Accounting Conservatism and the Market Value of Cash Holdings in Brazil.
| Autor | Manoel, Aviner Augusto Silva |
1 Introduction
This study aims to analyze the relationship between conservative accounting policies and the value that shareholders attribute to the cash reserves of publicly traded companies listed on the official stock exchange of Brazil, called the Brasil, Bolsa, Balcao (B3). A company's cash holdings, as a significant portion of its total assets, are thought to be the most susceptible asset to being consumed, deviated, and misused through the agent's opportunistic actions (Dittmar & Mahrt-Smith, 2007; Jensen, 1986; Myers & Rajan, 1998). The agent, as an individual who maximizes their utility function, can more easily use their privileged informational situation to consume the private benefits linked to their company's cash holdings at the cost of the principal (Dittmar & Mahrt-Smith, 2007; Jensen, 1986; Manoel & Moraes, 2021a; Masulis et al., 2009; Myers & Rajan, 1998; Opler et al., 1999).
In general, the value that shareholders attribute to cash reserves is mirrored in the way they expect these resources to be used (Bates et al., 2018; Dittmar & Mahrt-Smith, 2007; Fresard & Salva, 2010; Kalcheva & Lins, 2007; Pinkowitz & Williamson, 2007). In capital markets that are believed to be perfect, the value of an additional dollar of cash should be exactly US$ 1.00, where the costs for obtaining and maintaining these resources are equal to their expected benefits (Bates et al., 2018). However, capital market imperfections, such as information asymmetry and agency costs, mean that managers attribute a different value to companies' cash reserves (Bates et al., 2018; Dittmar & Mahrt-Smith, 2007; Fresard & Salva, 2010; Kalcheva & Lins, 2007; Pinkowitz & Williamson, 2007). Aware of the vulnerability of cash holdings, the market discounts their value in organizations in which the corporate governance mechanisms cannot mitigate the managerial entrenchment related to their use. In other words, an additional dollar in cash may not be worth a dollar for the shareholders in the absence of robust mechanisms for aligning interests between the agent and principal (Bates et al., 2018; Dittmar & Mahrt-Smith, 2007; Fresard & Salva, 2010; Kalcheva & Lins, 2007; Pinkowitz & Williamson, 2007).
The discounts related to the market value of cash holdings, however, may be mitigated by the existence and effectiveness of the monitoring mechanisms used in controlling the agent's opportunistic actions (Dittmar & Mahrt-Smith, 2007; Fresard & Salva, 2010; Masulis et al., 2009). Previous studies, for example, indicate that a set of robust corporate governance mechanisms can reduce the risk of managers transforming cash into private benefits. As a result of the reduced value-destruction associated with cash reserves, investors attribute a higher value to this asset in companies with better corporate governance (Bates et al., 2018; Fresard & Salva, 2010; Dittmar & Mahrt-Smith, 2007; Masulis et al., 2009; Pinkowitz et al., 2006).
Accounting conservatism forms part of this scenario, given that conservative accounting policies at least partly reduce the agency costs that permeate the relationships between the parties involved in a company (Garcia Lara et al., 2009; Manoel & Moraes, 2021a; Watts, 2003). Positive accounting theory suggests that the conservatism of financial reports plays an important role in reducing investment inefficiencies. More precisely, conservative accounting policies restrict, ex ante, managers' incentives to invest in value-destroying projects, as they do not allow them to defer recognizing losses to subsequent managers. They similarly provide mechanisms ex post in the early abandonment of low performance projects before the accumulation of large losses (Ahmed & Duellman, 2011; Ball & Shivakumar, 2005; Francis & Martin, 2010; Watts, 2003).
Therefore, accounting conservatism, as a component of accounting information quality and a corporate governance mechanism, is an important aspect in the effective monitoring of a company, reducing agency costs and increasing contract efficiency. Thus, the study is based on the literature that suggests that conservative accounting policies are part of a company's corporate control structure, which reduces managers' incentives to accept value-destroying projects (Ahmed & Duellman, 2007; Ball & Shivakumar, 2005; Francis & Martin, 2010; Garcia Lara et al., 2009; Watts, 2003). Hence, this study is based on the assumption that conservative accounting policies can mitigate part of the value destruction associated with cash reserves.
Despite the literature addressing the effects of corporate governance mechanisms over the market value of cash holdings (Dittmar & Mahrt-Smith, 2007; Fresard & Salva, 2010; Pinkowitz et al., 2006), little is known about the relationship between conservative accounting policies and the value that shareholders attribute to cash reserves. Exploring this association represents a promising opportunity to expand the understanding of the interaction between agency conflicts and cash management, and their combined effect on company value. This study takes advantage of this empirical-theoretical gap in the literature to examine whether accounting conservatism can mitigate part of the agency costs related to the use of cash and whether that is reflected in the value shareholders attribute to this asset. Given the theoretical assumptions, a positive association is expected between conservative accounting policies and the market value of cash holdings.
To achieve the research objective, this study used the Brazilian stock market. Brazil, which is considered an emerging market, is marked by the difficulty of accessing sources of funding (Manoel & Moraes, 2018). So, in an environment of financial constraints, it is essential to have mechanisms that can control the manager's opportunistic actions, since managerial entrenchment is undesirable and results, among other things, in reduced shareholder wealth (Jensen, 1986). Accounting conservatism would therefore represent an alternative and less costly corporate governance mechanism, aiming to mitigate the agency conflicts related to the misuse of cash.
Analyzing the value that shareholders attribute to companies' cash holdings is relevant, especially in less developed markets, since maintaining assets in the form of cash and cash equivalents is costly, given that part of these resources could be allocated in other more profitable investments (Kim et al., 1998; Manoel & Moraes, 2021b; Opler et al., 1999). In addition, firms allocate a substantial part of their assets in cash and the expropriation of these resources has a devastating impact on shareholders' well-being (Bates et al., 2018; Dittmar & Mahrt-Smith, 2007; Manoel & Moraes, 2021a; Pinkowitz et al., 2006). Consequently, the existence of mechanisms that improve contract efficiencies and act as a limiter of managerial opportunism, such as accounting conservatism, can mean that in the best-case scenario the agent only uses cash in projects that maximize the principal's utility function.
Consistently with the arguments presented, we verified a positive association between conservative accounting policies and the market value of cash holdings. The evidence obtained is consistent with accounting conservatism performing a relevant corporate governance role, providing managers with ex ante incentives to avoid projects with negative net present value (NPV) and in the ex post monitoring of investment decisions (Ball & Shivakumar, 2005; Watts, 2003). Therefore, aware that accounting conservatism can mitigate part of the agency costs associated with cash reserves, it can be verified that shareholders attribute a higher value to the cash holdings of companies that adopt conservative accounting practices. A series of robustness tests were run that provide additional evidence in support of the research hypothesis.
The literature indicates various benefits associated with conservative accounting policies, such as: reduced cost of debt (Ahmed et al., 2002); reduced agency conflicts over dividends policies (Ahmed et al., 2002) and reduced risk of a collapse of the share price (Kim & Zhang, 2016); a lower level of informational asymmetry (LaFond & Watts, 2008) and of management of bad news (Kim & Zhang, 2016); and more profitable acquisitions (Francis & Martin, 2010), among others. The evidence from this study, in turn, indicates that conservative accounting policies mitigate part of the agency problems associated with the most vulnerable asset to opportunistic actions, so that shareholders place a higher value on the cash holdings of more conservative companies. Thus, this study initially contributes to the literature by providing evidence that accounting conservatism, as a corporate governance mechanism and a prominent attribute of financial reports, reduces the value destruction associated with the inappropriate use of cash reserves.
The findings of this study also have relevant practical implications. The literature considers studies on the economic benefits of accounting conservatism to be relevant, given the debate throughout the 2000s on the merits of neutrality versus conservatism as a desirable characteristic of accounting numbers (Artiach & Clarkson, 2012; Francis et al., 2013). And, in the end, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) adopted the neutrality of financial statements as being higher order, to the detriment of prudence or conservatism as desirable qualities. This choice was made since the IASB and the FASB state that conservatism introduces preconceptions in financial reports and, as a result, increases informational asymmetry (Artiach & Clarkson, 2012; Francis et al., 2013).
Thus, the empirical evidence indicates that removing the prudence principle would represent, among other things, an increase in agency costs, which would in turn reduce the accuracy in the decision-making process and the...
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