Accounting conservatism and corporate cash levels: Empirical evidence from Latin America

• Published date: 01 May 2022
• Author: Aviner Augusto Silva Manoel,Marcelo Botelho da Costa Moraes
• Date: 01 May 2022
• DOI: http://doi.org/10.1111/corg.12403

ORIGINAL ARTICLE

Accounting conservatism and corporate cash levels: Empirical

evidence from Latin America

Aviner Augusto Silva Manoel

1

| Marcelo Botelho da Costa Moraes

2

1

School of Economics, Business Administration

and Accounting in Ribeir~

ao Preto (FEA-RP),

University of S~

ao Paulo (USP), Ribeir~

ao Preto,

S~

ao Paulo, Brazil

2

Department of Accounting, School of

Economics, Business Administration and

Accounting in Ribeir~

ao Preto (FEA-RP),

University of S~

ao Paulo (USP), Ribeir~

ao Preto,

S~

ao Paulo, Brazil

Correspondence

Aviner Augusto Silva Manoel, School of

Economics, Business Administration and

Accounting in Ribeir~

ao Preto (FEA-RP),

University of S~

ao Paulo (USP), Ribeir~

ao Preto,

S~

ao Paulo, Brazil.

Email: aviner_augusto@hotmail.com

Funding information

CNPq

Abstract

Research Question/Issues: The aim of this research is to shed light on the role

accounting conservatism plays in the determination of firms' cash levels. Previous lit-

erature suggests that conservatism is a governance mechanism that can alleviate

agency problems associated with managers' investment decisions. Hence, we

hypothesize that strong conservatism limits managers' ability to expend cash to bene-

fit themselves. For that, we used an unbalanced panel data of firms from Latin

America (Argentina, Brazil, Chile, Mexico, and Peru) with data available from 2000

to 2018.

Research Findings/Insights: Our results are, for the most part, consistent with our

theoretical predictions. Indeed, we find strong and robust evidence that Latin

American firms with more conservative accounting policies have higher cash holdings

as a result of a reduction in cash misappropriation. These results are robust to alter-

native measures of conservatism, after controlling for other factors associated with

timely loss recognition, for country fixed effects and after a battery of robustness

checks.

Theoretical/Academic Implications: Our analyses suggest that increased conserva-

tism has the potential to bring real economic benefits to organizations, serving as an

efficient mechanism that reduces agency costs regarding cash management by induc-

ing a more efficient use of cash holdings. Therefore, we contribute to the interna-

tional literature on conservatism, cash holdings, and corporate governance by

demonstrating the importance of conservatism in firms' decisions on how cash is

employed. These findings are particularly interesting because cash expropriation can

have a devastating impact on shareholder wealth.

Practitioner/Policy Implications: Given the ongoing debate about whether neutrality,

as opposed to conservatism, is a desirable feature in financial reports, by docu-

menting how conservatism reduces agency problems related to cash management,

we also provide practical implications for accounting standard-setters.

KEYWORDS

corporate governance, cash holdings, timely loss recognition

Received: 25 February 2020 Revised: 25 August 2021 Accepted: 27 August 2021

DOI: 10.1111/corg.12403

Corp Govern Int Rev. 2022;30:335–353. wileyonlinelibrary.com/journal/corg © 2021 John Wiley & Sons Ltd 335

1|INTRODUCTION

The objective of this article is to shed light on the role accounting

conservatism plays in the determination of cash levels.

1

More specifi-

cally, we argue that accounting conservativism is a governance mech-

anism that serves to limit managers' ability to expropriate cash

holdings to benefit themselves. Previous literature documents how

cash reserves, despite providing benefits to firms in imperfect capital

markets by, for example, allowing them to take advantage of invest-

ment opportunities and avoiding costly external financing, can be det-

rimental to shareholders when the interests between firm managers

and shareholders diverge (Graham & Leary, 2018; Harford, 1999;

Myers & Rajan, 1998; Opler et al., 1999; Pinkowitz et al., 2007).

According to agency theory, a manager can use his or her privileged

position to maximize his or her utility function instead of serving a

firm's owner (Jensen & Meckling, 1976). The decision to hold and

deploy cash holdings is at the discretion of managers, with little over-

sight (Dittmar & Mahrt-Smith, 2007). Therefore, cash resources are

especially at risk of being expropriated for negative net present value

(NPV) projects or for opportunistic actions that do not create

value for shareholders (Dittmar & Mahrt-Smith, 2007; Graham &

Leary, 2018; Harford, 1999; Myers & Rajan, 1998; Pinkowitz

et al., 2007).

A convergence of interests, however, can be achieved through

the use of corporate governance mechanisms. Dittmar and Mahrt-

Smith (2007), for instance, point out that corporations with weak gov-

ernance structures dissipate cash quickly, in ways that can destroy

operating performance. This negative effect on operating perfor-

mance, however, can be cancelled out if a company is well governed.

In other words, the authors' evidence suggests that a well-governed

company has its cash effectively “fenced in,”but in a poorly governed

corporation, cash is dissipated more quickly on less profitable invest-

ments. Therefore, in a weak governance context, entrenched man-

agers may have a strong incentive to distort cash holdings to benefit

themselves, at the expense of minority shareholders (Dittmar &

Mahrt-Smith, 2007).

Prior literature also suggests that accounting conservatism is an

important governance mechanism and a relevant characteristic of a

firm's accounting system that may reduce information asymmetry and

thereby lessen agency problems in general. The role accounting con-

servatism plays as a governance mechanism stems from its ability to

mitigate agency problems related to managers' investment decisions

(Ball & Shivakumar, 2005; Watts, 2003). More precisely, accounting

conservatism can provide incentives for ex ante efficient investment

decisions and can also be used to facilitate ex post monitoring of man-

agers' investment decisions (Louis et al., 2012; Watts, 2003).

For example, if managers know ex ante that losses will be recog-

nized during their tenures, then they are less likely to invest in nega-

tive NPV investments, such as “pet projects”or “trophy acquisitions.”

Conversely, if managers can defer loss recognition to later periods,

then the earnings consequences of their decisions can be delayed or

possibly avoided. The ability of managers to defer loss recognition

also provides them, especially those with a limited tenure, an

accounting-based incentive to continue operating projects with ex

post negative cash flows to avoid the adverse effects resulting from

the abandonment of these projects. These agency problems, in turn,

can be mitigated by timely loss recognition, irrespective of a man-

ager's decision to continue or abandon these projects (Ball &

Shivakumar, 2005; Francis & Martin, 2010; García Lara et al., 2009;

Hu & Jiang, 2018; Lobo et al., 2020; Watts, 2003).

By imposing timely loss recognition and delayed gain recognition,

accounting conservatism makes investment decisions apparent in

earnings sooner than they would be otherwise. Accounting conserva-

tism thus provides shareholders with timely signals about the profit-

ability of projects undertaken by managers, in a manner that allows

shareholders to take corrective actions amid the opportunistic behav-

iors of managers in charge of these projects. Thus, the fear of job loss

or damage to reputation can deter managers from taking on

value-destroying projects. Conservatism, therefore, limits managerial

incentives to undertake ex ante negative-NPV and prompts the early

abandonment of projects with ex post negative cash flows, limiting

further value destruction (Ahmed & Duellman, 2011; Ball &

Shivakumar, 2005; Francis & Martin, 2010; García Lara et al., 2009;

Hu & Jiang, 2018; LaFond & Watts, 2008; Roychowdhury, 2010;

Watts, 2003).

Hence, the implementation of more conservative accounting poli-

cies settles, at least in part, existing agency conflicts and increases

firm and equity values (Ball & Shivakumar, 2005; García Lara

et al., 2009; LaFond & Watts, 2008; Watts, 2003). Building on the

insights of these studies, we extend the literature by shedding light on

the role played by accounting conservatism in the determination of

cash levels. More precisely, we argue that conservation is a gover-

nance mechanism that limits managers' ability to expropriate cash

holdings to benefit themselves.

Many studies have already analyzed the effects of corporate gov-

ernance on cash levels (Dittmar et al., 2003; Harford et al., 2008;

Huang et al., 2013; Manoel et al., 2018). However, only one prior

study, Louis et al. (2012), analyzes the effect of conservatism on the

market value of cash. Using a sample of 101,221 firm-year observa-

tions from the United States over the period of 1974–2006, Louis

et al. (2012) find that the market value of each additional dollar of

cash increases via accounting conservatism. This result suggests that

cash holdings are used more efficiently in firms that adopt more con-

servative financial reporting policies.

Our research differs from Louis et al. (2012) in important ways.

Although their study documents the effect of conservatism on the

market value of cash, no previous research has provided a detailed

analysis of the role accounting conservatism plays in determining cash

levels. Furthermore, Roychowdhury (2010) argues for more studies

about conservatism's monitoring and governance benefits for stake-

holders. Our article fills this gap in the literature by evaluating a Latin

American context.

The determinants of accounting conservatism vary according to

four factors: contracts, litigation, taxation, and regulation

(Watts, 2003). Moreover, the demand for an accounting of income in

different economic, political, and social contexts causes accounting's

336 MANOEL AND MORAES