovations will receive positive future earnings reports if they are not offset by appropriate incentive contracting.
What Is the Investment Issue?
The authors investigate how conservative financial reporting relates to corporate investment efficiency, optimal contracting, and innovation. Conservative accounting practices and innovation seem to be in opposition, because innovation requires an environment that allows failure and risk-taking whereas conservative reporting practices impose stricter verification standards for recognizing good news relative to bad news. More-conservative accounting policies raise the profitability threshold above which the manager invests in a new idea. A firm will be less likely in these circumstances to issue a favorable report showing new investments that yield high profits, but if it does so, such a favorable report is more likely an accurate indicator. Conservative reporting may foster risk avoidance and tamp managers’ inclination to overinvest, but it also may inhibit innovation in organizations.
The solution to this difficult balance is proper incentive contracting. The key to optimizing investment efficiency is finding the right balance between a manager’s inclinations to overinvest and to underinvest. Managers may not want to put in the work on innovative ideas that have a low probability of success, but they will if their pay reflects the positive outcomes they achieve.
How Did the Authors Conduct This Research?
The authors built a theoretical model with shareholders, represented by a manager and a board of directors. The manager is responsible for growing new investment possibilities and choosing investments based on a privately observed signal about a project’s profitability. The board establishes a firm’s financial reporting system and creates a manager’s incentive plan. These elements are trackable with numbers and documentation.
Previous studies tried to measure innovation by looking at the number of patents and patent citations, but the authors of this study track innovation differently. They question the effectiveness of using patents as data because many patents retain no commercial value. A count of patents can also be misleading because many new patents cite other patents owned by the same company, and thus they are based on existing knowledge rather than exploration. Previous accounting literature that evaluates conservative innovation practices and investment efficiency view other governance tools as exogenously fixed.
What Are the Findings and Implications for Investors and Investment Professionals?
Innovation and conservatism conflict: Innovation requires risk taking, whereas conservatism is risk avoidant. Because innovation takes time, managers are compensated in alignment with regular reports that are supposed to reflect the firm’s economic status. The true value of R&D is hard to ascertain, and write-downs are not uncommon. US GAAP are perceived as more conservative than International Financial Reporting Standards with regard to R&D costs.
The main predictions of the authors’ model are directional: Conservative accounting practices result in stronger managerial incentives to develop innovative ideas and weaker incentives to invest in new ideas with negative net present value.
The negative relation between conservatism and overinvestment seems obvious, but properly balancing the manager incentive is challenging in practice.