Accounting choices under ifrs and their effect on over-investment in capital expenditures

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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CHAPTER II 
RELATED LITERATURE AND HYPOTHESES DEVELOPMENT
2.1 Related Literature 
2.1.1 Timely Loss Recognition and Over-investment 
Prior literature argues that conservative accounting policies characterized by 
timely loss recognition discipline managers to make better investment decisions (e.g., 
Ball 2001; Watts 2003; Ball and Shivakumar 2005). Specifically, timely loss recognition 
causes economic losses from poorly performing investments to be recognized more 
quickly. Hence, managers are less likely to make investments that decrease shareholder 
value because timely loss recognition will reduce managers’ earnings-based 
compensations (Ball and Shivakumar 2005). Further, in the absence of timely loss 
recognition, subsequent generations of managers will inherit losing investments and, 
therefore, timely loss recognition provides more effective disciplining of current 
managers (Ball 2001).
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In addition to its direct effect on managers via reported earnings, 
timely loss recognition provides external directors and shareholders with timely signals 
for investigating the existence of losing investments and taking corrective actions (Watts 
2003). 
Francis and Martin (2010) examine the association between timely loss 
recognition and firms’ acquisition-investment decisions. For a sample of corporate 
acquisitions and divestitures by U.S. firms between 1980 and 2006, they find that the 
bidder’s acquisition profitability is positively associated with the bidder’s timeliness of 
loss recognition. They also find that firms with more timely loss recognition are less 
likely to make post-acquisition divestitures, but when they do, they act more quickly to 
divest losing investments. In two related studies, Srivastava et al. (2010) and Bushman et 
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Watts (2003) and Leone et al. (2006) argue that it is difficult and costly for shareholders to recover 
excess compensation to managers for overstated current earnings that subsequently reverses, especially 
when managers leave the firm.

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al. (2011) find results consistent with those of Francis and Martin (2010). Srivastava et al. 
(2010) find that timely loss recognition among U.S. firms allows lenders and 
shareholders to identify unprofitable projects more quickly and, hence, enables them to 
force managers to discontinue such projects before large value erosion occurs. Bushman 
et al. (2011) examine the association between corporate investment and timely loss 
recognition in twenty-five countries over the period 1995 to 2003. They find that timely 
loss recognition curbs investments in ex-ante value-destroying projects when managers 
face declining investment opportunities. 
Ahmed and Duellman (2010) find that firms with more timely loss recognition 
have higher future profitability and lower magnitude (and likelihood) of future special 
items charges. Ahmed and Duellman’s findings are consistent with timely loss 
recognition playing an important governance role by reducing managers’ incentives to 
take on negative net present value (NPV) projects and improving monitoring of 
investments. In addition, LaFond and Watts (2008) show that timely loss recognition is 
part of a firm’s governance structure that mitigates agency conflicts between insiders 
(managers) and outside shareholders. In their setting, timely loss recognition mitigates 
agency conflicts by reducing deadweight costs arising from asymmetric information. In a 
related study, LaFond and Roychowdhury (2008) investigate the association between 
managerial ownership and timely loss recognition and find that firms with lower 
managerial ownership have more timely loss recognition. Their results are consistent with 
outside shareholders demanding more timely loss recognition as a means of addressing 
agency conflicts arising from greater separation between ownership and control.
Several studies suggest that high-quality financial reporting, through its role in 
governance, can reduce over-investment. For example, Lambert et al. (2007) argue that 
high-quality financial reporting reduces managers’ ability to appropriate assets to 
themselves and improves the coordination between managers and investors with respect 
to capital investment decisions. Bushman and Smith (2001) suggest that high-quality 

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financial reporting increases investment efficiency by encouraging investments in high-
return projects, by reducing investments in low-return projects, and by reducing the 
expropriation of investors’ wealth. In this regard, Biddle et al. (2009) provide empirical 
evidence that high-quality financial reporting among firms reporting under U.S. GAAP 
increases investment efficiency. Specifically, they find that high-quality financial 
reporting is associated with lower investment among firms that are more likely to over-
invest. For a sample of private firms in emerging markets over the period 2002-2005, 
Chen et al. (2011b) also find that financial reporting quality positively affects investment 
efficiency. Collectively, the studies noted above suggest that an accounting choice (e.g., 
historical cost accounting with strict impairment rules) characterized by more timely loss 
recognition will reduce over-investment.