Advertisement

Review of Quantitative Finance and Accounting

, Volume 52, Issue 3, pp 781–813 | Cite as

Managerial risk incentives and accounting conservatism

  • Chengru HuEmail author
  • Wei Jiang
Original Research

Abstract

We provide empirical evidence of the effect of managerial risk incentives on financial reporting conservatism. We hypothesize that firms use greater accounting conservatism as a means of addressing increased firm risk arising from excessive managerial risk incentives provided by option compensation. Consistent with this hypothesis, we find a positive association between excessive managerial risk incentives and accounting conservatism measured as asymmetric timeliness of loss recognition. By contrast, we find no impact by normal (anticipated) risk-taking on accounting conservatism. Further analysis shows that the association between excessive managerial risk incentives and accounting conservatism is more pronounced when firms face more severe debtholder–shareholder conflicts. We also find that while cost of debt financing is positively associated with both anticipated and excessive risk incentives, the relationship with the latter is weakened by timelier loss recognition, suggesting firms with heightened risk incentives could economically benefit from using more conservative accounting.

Keywords

Conditional accounting conservatism Timely loss recognition Risk-taking incentives Executive compensation 

JEL Classification

M1 M41 J333 

References

  1. Acharya VV, Mehran H, Thakor AV (2016) Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting. Rev Corp Financ Stud 5:36–75Google Scholar
  2. Agrawal A, Mandelker G (1987) Managerial incentives and corporate investment and financing decisions. J Finance 42:237–823CrossRefGoogle Scholar
  3. Ahmed SA, Billings BK, Morton RM, Stanford-Harris M (2002) The role of accounting conservatism in mitigating Bondholder–Stockholder conflict over dividend policy and in reducing debt costs. Acc Rev 77:867–890CrossRefGoogle Scholar
  4. Aiken LS, West SG, Reno RR (1991) Multiple regression: testing and interpreting interactions. Sage, LondonGoogle Scholar
  5. Altman EI (1968) Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. J Finance 23:589–609CrossRefGoogle Scholar
  6. Anantharaman D, Fang VW, Gong G (2013) Inside debt and the design of corporate debt contracts. Manag Sci 60:1260–1280CrossRefGoogle Scholar
  7. Armstrong CS, Vashishtha R (2012) Executive stock options, differential risk-taking incentives, and firm value. J Financ Econ 104:70–88CrossRefGoogle Scholar
  8. Ball R (2001) Infrastructure requirements for an economically efficient system of public financial reporting and disclosure. In: Brookings-Wharton papers on financial services, vol 1, pp 127–169Google Scholar
  9. Ball R, Shivakumar L (2005) Earning quality in UK Private Firms: comparative loss recognition timeliness. J Account Econ 39:83–128CrossRefGoogle Scholar
  10. Ball R, Shivakumar L (2006) The role of accruals in asymmetrically timely gain and loss recognition. J Account Rev 44:207–242Google Scholar
  11. Ball R, Kothari S, Robin A (2000) The effect of international institutional factors on properties of accounting earnings. J Account Econ 29:1–51CrossRefGoogle Scholar
  12. Basu S (1997) The conservatism principle and the asymmetric timeliness of earning. J Account Econ 24:3–37CrossRefGoogle Scholar
  13. Beatty A (2007) Discussion of asymmetric timeliness of earnings, market-to-book and conservatism in financial reporting. J Financ Econ 44:32–35Google Scholar
  14. Bebchuk L, Jackson R (2005) Executive pensions. J Corp Law. 30:823–855Google Scholar
  15. Bharath T, Shumway T (2008) Forecasting default with the Merton distance to default model. Rev Financ Stud 21:1339–1369CrossRefGoogle Scholar
  16. Black F, Scholes M (1973) The Pricing of options and corporate liabilities. J Polit Econ 81:637–654CrossRefGoogle Scholar
  17. Brick IE, Palmon O, Wald JK (2012) Too much pay-performance sensitivity? Rev Econ Stat 94:287–303CrossRefGoogle Scholar
  18. Brockman P, Ma T, Ye J (2015) CEO compensation risk and timely loss recognition. J Bus Finance Account 42:204–236CrossRefGoogle Scholar
  19. Carter ME, Lynch LJ, Tuna I (2007) The role of accounting in the design of CEO equity compensation. Account Rev 82:327–357CrossRefGoogle Scholar
  20. Cassell CA, Huang SX, Sanchez JM, Stuart MD (2012) Seeking safety: the relation between CEO inside debt holdings and the riskiness of firm investment and financial policies. J Financ Econ 103:588–610CrossRefGoogle Scholar
  21. Chava S, Purnanandam A (2010) CEOs versus CFOs: incentives and corporate policies. J Financ Econ 97:263–278CrossRefGoogle Scholar
  22. Chen YC, Lee CH, Chou PI (2015) Stock-based compensation and earnings management behaviors. Rev Pac Basin Financ Mark Polic 18:1–33Google Scholar
  23. Coles JL, Daniel ND, Naveen L (2006) Managerial incentives and risk-taking. J Financ Econ 79:431–468CrossRefGoogle Scholar
  24. Core J, Guay W (2002) Estimating the value of employee stock option portfolios and their sensitivities to price and volatility. J Account Rev 40:613–630Google Scholar
  25. Core J, Guay W, Larcker D (2003) Executive equity compensation and incentives: a survey. Econ Polit Rev 9:27–50Google Scholar
  26. Daniel ND, Martin JS, Naveen L (2004) The hidden cost of managerial incentives: evidence from the bond and stock markets. Available at SSRN 612921Google Scholar
  27. Diamond DW (1991) Monitoring and reputation: the choice between bank loans and directly placed debt. J Polit Econ 99:689–721CrossRefGoogle Scholar
  28. Dichev ID, Skinner DJ (2002) Large-sample evidence on the debt covenant hypothesis. J Account Rev 40:1091–1123Google Scholar
  29. Dietrich J, Muller A, Riedl J (2007) Asymmetric timeliness tests of accounting conservatism. Rev Account Stud 12:95–124CrossRefGoogle Scholar
  30. Fama EF (1985) What’s different about banks? J Monetary Econ 15:29–39CrossRefGoogle Scholar
  31. Gaver JJ, Kenneth MG (1993) Additional evidence on the association between the investment opportunity set and corporate financing, dividend, and compensation policies. J Account Econ 16:125–160CrossRefGoogle Scholar
  32. Givoly D, Hayn C (2000) The Changing time-series properties of earnings, cash flows and accruals: has financial reporting become more conservative? J Account Econ 29:287–320CrossRefGoogle Scholar
  33. Givoly D, Hayn CK, Natarajan A (2007) Measuring reporting conservatism. Account Rev 82:65–106CrossRefGoogle Scholar
  34. Graham JR, Li S, Qiu J (2012) Managerial attributes and executive compensation. Rev Financ Stud 25:144–186CrossRefGoogle Scholar
  35. Green RC, Talmor E (1986) Asset substitution and the agency costs of debt financing. J Finance Bank 10:391–399CrossRefGoogle Scholar
  36. Greene WH (2000) Econometric analysis, 4th edn. Prentice-Hall, Upper Saddle RiverGoogle Scholar
  37. Guay WR (1999) The sensitivity of CEO wealth to equity risk: an analysis of the magnitude and determinants. J Financ Econ 53:43–71CrossRefGoogle Scholar
  38. Haugen RA, Senbet LW (1981) Resolving the agency problems of external capital through options. J Finance 36:629–647CrossRefGoogle Scholar
  39. Hayes RM, Lemmon M, Qiu M (2012) Stock options and managerial incentives for risk taking: evidence from FAS 123R. J Financ 105:174–190Google Scholar
  40. Hegemann S, Ismailescu I (2017) The effect of FASB statement no. 123R on Stock repurchases: an empirical examination of management incentives. Rev Pac Basin Financ Mark Polic 20:1–31Google Scholar
  41. Hillegeist SA, Keating EK, Cram DP, Lundstedt KG (2004) Assessing the probability of bankruptcy. Rev Account Stud 9:5–34CrossRefGoogle Scholar
  42. Holthausen RW, Watts RL (2001) The Relevance of value-relevance literature for financial accounting standard setting. J Account Econ 31:3–75CrossRefGoogle Scholar
  43. Jensen MC, Meckling WH (1976) Theory of the firm: managerial behavior, agency costs and ownership structure. J Financ Econ 3:305–360CrossRefGoogle Scholar
  44. Khan M, Watts RL (2009) Estimation and empirical properties of a firm-year measure of accounting conservatism. J Account Econ 48:132–150CrossRefGoogle Scholar
  45. Kim I, Skinner DJ (2012) Measuring securities litigation risk. J Account Econ 53:290–310CrossRefGoogle Scholar
  46. LaFond R, Roychowdhury S (2008) Managerial ownership and accounting conservatism. J Account Rev 46:101–135Google Scholar
  47. Lang L, Ofek E, Stulz RM (1996) Levrage, investment, and firm growth. J Financ Econ 40:3–29CrossRefGoogle Scholar
  48. Leftwich R (1983) Accounting information in private markets: evidence from private lending agreements. Account Rev 58:23–42Google Scholar
  49. Liu ZF, Elayan FA (2015) Litigation risk, information asymmetry and conditional conservatism. Rev Quant Finance Account 44:581–608CrossRefGoogle Scholar
  50. Liu M, Magnan M (2016) Conditional conservatism and the yield spread of corporate bond issues. Rev Quant Finance Account 46:847–879CrossRefGoogle Scholar
  51. Lobo GJ, Zhou J (2006) Did conservatism in financial reporting increase after the Sarbanes-Oxley Act? Initial evidence. Account Horiz 20:57–73CrossRefGoogle Scholar
  52. Merton RC (1974) On the pricing of corporate debt: the risk structure of interest rates. J Finance 29:449–470Google Scholar
  53. Myers SC (1977) Determinants of corporate borrowing. J Financ Econ 5:147–175CrossRefGoogle Scholar
  54. Nikolaev VV (2010) Debt covenants and accounting conservatism. J Account Rev 48:137–175Google Scholar
  55. Ohlson JA (1980) Financial ratios and the probabilistic prediction of bankruptcy. J Account Rev 18:109–131Google Scholar
  56. Ortiz-Molina H (2006) Top management incentives and the pricing of corporate public debt. J Financ Quant Anal 41:317–340CrossRefGoogle Scholar
  57. Press EG, Weintrop JB (1990) Accounting-based constraints in public and private debt agreements: their association with leverage and impact on accounting choice. J Account Econ 12:65–95CrossRefGoogle Scholar
  58. Prevost AK, Devos E, Ramesh PR (2013) The effects of relative changes in CEO equity incentives on the cost of corporate debt. J Bus Finance Account 40:470–500CrossRefGoogle Scholar
  59. Rajgopal S, Shevlin T (2002) Empirical evidence on the relation between stock option compensation and risk taking. J Account Econ 33:145–171CrossRefGoogle Scholar
  60. Roberts MR, Amir S (2009) Renegotiation of financial contracts: evidence from private credit agreements. J Financ Econ 93:159–184CrossRefGoogle Scholar
  61. Roychowdhury S, Watts RL (2007) Asymmetric timeliness of earnings, market-to-book and conservatism in financial reporting. J Account Econ 44:2–31CrossRefGoogle Scholar
  62. Smith CW, Stulz RM (1985) The determinants of firms’ hedging policies. J Financ Quant Anal 20:391–405CrossRefGoogle Scholar
  63. Smith CW, Warner JB (1979) On financial contracting: an analysis of bond covenants. J Financ Econ 7:117–161CrossRefGoogle Scholar
  64. Spiceland CP, Yang LL, Zhang JH (2016) Accounting quality, debt covenant design, and the cost of debt. Rev Quant Finance Account 47:1271–1302CrossRefGoogle Scholar
  65. Stulz RM, Johnson H (1985) An analysis of secured debt. J Financ Econ 14:501–521CrossRefGoogle Scholar
  66. Sundaram RK, Yermack DL (2007) Pay me later: inside debt and its role in managerial compensation. J Finance 62:1551–1588CrossRefGoogle Scholar
  67. Vassalou M, Yuhang X (2004) Default risk in equity returns. J Finance 59:831–868CrossRefGoogle Scholar
  68. Watts RL (2003a) Conservatism in accounting part I: explanations and implications. Account Horiz 17:207–221CrossRefGoogle Scholar
  69. Watts RL (2003b) Conservatism in accounting part II: evidence and research opportunities. Account Horiz 17:287–301CrossRefGoogle Scholar
  70. Wei KD, Laura TS (2013) Foreign exchange exposure elasticity and financial distress. Financ Manag 42:709–735CrossRefGoogle Scholar
  71. Zhang J (2008) The contracting benefits of accounting conservatism to lenders and borrowers. J Account Econ 45:27–54CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC, part of Springer Nature 2018

Authors and Affiliations

  1. 1.The State University of New York – CantonCantonUSA
  2. 2.California State University – FullertonFullertonUSA

Personalised recommendations