Impact of Accounting Conservatism on Innovation

Introduction

Background

Accounting conservatism refers to a collection of record of financial principles of maintaining a record that requires a high level of scrutiny before a corporation can legally claim some gain (Guo et al., 2020). The basic idea is to consider the worst scenario for a company’s financial status. Uncertain liabilities must be identified as soon as possible (Shen et al., 2020). Revenues, on the other hand, could only be documented once they are certain to be paid (Čičak & Vašiček, 2019). To guarantee that organizations record their financials as precisely as possible, Generally Accepted Accounting Principles (GAAP) require that a number of accounting rules are observed (Čičak & Vašiček, 2019). In times of uncertainty, a few of these concepts, conservatism, urges accountants to exercise prudence, selecting solutions that have the least favorable impact on a corporation’s bottom line (Chang et al., 2013). Thus, accounting conservatism may be helpful for reducing investment risks, as it ensures that the company has enough funds to cover the expenses.

However, accounting conservatism can stifle company innovation by aggravating the impacts of management blindness (Chang et al., 2013). According to previous research, managers are under pressure to accomplish particular short-term accounting targets (e.g., positive or rising income or a set level of operating profits) and will reduce R&D investment if doing so jeopardizes their ability to meet these goals (Laux & Ray, 2020). Accounting conservatism exasperates the impact of management myopia since the uneven presentation of positive and negative shocks increases the chance of missing these objectives and, as a result, increases the proclivity to minimize R&D activity (Salehi et al., 2021). In other words, Since R&D activity does contribute to the bottom line directly, companies may be prone to reduce investments in R&D due to accounting conservatism.

Accounting methods that are conservative and innovative appear to be at odds (Owais, 2021). On the one side, innovation needs a climate that shields management from failure while also encouraging them to take risks (Lawal & Hassan, 2021). Conservative reporting policies establish tighter verification requirements for distinguishing good news from bad news, lowering the likelihood that riskier investments would result in positive earnings reports (Chen et al., 2022). As a result, conservatism may encourage caution and risk avoidance while inhibiting organizational innovation (Bhutta et al., 2021). Thus, literature concerning the effect of conservative accounting on innovation agrees that there is a negative relationship between the two concepts.

Rationale

The research on accounting conservatism is abundant due to a high interest in the phenomenon. Salehi et al. (2021) stated accounting conservatism was positively correlated with managerial entrenchment. In other words, accounting conservatism negatively affected the ability of managers to make innovative decisions and tolerate less risk in the decision-making process. Haider et al. (2021) studied the relationship between managerial ability and accounting conservatism. The analysis revealed that the high-ability managers are more likely to utilize accounting conservatism, as it benefits all the stakeholders. Burke et al. (2020) assessed the relationship between accounting conservatism and corporate social responsibility (CSR). The results demonstrated that there was a negative relationship between CSR and accounting conservatism (Burke et al., 2020). Thus, accounting conservatism is known to have various effects on different aspects of business.

Recent literature on the relationship between innovation and accounting conservatism is also abundant. For instance, Khalifa et al. (2022) state that highly innovative firms are less likely to use accounting conservatism in comparison with their competitors. Laux and Ray (2020) stated that accounting conservatism makes managers less likely to make innovative decisions. As a result, managers are less likely to make risky investments due to low-risk tolerance (Lawal & Hassan, 2021). Thus, even though new evidence on the relationships between accounting conservatism, innovative decisions, invention, and investment is abundant, recent literature reviews that summarize the current state of knowledge concerning the matter are absent. The most recent literature review concerning the effect of accounting conservatism was conducted seven years ago by Ruch and Taylor (2015). Thus, this research is expected to help the managers to understand the relationship between accounting conservatism, innovative decisions, invention, and investment by summarizing the current state of knowledge on the matter.

Aims, Objectives, and Research Questions

The present paper aims to review recent literature concerning the relationship between accounting conservatism, innovative decisions, invention, and investment and provide managers with a summary of the current state of knowledge on the matter. Since the most recent literature review on the topic was conducted in 2015, a review of recent literature was needed to demonstrated how the state of knowledge concerning accounting conservatism. This literature review also identifies the areas concerning accounting conservatism that need further investigation and provides scholars with recommendations concerning future research. In order to achieve the central aim, the following steps were identified:

1. Conduct a search for recent articles that describe the relationship between accounting conservatism, innovative decisions, invention, and investment;
2. Conduct thematic analysis of the current literature on the inter-relations between accounting conservatism, innovative decisions, invention, and investment;
3. Identify gaps in the current body of knowledge concerning the relationship between accounting conservatism, innovative decisions, invention, and investment;
4. Provide recommendations for future research on the topic.

The research was guided by three research questions:

• RQ1. What is the relationship between conservative accounting and invention in business?
• RQ2. What is the relationship between conservative accounting and business investment decisions?
• RQ3. What is the relationship between conservative accounting and innovative managerial decisions?

Methods

Research Methodology and Justification

Since the purpose of this research is to summarize the current knowledge concerning the relationships between accounting conservatism, innovative decisions, invention, and investment, the most appropriate method for the study is a literature review. There are two types of literature reviews, systematic literature reviews (SLRs) and narrative literature reviews (NLRs). Systematic literature reviews are used to answer a very specific research question based on an overview of the results of several quantitative studies (Green, 2006). Systematic literature reviews require a rigorous study selection procedure, as all the studies are to have the same research questions and methods utilized to answer them (Green, 2006). When conducting an SLR, researchers usually follow seven steps, including posing a research question, locating studies, critical evaluation of studies, data collection, data analysis, interpretations of findings, and refinement and updating the review (Rother, 2007). Systematic literature reviews require significant time from us which we could not spare after the multiple changes of our methodology.

NLRs are general descriptions of the current body of knowledge on the topic of interest. NLRs do not employ strict selection procedures, which makes them easier to conduct (Green, 2006). According to Rother (2007), “narrative literature review articles have an important role in continuing education because they provide readers with up-to-date knowledge about a specific topic or theme” (p. v). Even though NLRs are not associated with high reliability of findings, they provide a broader review of the current body of knowledge.

A narrative literature review was used for this paper as the primary method for several reasons. First, it was appropriate for the revised purpose of the study, which was to provide a broad overview of the current body of literature concerning the relationship between accounting conservatism, innovative decisions, invention, and investment. Second, the literature on the subject of interest had different research questions and used varying research methods, which did not allow using SLR as the research method. Finally, we had limited time about the strategy for conducting an SLR.

Procedures

Scholarly databases were searched for relevant articles on the topic of interest. We searched through five databases, including AUT Library, Science Direct, Research Gate, Google Scholar, and JSTOR. The utilized keywords were ‘accounting conservatism’, ‘innovation’, ‘invention’, ‘R&D’, ‘investment decisions’. The keywords were searched in different combinations to find literature on different types of correlations. All the studies pulled were recently published in 2018 or later. The following selection process was used to find relevant studies to our time:

1. Titles of the articles were read to ensure that the studies had focused on a general topic relevant to this research;
2. We read the abstracts of the articles to understand if the findings and the studies and utilized methods were appropriate;
3. The remaining articles were read entirely to acquire an in-depth understanding of the research findings and methods.

The abstracts of the articles were printed out and arranged into piles according to the themes discussed in them. Some of the articles were placed in more than one pile since they touched upon several important themes. Such an organization of the studies allowed to single out the central themes.

Literature Review

This chapter provides a summary of papers by themes. A total of two themes were identified, including invention and innovation as well as investment. The purpose of this chapter was to describe the results without interpretation or further analysis.

Invention and Innovation

A total of four recent articles that focus on the relationship between innovation and accounting conservatism were found. While there were some other articles that touched upon the relationship between the concepts, these articles did have the relationship between the accounting conservatism and innovation/invention as the central research question. The summaries of these articles are provided in Table 1 below.

Table 1. Research articles used for the theme of innovation and invention

The results demonstrate that all the researchers described in the section agree that there is a negative correlation between accounting conservatism and innovation/invention (Haque et al., 2019; Khalifa et al., 2022; Laux & Ray, 2020; Li, 2019). Khalifa et al. (2022) stated that high-tech firms are less likely to use conservative accounting in comparison with low-tech firms. The lack of conditional conservatism was due to higher expenditures on R&D and lower financial leverage. In other words, Khalifa et al. (2022) stated that the higher the R&D expenditures, the less likely a firm is to utilize conservative accounting. Additionally, Khalifa (2022) stated that high-tech firms need to stay more innovative in their products and operations. Therefore, high-tech firms spend more money on R&D.

Li (2019) arrived at similar conclusions after conducting a quantitative study on the relationship between accounting conservatism, earnings management, and innovation. The results revealed that accounting conservatism had a negative effect on firm-level innovation. Li (2019) measured innovation as investment in R&D, which implies that the author assumed the innovation and invention (R&D) are synonymic concepts. Li (2019) also mentioned that accounting conservatism had a negative effect on earnings management.

While Haque et al. (2019) stated that there was a negative correlation between the level of accounting conservatism and firm-level innovation, the researchers proposed that earnings management acts as a mediator in the relationship between accounting conservatism and innovation. Haque et al. (2019) stated that increased expenditures on R&D are associated with increased use of earnings management practices. Since accounting conservatism reduces the possibility to use earnings management practices, it decreases the ability of managers to invest in R&D due to the inability to justify the investments to the stakeholders.

Laux and Ray (2020) agreed with previous findings only partially. While the researchers found a significant negative relationship between innovation and conservative accounting in a vacuum, if the incentive pay plans are taken into account, conservative accounting may foster innovation. Thus, the authors state that analyzing the relationship between innovation and accounting conservatism is a source of biased conclusions.

The implications of findings of the four studies can also be consolidated in several statements. The findings suggest that there is a negative correlation between accounting conservatism and innovation; therefore, companies that see innovation as their central priority should avoid employing accounting conservatism (Haque et al., 2019; Khalifa et al., 2022; Laux and Ray, 2020; Li, 2019). This recommendation applies to high-tech firms in a greater sense since it may affect the companies’ competitive advantage negatively (Khalifa et al., 2022). However, if the companies decide to turn to accounting conservatism practices, they should ensure to implement incentive pay plans to ensure increased level of innovative decisions regardless the decreased investments in R&D.

Investment

A total of five studies were found on the relationship between investment and accounting conservatism. Table 2 below provides a summary of the findings of these studies.

Table 2. Research articles used for theme of investment

Researchers agree that there was a positive relationship between investment efficiency and accounting conservatism (Laux and Ray, 2020; Latif et al., 2020). The primary reason for that is that stakeholders have improved quality of information about the financial performance of the company, which makes them more informed about the current situation (Laux and Ray, 2020; Latif et al., 2020). As a result, the companies take less unnecessary risks, which improves the efficiency of investment.

At the same time, researchers agreed that there was a negative correlation between investment in CSR and accounting conservatism (Burke et al., 2020; Guo et al., 2020). Research explains the correlation by stating that accounting conservatism reducing asymmetry in information distribution, which allows the stakeholders to make more informed decisions (Burke et al., 2020; Guo et al., 2020). As a result, the stakeholders are less likely to approve over-spending on CSR practices.

It should be noticed that an inconsistency in research was determined concerning the relationship between accounting conservatism and investment. On the one hand, Burke et al. (2020) stated that accounting conservatism reduces managerial opportunism, which is manager’s acting in self-interest rather than in the interest of stakeholders. On the other hand, Salehi et al. (2020) found a positive correlation between managerial entrenchment, which is a synonymic concept to managerial opportunism, and accounting conservatism. The possible reason for inconsistency may be the difference in the populations. Burke et al. (2020) included random firms from S&P500, while Salehi et al. (2020) used only Iranian firms in the sample.

The implications of the studies were also somewhat controversial. On the one hand, the review demonstrated that companies are recommended to employ accounting conservatism practices to make investment decision-making more efficient due to a reduce in overspending (Latif et al., 2020; Laux and Ray, 2020). For the same reason, managers are recommended to use accounting conservatism to optimise expenditures on CSR (Burke et al., 2020; Guo et al., 2020). On the other hand, the implications concerning addressing managerial opportunism were uncertain. While Burke et al. (2020) stated that companies should utilise accounting conservatism to reduce managerial opportunism, Salehi et al. (2020) stated against the recommendation. The reason for that may lie in the differences of the populations under analysis.

Discussion

Invention and Innovation

The results of the literature review concerning the relationship between innovation and accounting conservatism were uncertain. While most researchers stated that there was a negative relationship between innovation and accounting conservatism (Haque et al., 2019; Khalifa et al., 2022; Li, 2019), Laux and Ray (2020) stated that innovation increases due to accounting conservatism. Thus, concept analysis was used to explain the results.

Rogers and Rogers (1998) reviewed all the definition of innovation and concluded that innovation is a process associated with one of the following:

1. Introduction of a new product or moderation of an old product;
2. Introduction of a process new to industry;
3. Opening a new market;
4. Findings new sources of supplies;
5. Changing the industrial organization.

Thus, the concept of innovation is complicated and requires significant consideration of methods that can accurately measure it. However, the majority of studies used investment in R&D as the primary measure of innovation (Haque et al., 2019; Khalifa et al., 2022; Li, 2019). Considering that R&D investment can measures only how much money was spent on product innovation, using R&D expenditures as a measure for innovation is associated with significant bias. Laux and Ray (2020) stated that decreased expenditures on R&D may be a sign of increased investment efficiency. Moreover, since accounting conservatism is associated with increased incentivization of managers to be more efficient, they may look for innovative ways to change the process or products with less money spent on R&D. In summary, the central problem in determining the relationship between innovation and accounting conservatism lies in inadequate measurement of innovation.

Investment

The relationship between investment and accounting conservatism was analysed using Freeman’s stakeholder theory. According to the theory, a firm should create value for all stakeholders instead of focusing on only shareholders (Freeman et al., 2010). The stakeholder theory acknowledges different types of stakeholders and describes various levels of interest and power of the stakeholders.

The results of the research reviewed in this paper are consistent with the stakeholder theory. Accounting conservatism leads to increased robustness in reporting financial data (Burke et al., 2020; Laux and Ray, 2020). As a result, the discrepancy in the quality of information about the financial performance of companies. Without accounting conservatism, managers and other internal stakeholders had better (insider) information in comparison with other stakeholders. Since, according to the stakeholder theory, managers need to consider the interests of all the stakeholders, they become more careful in the decision-making process to reduce risks. As a result, investments in risky projects decreases, which maximizes value for all stakeholders. Therefore, accounting conservatism improves the efficiency of investments, as it was mentioned in research overviewed in this study (Laux and Ray, 2020; Latif et al., 2020).

Similarly, stakeholder theory explains the relationship between CSR and accounting conservatism. Since accounting conservatism improves the quality of knowledge received by the shareholders, managers have fewer opportunities to attend to the needs of customers in contradiction to the interests of shareholders (Burke et al., 2020; Laux and Ray, 2020). As a result, the investment in CSR decreases, which is in accord with the studies reviewed in this paper (Burke et al., 2020; Guo et al., 2020).

Stakeholder theory also explains a decrease in managerial opportunism when it comes to investment decisions. Since accounting conservatism increases transparency of financial information, managers are unlikely to act in their own interest. The control of other stakeholders that have improved information about the financial position of the company would not allow such actions. Without accounting conservatism, managers have increased opportunities to manipulate the numbers in the financial statements, which helps them to promote the decisions that bring them the most benefits. Thus, stakeholder theory provides explanations for findings of Burke et al. (2020), which stated that there was a negative correlation between managerial opportunism and accounting conservatism.

Stakeholder theory can also explain the results of research by Salehi et al. (2020), which found a positive correlation between managerial entrenchment and accounting conservatism. Managerial entrenchment is acting in manager’s personal interest to increase the perceived value of the manager for the firm. Mangers need to show that the act in the best interest of the stakeholders to ensure their trust. Without accounting conservatism, managers can use earnings management to improve the perceived personal value for the firm. However, according to Haque et al. (2019) accounting conservatism negatively affect earnings management practices. Therefore, managers are forced to look for alternative ways to improve their perceived values. While some managers will try to act in the interest of shareholders (Burke et al., 2020), others will try to make decisions that will make them look good in the eyes of the stakeholders (Salehi et al., 2020). The managers’ decisions are likely to be connected to workplace culture or national culture.

Conclusion

The results of this literature review revealed two major issues with the current body of literature. First, the study revealed a significant uncertainty concerning the relationship between innovation and accounting conservatism. The findings of current research provide contradicting results on the matter, which can be explained in two ways. On the one hand, the uncertainty may be attributed to the fact that researchers fail to acknowledge the introduction of incentive pay plans along with accounting conservatism. On the other hand, the uncertainty may be attributed to inadequate measurement of innovation. Second, this review revealed conflicting results concerning the relationship between managerial opportunism/entrenchment and accounting conservatism. The inconsistency was explained using stakeholder theory.

The following recommendations for future research were made based on the basis of the findings of this review:

• Conduct additional quantitative research on the relationship between innovation and accounting conservatism that will include incentive pay plans in the model;
• Search for effective methods to measure innovation other than R&D investments or other measures associated with R&D;
• Conduct additional research on the relationship between managerial entrenchment/opportunism and accounting conservatism to acquire additional evidence on the matter;
• Search for an explanation for the inconsistency of previous findings concerning the relationship between managerial entrenchment/opportunism and accounting conservatism.

The implications of this research for accounting practices include the following:

• Companies should utilise accounting conservatism if they want to optimise their spending on R&D;
• Integration of accounting conservatism practices should be supplemented with incentive pay plans to maintain high level of innovation;
• Firms should consider using accounting conservatism practices to optimise investment decisions and reduce overspending;
• When implementing accounting conservatism practices, company leader should control for managerial opportunism, as it may increase.

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