The role of accounting conservatism in firms' financial decisions

Kiat Bee Jimmy LEE, Singapore Management University


This paper investigates whether financial reporting conservatism is related to firms’ financial flexibility and their financial decisions. If conservatism facilitates monitoring and governance by capital providers, they should be more willing to extend financing and increase firms’ access to capital. However, because conservatism leads to systematic understatement of net worth and weakens the appearance of firms’ balance sheet strength, it may reduce firms’ access to capital. This study tests these two opposing views of the relation between conservatism and financial flexibility and its resultant effect on corporate financial activities. I find that firms with greater reporting conservatism exhibit less financial flexibility in their corporate liquidity management, their debt or equity issuance decisions, the sensitivity of their investments to financing constraints and their payout policies. Overall, the results suggest that while firms enjoy lower debt contracting costs and mitigate agency conflicts by reporting conservatively, they forgo some financial flexibility in future access to capital which affects their financial decisions.