Value of cash holdings and accounting conservatism

Henock Louis,a Amy Sun,a and Oktay Urcanb

a
Smeal College of Business, Pennsylvania State University, University Park, PA, 16802
b
London Business School, Regent's Park, London NW1 4SA, United Kingdom

Abstract

We posit that accounting conservatism could mitigate the value destruction associated with

increases in cash holdings. Consistent with this conjecture, we find that the market value of

an additional dollar in cash holdings increases in accounting conservatism. This result is

robust to controlling for strength of corporate governance, earnings quality, past stock

performance, potential unobserved firm heterogeneity, potential endogenous changes in

conservatism, and other relevant variables. Overall, the evidence suggests that accounting

conservatism is associated with a more efficient use of cash holdings, supporting the notion

that accounting conservatism can serve as a substitute for external monitoring and reduce

agency conflicts between managers and shareholders.

JEL Classification: M41; G30; G32

Keywords: Cash holdings; Accounting conservatism; Agency costs.
The paper has benefited from comments by two anonymous referees, Ashiq Ali, Eli Amir, Phil Berger, Jeffrey
Callen (the editor), Hemang Desai, Dan Givoly, Umit Gurun, Douglas Hanna, Mozaffar Khan, Sugata
Roychowdhury, Lakshmanan Shivakumar, Doug Skinner, Gregory Sommers, Eli Talmor, Ane Tamayo, Florin
Vasvari, Ram Venkataraman, Sunny Yang, and workshop participants at London Business School, Southern
Methodist University, University of Texas Dallas, the 19th Annual Conference on Financial Economics and
Accounting at University of Texas-Austin, the 8th London Business School Accounting Symposium, and the
2009 AAA meeting.

Electronic copy available at: http://ssrn.com/abstract=1415562

 Value of cash holdings and accounting conservatism
Abstract

We posit that accounting conservatism could mitigate the value destruction associated with

increases in cash holdings. Consistent with this conjecture, we find that the market value of

an additional dollar in cash holdings increases in accounting conservatism. This result is

robust to controlling for strength of corporate governance, earnings quality, past stock

performance, potential unobserved firm heterogeneity, potential endogenous changes in

conservatism, and other relevant variables. Overall, the evidence suggests that accounting

conservatism is associated with a more efficient use of cash holdings, supporting the notion

that accounting conservatism can serve as a substitute for external monitoring and reduce

agency conflicts between managers and shareholders.

Electronic copy available at: http://ssrn.com/abstract=1415562

1. Introduction

Recent studies find that, on average, the market value of an additional dollar in cash

holdings is less than one dollar (Faulkender and Wang 2006; Dittmar and Mahrt-Smith 2007).

This finding is consistent with Jensens (1986) free cash flow hypothesis, which suggests

that, on average, free cash flows negatively affect the efficiency of investment decisions.

Excess cash offers managers the opportunity to extract rents without subjecting themselves to

the monitoring associated with external financing, allowing them to engage in negative net

present value (NPV) projects. The value destruction associated with excess cash flow can be

enormous. For instance, according to Michael Jensen, during the conglomerate era, when

firms were diversifying because they had excess cash flow, something on the order of 50%

of the potential value of all corporations had been destroyed (Jensen and Walkling 2010, p.

9).

We posit that accounting conservatism could mitigate the value destruction associated

with cash holdings. Our conjecture is consistent with Watts (2003), who contends that

conservative accounting practices can alleviate agency problems in general. More

specifically, accounting conservatism can provide incentives for ex ante efficient investment

decisions, facilitate ex post monitoring of managers investment decisions and, therefore,

mitigate the value destruction associated with cash holdings. As Ball and Shivakumar (2005)

argue, because of accounting conservatism, losses from poorly performing projects tend to be

recognized early during a managers tenure. Early loss recognition then precipitates debt

covenant violations and jeopardizes the managers employment, which reduces then his

incentives to undertake negative NPV projects. Given top executives relatively short tenure,

their incentives to expand their empires and undertake negative NPV projects decrease

when losses are recognized early. Watts (2003) also suggests that conservatism allows

directors and shareholders to receive early signals about profitability of projects undertaken

by managers. Such signals could enable them to intervene in a timely manner and take

Electronic copy available at: http://ssrn.com/abstract=1415562

corrective actions, such as the abandonment of negative NPV projects or the replacement of

the managers responsible for such projects.1

Managers can use their financial reporting discretion to hide losses; however, all else

equal, firms that have conservative financial reporting cultures and policies are more likely to

report losses on new projects in a timely manner than those that have less conservative

financial reporting cultures and policies. As Skinner (1993) suggests, to maximize their

firms value, managers can voluntarily commit to an accepted set of accounting procedures,

which include conservative accounting procedures. The set of procedures is determined by

contracting parties and enforced by external auditors. Extant studies also find that, on

average, conservative accounting choices within firms tend to be fairly stable over time

(Khan and Watts 2009; Callen et al. 2010). Therefore, we presume that, in general, firms do

not drastically change their reporting policies after investments and that, in general,

conservative firms continue to report conservatively after the investments.

Because accounting conservatism involves timely recognition of losses and delayed

recognition of gains, it might also lead to underinvestment.2 Therefore, in a setting where

underinvestment is an issue, accounting conservatism could have a negative effect by

exacerbating the underinvestment problem. However, the observed reduction in the value of

cash holdings is generally related to overinvestment -- more specifically, to managers

tendency to expand their empires and engage in negative NPV projects (Jensen 1986;

Faulkender and Wang 2006; Dittmar and Mahrt-Smith 2007). If overinvestment is the
1
Firms that adopt conservative accounting policies are likely to report losses early as a direct result of their
reporting policies, but their future financial reports are less likely to be affected by accounting conservatism
because the effect of the asymmetric accounting treatment of gains and losses decreases as past accrual
accumulation also decreases. The lower the amount of assets booked, the lower the impact of conservative
accounting rules will be on the financial reports. Examples of such conservative rules include those governing
the accounting for asset impairment, inventory valuation, dispositions of assets, etc. However, a conservative
firm is more likely to report losses related to new projects early because there has not been any accumulated
accrual associated with the new projects. The effect of the new projects on future financial reports is driven by
the conservative nature of the firm, as opposed to past accumulated accruals (which are essentially nonexistent
for the new projects). The higher probability of reporting losses early on new projects should mitigate managers
incentives to use their free cash to make new investments that could destroy firm value.
2
Garcia et al. (2010) suggest that conservatism can also reduce underinvestment.

3
primary driver of the reduction in the marginal value of cash holdings, then we expect the

effect of conservatism on the marginal value of cash holdings to be positive.

Using the negative of the ratio of nonoperating accruals to total assets (Givoly and

Hayn 2000) and Callen, Segal, and Hopes (2010) conditional conservatism ratio to proxy for

conservatism, we find strong evidence that the value of an additional dollar in cash holdings

increases in accounting conservatism, suggesting that accounting conservatism is associated

with a more efficient use of cash holdings. The results are robust to controlling for the

governance proxies that Dittmar and Mahrt-Smith (2007) find to be correlated with the

market value of cash holdings, earnings quality, past stock performance, potential unobserved

firm heterogeneity, potential endogenous changes in conservatism, and other relevant

variables.

Our findings strongly suggest that accounting conservatism provides direct benefits to

shareholders. Watts (2003) and Ball, Robin, and Sadka (2008) maintain that accounting

conservatism is driven mainly by debt contracting. Accordingly, most of the discussion about

conservatism in the literature is about its role in mitigating conflicts of interest between

owners/managers and debtholders and in reducing the cost of debt. Our analysis suggests that

accounting conservatism also mitigates agency costs related to incentive conflicts between

shareholders and managers by inducing a more efficient use of cash holdings by managers.

The notion that conservatism would reduce managers incentives to engage in value-

destroying projects has long been suggested in the literature. However, our study is the first

to empirically establish that accounting conservatism increases the value of cash holdings.

This evidence is particularly important in light of the tremendous growth in cash holdings in

the U.S. in recent years (Bates, Kahle, and Stulz 2009) and the massive value losses that can

result from cash holdings.

Bushman, Piotroski, and Smith (2011) suggest that timely recognition of economic

losses increases the sensitivity of corporate investments to declining investment opportunities

4
across countries. Biddle and Hilary (2006) hypothesize that firms with high financial

reporting quality have less information asymmetry and, accordingly, report that investment-

cash flow sensitivity is negatively associated with financial reporting quality. In a follow-up

paper, Biddle, Hilary, and Verdi (2009) document that higher quality financial reporting

enhances investment efficiency by helping to mitigate both over- and under-investment.

McNichols and Stubben (2008) also find that firms that manipulate their reported financial

results tend to over-invest. Our study is fundamentally different from these studies. First,

none of these studies analyzes the effect of accounting conservatism on the value of cash

holdings. Second, our paper might seem to be closely related to these studies because of the

apparent relation between earnings quality and accounting conservatism. However, the two

concepts are actually quite different. While it is generally presumed that superior earnings

quality reduces information asymmetry, LaFond and Watts (2008) find a positive association

between conservatism and information asymmetry. Prior studies also suggest that managers

mitigate information asymmetry by communicating favorable private information to the

market through less conservative financial reporting.3

The remainder of the study is organized as follows. Section 2 describes our research

design. Section 3 presents some descriptive statistics. The results are reported in Section 4.

The study concludes in Section 5 with a summary.

2. Research design

2.1 Our basic regression model

Faulkender and Wang (2006) find that one additional dollar in cash holdings is

associated with less than one dollar change in market value. Our objective is to determine

whether accounting conservatism improves the marginal market value of cash holdings.

Accordingly, we extend Faulkender and Wangs (2006) model by including accounting

3
See, e.g., Subramanyam (1996), Rees, Gill, and Gore (1996), Demski (1998), Arya, Glover, and Sunder (2003),
and Louis and Robinson (2005).

5
conservatism (CON) as an additional explanatory variable and interacting change in cash

holdings (C) with CON. More specifically, we use the following regression model:4

ABRETi = 1Ci + 2CONi + 3Ci*CONi + 4Ei + 5NCAi + 6R&Di + 7Ii

+ 8Di + 9NFi + 10LAGEi + 11LAGCi + 12LAGLi + 13Ci*LAGCi
+ 14Ci*LAGLi + Industry fixed effectsi + Year fixed effectsi + i, (1)

where

ABRET is abnormal stock return over the year ending three months after the fiscal year end
(raw return minus the Fama and French (1993) size and book-to-market matched portfolio
return);

C is the change in cash plus marketable securities (Data1) over the fiscal year scaled by
market value of equity (Data54*Data199) at the beginning of the year (the data numbers in
parentheses are the COMPUSTAT data numbers);

CON is a proxy for accounting conservatism measured at the beginning of the fiscal year;

E is the change in earnings before extraordinary items (Data18 + Data15 + Data50 +

Data51) over the fiscal year scaled by market value of equity at the beginning of the year;

NCA is the change in noncash assets (Data6 Data1) over the fiscal year scaled by market
value of equity at the beginning of the year;

R&D is the change in research and development expenses (Data46 or zero if missing) over
the fiscal year scaled by market value of equity at the beginning of the year;

I is the change in interest expenses (Data15) over the fiscal year scaled by market value of
equity at the beginning of the year;

D is the change in common dividends (Data21) over the fiscal year scaled by market value
of equity at the beginning of the year;

NF is net financing [total equity issuance (Data108) minus repurchase (Data115) plus debt
issuance (Data111) minus debt redemption (Data114)] for the fiscal year scaled by market
value of equity at the beginning of the year;

LAGE is earnings before extraordinary items (Data18 + Data15 + Data50 + Data51) at the
beginning of fiscal year scaled by beginning market value of equity;
4
Dittmar and Mahrt-Smith (2007) also use a price-level regression consistent with Fama and French (1998).
Untabulated results based on price-level regressions are consistent with our expectations. However, we do not
base our inferences on price-level regressions for two reasons. First, Holthausen and Watts (2001) raise
questions about the validity of references drawn from level regressions like the one used by Dittmar and Mahrt-
Smith (2007). Second, to improve the validity of the estimates from a price-level regression, the dependent
variable (firm value) would have to be deflated by book value of equity or assets. Therefore, the dependent
variable would become market-to-book ratio. Because market-to-book is often used as a proxy for conservatism,
it is not appropriate to have market-to-book on the left-hand side of the model.

6
LAGC is cash plus marketable securities (Data1) at the beginning of the fiscal year scaled by
beginning market value of equity;

LAGL is leverage [total debt (Data9 + Data34) at the beginning of the fiscal year over the
sum of total debt and beginning market value of equity]; and

Industry fixed effects are defined according to Fama and Frenchs (1997) 48 industry
classification.

Our conservatism proxies are described in the next section. Following Zhang (2008),

we convert the conservatism measures into ranks to reduce noise in the estimates. For each

year, we rank the conservatism measures into deciles and then standardize the deciles so that

they range between zero and one, with observations in the bottom decile taking the value zero

and those in the top decile taking the value one. The coefficient on the conservatism variable

can be interpreted as the difference in the effect of conservatism between the top and bottom

conservatism deciles. The other variables are exactly as in Faulkender and Wang (2006), with

the exception of LAGE.5 They control for firm-specific characteristics that could be

correlated with both returns and cash holdings due to profitability (E), investments (NCA

and R&D), or financing (I, D, LAGL, and NF). In addition to change in earnings, we also

control for level of earnings by including lagged earnings (LAGE) in the model because both

change in earnings and level of earnings have incremental explanatory power for returns

(Easton and Harris 1991). However, our results are not qualitatively affected if we do not

include LAGE in the model. Throughout the study, we winsorize all the continuous variables

at the top and bottom one-percentiles.

2.2. Proxying for accounting conservatism

We use two proxies for conservatism. The first proxy, CON-AC, is the negative of the

ratio of nonoperating accruals to total assets cumulated over the previous three years (Givoly

5
Another exception is the timing of the measurement of LAGL. Faulkender and Wang (2006) measure leverage
at the end of the return horizon. We believe that it is more appropriate to measure leverage at the beginning of
the return horizon; however, the results are similar whether we measure leverage at the beginning or the end of
the return horizon.

7
and Hayn 2000). Nonoperating accruals are defined as net income (Data172) plus

depreciation (Data14) minus cash flow from operations (Data308) minus change in accounts

receivable (Data2) minus change in inventories (Data3) minus change in prepaid expenses

(Data160) plus change in accounts payable (Data70) plus change in tax payable (Data71).

Cash flow from operations (Data308) is available starting in 1987. If Data308 is missing, we

estimate cash flow from operations as funds from operations (Data110) minus change in

current assets (Data4) minus change in short term debt (Data34) plus change in current

liabilities (Data5) plus change in cash (Data1). Accumulated nonoperating accruals are

multiplied by negative one so that the value of the conservatism proxy increases with a firms

level of conservatism. The second proxy, CON-CR, is the conditional conservatism ratio

(CR) proposed by Callen, Segal, and Hope (2010) and averaged over the previous three

years. CR measures the percentage of a shock to total current and future earnings recognized

in current period earnings. Consistent with Callen et al. (2010), we remove negative CR

observations.

Khan and Watts (2009) also propose a conservatism measure (C_Score). Using this

measure yields results similar to those reported in the paper (where we use CON-AC and

CON-CR). We do not report the results based on the C_Score because of concerns that this

measure may not be suitable for our setting since it is a linear function of firms leverage,

which is an important determinant of cash balance. We also find consistent results if we use

market-to-book to proxy for conservatism; however, market-to-book also proxies for many

other constructs, such as growth and overvaluation, that are also likely determinants of cash

balance and firm performance. The results also hold if we proxy for conservatism by the

difference between the skewness in operating cash flows and the skewness in net income over

the preceding three years (Givoly and Hayn 2000). We focus on CON-AC and CON-CR

because these measures capture some aspects of conditional conservatism and are affected by

8
firms reporting policies and managerial discretion.6 The effect of conservatism on the value

of cash holdings is driven mainly by firms financial reporting cultures and policies and

managerial reporting choices. Investors value cash balances more when the firm and its

managers are committed to conservative reporting.

3. Data and summary statistics

Our sample covers the period 1974 2006. Following Faulkender and Wang (2006), we

exclude financial firms and utility firms (SIC codes between 6,000 and 6,999, and between

4,900 and 4,999, respectively) and firm-years for which total non-cash assets are negative.7

Our base sample consists of 101,221 firm-years; however, the sample size varies, depending

on the accounting conservatism proxy. We obtain return data from the Center for Research in

Security Prices (CRSP) and the accounting data from COMPUSTAT.

Summary statistics for the sample are reported in Table 1. The distributions of the

variables in Model (1) are consistent with those reported in Faulkender and Wang (2006).

The average raw (abnormal) return is 16.6% (-0.6%) whereas the median is 5.5% (8.7%),

which is consistent with the notion that the return distributions are skewed to the right. The

average change in cash holdings is positive, which is consistent with the notion that, on

average, firms have been increasing their cash holdings over time. Operating performance has

also been increasing over time, as indicated by the change in earnings. Research and

development expenses, interest expenses, and dividend payments appear to be quite stable.

6
Other accounting conservatism proxies have been used in the literature. However, most of them are cross-
sectional measures whereas our analysis requires firm-specific measures. We could obtain firm-specific
measures by using time-series estimations of the accounting conservatism models, but such estimations would
result in substantial observation losses and would apply only to certain types of firms. For instance, a firm-
specific estimation of Basus (1997) model would require that a firm have a sufficient number of negative and
positive annual stock returns over a reasonably short period prior to the cash balance measurement year.
Similarly, Ball and Shivakumar (2005) capture the effect of conservatism by relying on the incremental effect of
negative changes in earnings. Therefore, the use of their approach to estimate firm-specific conservatism
measures requires that a firm have both some negative and some positive earnings changes over a reasonably
short period prior to the cash balance measurement year.
7
We also delete one observation that is coded on COMPUSTAT with a negative dividend.

9
4. Empirical results

4.1 The effect of conservatism on the relation between change in cash holdings and return

We first replicate the results in Faulkender and Wang (2006). Consistent with

Faulkender and Wang (2006), the results in Column (1) of Table 2 show that a change of a

dollar in cash holdings is associated with less than a dollar change in market value. On

average, a change of one dollar in cash holdings is associated with a change of 84 cents in

market value. The marginal value of one dollar change in cash holdings for the average

sample firm is calculated by adding up the coefficient on the change in cash (C), the

coefficient on C*LAGC times the mean of LAGC, and the coefficient on C*LAGL times

the mean of LAGL (1.149 - 0.707*0.177 - 0.731*0.251).8 Because C is interacted with

LAGC and LAGL, it is difficult to test whether the marginal value of one dollar change in

cash holdings is statistically different from one dollar. To directly conduct such a test, we

estimate the model without the interaction terms. The results are reported in Column (2) of

Table 2. The coefficient on C is 0.652. The p-value for the F-statistic testing whether the

coefficient is different from one is 0.000.

The primary objective of our study is to estimate the effect of conservatism on the

association between stock returns and changes in cash holdings. We therefore extend the base

model by adding accounting conservatism and the interaction between change in cash and

accounting conservatism. The results are reported in Columns (3) and (4) of Table 2.9

Consistent with our expectation, we find a significant increase in the market value of a

change in cash holdings as the average firm is getting more conservative in its accounting

practices. This result holds for both conservatism measures. For firms in the bottom decile of

8
The dependent variable in Table 2 is abnormal returns; however, the results in this table, as well as those in the
subsequent tables, are qualitatively similar if we use raw returns instead of abnormal returns.
9
The sample size changes in Columns (3) and (4) of Table 2 because necessary data to compute the
conservatism proxies are not always available. The basic results in column (1) are qualitatively similar if we
restrict the sample to the firms used in the analyses in Columns (3) and (4).

10
accounting conservatism, a change of one dollar in cash holdings is associated with an

average change of 63 cents in market value whether we use CON-AC or CON-CR. These

numbers are obtained by adding the coefficient on the change in cash (C), the coefficient on

C*LAGC times the mean of LAGC, and the coefficient on C*LAGL times the mean of

LAGL. Consistent with the conjecture that accounting conservatism mitigates the value

destruction associated with cash holdings, we find that, for the average firm in the top decile

of accounting conservatism, the estimated changes in market value associated with a change

of one dollar in cash holdings increase by 43 and 41 cents (3) to a total value of 106 and 104

cents for CON-AC and CON-CR, respectively. The increase in market value is both

economically substantial and statistically significant, with t-values of 6.37 and 3.46,

respectively (all the t-statistics reported in the study are based on standard errors adjusted for

clustering at firm level). It is important to note that 3 represents the difference in the market

value of cash balances between the extreme deciles of conservatism.

The fact that we obtain estimates of the total market value of a change of one dollar in

cash holdings that are over 100 cents might seem puzzling. However, as Dittmar and Mahrt-

Smith (2007, p. 607) argue, evidence that $1 in cash is worth more than one dollar once

inside the firm is consistent with Myers and Majluf (1984) and others, who argue that

financial slack is valuable for firms with positive investment opportunities that face costs of

external finance. Moreover, although the estimates are over 100 cents, they are not

statistically different from 100 cents.

4.2 Controlling for corporate governance

Dittmar and Mahrt-Smith (2007) find that the marginal value of cash increases with the

quality of a firms corporate governance, and Ahmed and Duelman (2007) and Garca et al.

(2009) document a link between accounting conservatism and corporate governance. We

have not controlled for governance in our main analysis because requiring data on

11
governance substantially reduces our sample size. Nonetheless, to ensure that the accounting

conservatism effect is robust to controlling for the corporate governance effect documented

by Dittmar and Mahrt-Smith (2007), in this section, we replicate our analysis using the

subsample of firms that have available governance data.

We use the following two corporate governance proxies, which Dittmar and Mahrt-

Smith (2007) find to be related to the value of cash holdings: (1) Gompers, Ishii, and

Metricks (2003) G-score and (2) large blockholdings. G-scores are reported for 1990, 1993,

1995, 1998, 2000, 2002, 2004, and 2006 by the Investor Responsibility Research Center

(IRRC). Therefore, for the analyses involving G-scores, the sample period is limited to 1990 -

2006. For years when G-scores are not available, we use the G-scores for the most recent

year. Consistent with Dittmar and Mahrt-Smith (2007), we measure large blockholdings as

the sum of all institutional ownership positions greater than 5%. These blockholdings,

collected from the 13-F filings by Thomson Financial, proxy for the extent of external

monitoring by presumably active and sophisticated large shareholders with substantial vested

interests.10 The data are available starting in 1980. Therefore, for the analyses involving

institutional blockholdings, the sample period is limited to 1980 2006. Following Dittmar

and Mahrt-Smith (2007), we transform the governance proxies into binary variables. We sort

the sample into terciles: the lowest tercile of G-scores and the highest tercile of block-

holdings are coded as one (best governance), the highest tercile of G-scores and the lowest

tercile of block-holdings are coded as zero (poor governance),11 and the middle terciles are

discarded.12

10
As a robustness check, we use total institutional ownership instead of large blockholdings and obtain
qualitatively similar results.
11
G-scores vary from zero to 24, with a low score indicating high shareholder rights and a high score indicating
low shareholder rights (see Gompers, Ishii, and Metrick (2003) for details).
12
We obtain similar results if we depart from Dittmar and Mahrt-Smith (2007) and use the original continuous
governance variables instead of the transformed variables.

12
 When using G-scores to proxy for governance quality, the number of observations falls

substantially. It falls to 11,398 when we proxy for conservatism by CON-AC and to 7,772

when we proxy for it by CON-CR. The sample size falls even further when we control for

both G-score and institutional blockholdings. Nonetheless, our inferences do not change after

we include the governance proxies in our model, whether we control for G-score and

institutional blockholdings, separately, as in Dittmar and Mahrt-Smith (2007), or we include

both variables in the model. Consistent with the evidence in Table 2, untabulated results show

that the market value of a change of one dollar in cash holdings significantly increases with

accounting conservatism. Therefore, the accounting conservatism effect that we document

holds even after controlling for managerial entrenchment (as captured by the G-scores) and

block-holdings. We recognize that the conservatism effect might be related to other

governance aspects for which we do not have readily available proxies. However, the

evidence indicates that the accounting conservatism effect that we document is robust to

controlling for the governance factors that Dittmar and Mahrt-Smith (2007) find to be related

to the value of cash holdings.

Dittmar and Mahrt-Smith (2007) find that the marginal value of cash holdings

significantly increases with good governance. The coefficients on the interactions between

change in cash and the governance proxies used by Dittmar and Mahrt-Smith (2007) are not

significant in our analysis. Further analyses show that the difference between our findings

and those reported by Dittmar and Mahrt-Smith (2007) is due to the inclusion of the

conservatism proxies in our model. Untabulated results also show that the coefficients on the

interactions between the governance proxies and change in cash are significantly positive if

we remove the conservatism variables from the model.

It is also important to note that the analysis is based on relative small samples with the

middle terciles of the governance proxies discarded (following Dittmar and Mahrt-Smith

(2007)). Therefore, it is at least difficult to generalize the results, and we accordingly caution

13
the reader against over-interpreting these results. Nonetheless, it is reassuring to observe that

the accounting conservatism effect is very strong even in these smaller samples and even

after controlling for the governance factors.

4.3 Controlling for earnings quality

Pinkowitz, Stulz, and Williamson (2006) find that the relation between cash holdings

and firm value is weaker in countries with poor investor protection. They raise (and leave

open) the possibility that investors could believe that accounting statements from countries

with poor investor protection misrepresent cash holdings. However, although managers

allegedly manipulate earnings in the U.S., misrepresentation of cash balances in the U.S. is

presumably rare. Nonetheless, to ensure that the effect that we document is related to

conservatism as opposed to earnings quality, we replicate our analysis by replacing our

conservatism measures by a measure of earnings quality. This analysis should enable us to

distinguish the effect that we document from the effect documented by Biddle and Hilary

(2006), who find that investment-cash flow sensitivity is negatively associated with financial

reporting quality (as proxied by Dechow and Dichevs (2002) earnings quality measure).

Following Biddle and Hilary (2006) and Biddle et al. (2009), to proxy for earnings

quality, we use the cross-sectional Dechow and Dichev (2002) model, augmented with the

fundamental variables from the Jones model, namely change in revenues and plant, property

and equipment.13 More specifically, we use the following model:

WCi,t = a0 + a1CFOi,t-1 + a2CFOi,t + a3CFOi,t+1 + a4REVi,t + a5PPEi,t + errori,t (2)

where WCt is change in working capital accruals from year t-1 to t (Accounts Receivable (-

Data302) + Inventory (-Data303) Accounts Payable (-Data304) Taxes Payable (-

13
McNichols (2002) argues that changes in sales revenue and plant, property and equipment are important in
forming expectations about current accruals, over and above the effects of operating cash flows. She shows that
adding these variables to the cross-sectional Dechow and Dichev (2002) regression significantly increases its
explanatory power, thus reducing measurement error.

14
Data305) + Other Assets (-Data307)) and CFOt is cash flow from operations (Data308) in

year t. If cash flow statement data are not available, we estimate WCt as CAt CLt

CASHt + STDEBTt, where CAt is the change in current assets (Data4), CLt is the change

in current liabilities (Data5), CASHt is the change in cash (Data1) and STDEBTt is the

change in short-term debt in current liabilities (Data34). We then define CFOt as the

difference between funds from operations (Data110) and WC. REVt is change in sales

(Data12) from year t-1 to t, and PPEt is property, plant, and equipment (Data7) in year t. All

variables, including the intercept, are scaled by previous years total assets and winsorized at

the top and bottom one-percentiles.

We estimate Model (2) annually for each two digit SIC code having at least 20 firms.

Annual cross-sectional estimation of equation (2) yields firm- and year-specific residuals,

which form the basis for the accruals quality measure, EQt. We measure EQt as the negative

of the standard deviation of the firms residuals calculated from t-5 to t-1, ranked into deciles,

and standardized to range between 0 and 1. Larger values of EQ indicate higher accruals

quality than smaller values.

The results are reported in Table 3 under Column (1). Although we find that earnings

quality, as proxied by Dechow and Dichevs (2002) measure, is positively associated with the

abnormal returns, we find no evidence that it has an incremental effect on the market value of

cash holdings. The coefficient (t-value) on the interaction between change in cash balance

and earnings quality (C*EQ) is -0.108 (-1.39).

We then include both earnings quality and accounting conservatism in the model. The

results are reported in Table 3 under Columns (2) and (3). Again, we find no evidence that

earnings quality, as proxied by Dechow and Dichevs (2002) measure, affects the market

value of cash holdings. The coefficients (t-values) on the interaction between change in cash

balance and earnings quality (C*EQ) are -0.131 (-1.69) and -0.014 (-0.16) when

15
conservatism is proxied by CON-AC and CON-CR, respectively. In contrast, the coefficients

(t-values) on the interaction between change in cash balance and accounting conservatism

(C*CON) are 0.318 (4.06) and 0.337 (2.40), respectively. Therefore, the conservatism effect

is robust to controlling for Dechow and Dichevs (2002) earnings quality measure.

4.4 Excluding marketable securities from the definition of cash

The market value of marketable securities can be different from their book value and

that difference might be correlated with accounting conservatism. To ensure that our

inferences are not driven by this potential effect, we also conduct the analysis with pure cash

balances (Compustat Data162) as opposed to cash plus marketable securities (Compustat

Data1). The untabulated results are qualitatively similar to those reported in Table 2 where

we use cash plus marketable securities balances. The coefficients on C*CON (3) are larger

(0.447 and 0.481, when conservatism is proxied by CON-AC and CON-CR, respectively) but

the t-values tend to be smaller (4.95 and 2.68, respectively). Note that the sample sizes are

different and, therefore, a direct comparison of the t-values is not warranted.

4.5 Distinguishing the conservatism effect from the effect of negative news

The effect of conservatism is most evident when a firm performs poorly (i.e., when it

experiences bad news). As a firms market value decreases, conservatism tends to also lead to

a markdown in the book value of the firms assets. One might also argue that investors value

the cash holdings of poorly performing firms more than the cash holdings of well performing

firms and, therefore, the effect that we document is an artifact of the effect of past

performance on the value of cash holdings. However, there is no evidence in the literature

that the value of cash holdings depends on past performance. In addition, one could even

argue that, if anything, cash holdings should be more valuable for well performing firms than

for poorly performing firms. Investors could trust managers of well performing firms to make

16
better use of cash holdings than managers of poorly performing firms. Nonetheless, to ensure

that the effect that we document is not driven by firms that previously experienced bad news,

we condition our analysis on the abnormal stock return (i.e., the unexpected economic news)

for the three-year window over which we estimate the conservatism measures.

To conduct the robustness test, we interact the change in cash holdings with past

abnormal stock returns. Consistent with De Bondt and Thaler (1985), the untabulated results

show that current stock returns are negatively correlated with past returns. However, the

coefficient on the interaction between change in cash holdings and past returns is statistically

significant only when we use CON-CR to proxy for conservatism. More importantly, the

coefficients on the interactions between change in cash holdings and the conservatism proxies

are still significantly positive, even after controlling for the potential effect of past returns,

with adjusted t-values of 6.27 and 3.65, respectively. Overall, there is no evidence that the

effect that we document is driven by firms that previously experienced bad news.

4.6 Controlling for potential unknown correlated firm-specific characteristics

We estimate our regression models with industry and year fixed effects (as opposed to

firm fixed effects) and adjust the standard errors using firm clustering. However, there is a

concern that the conservatism effect that we document captures the effects of some omitted

firm-specific characteristics. Our regression models already control for firm-specific

characteristics that could be correlated with both returns and cash holdings due to

profitability (E, LAGE), investments (NCA and R&D), or financing (I, D, LAGL, and

NF). Nonetheless, we estimate the model with firm fixed effects to control for potential

unknown correlated firm-specific characteristics.

We still find a significant increase in the market value of a change in cash holdings as

the average firm is getting more conservative in its accounting practices. Specifically, the

untabulated results show that, on average, the differential increases in market value between

17
firms in the top decile and those in the bottom decile of accounting conservatism that are

associated with a change of one dollar in cash holdings (3) are 42.0 and 33.1 cents, with t-

values of 8.08 and 3.41 for CON-AC and CON-CR, respectively.14 Therefore, there is no

evidence that our inferences are due to the omission of some unknown correlated firm-

specific factor.

4.7 Controlling for potential endogeneity effects associated with financial reporting

Thus far, we treat accounting conservatism as an exogenous variable. However,

because firms choose their financial reporting policies, it is possible that a firms

conservatism level is affected by its stock performance. Addressing this potential endogeneity

problem poses many difficulties. First, conservatism is a continuous variable and therefore is

not amenable to the standard self-selection correction procedures. Second, conservatism is

interacted with change in cash balance. Therefore, even if we transform our conservatism

proxy into a binary variable, we would be facing the forbidden regression problem because

of the interaction term, which would also be endogenous (see Wooldridge 2002; Wooldridge

2008). Third, it is difficult to find good instruments for conservatism that would be correlated

with conservatism and conservatism interacted with change in cash but uncorrelated with

returns. To circumvent these problems, we use a procedure similar to the one used by Dittmar

and Mahr-Smith (2007) and Bebchuk, Cohen, and Ferrell (2009) to control for the effect of

endogenous changes in governance. More specifically, we hold conservatism constant for

each firm by using only the initial-year conservatism estimate in our sample. A firms level of

conservatism changes very slowly and low (high) conservatism levels tend to remain relative

low (high) over time, as indicated by the high serial correlations of the various conservatism

measures (see, e.g., Callen et al. 2010). Therefore, we should be able to document the

conservatism effect even if we hold conservatism constant at its initial value, although the

14
The model includes firm fixed effects, with no further clustering adjustment. However, the inferences have not
changed if we further adjust the standard errors for any potential firm clustering effect that remains after
including the firm fixed effects. The t-values are 6.02 and 2.65 for CON-AC and CON-CR, respectively.

18
results are likely to be weaker. However, because the initial conservatism level is unlikely to

be affected by subsequent changes in performance, it is unlikely that any conservatism effect

documented using this measure is affected by endogenous changes in conservatism.

The results of our analysis are reported in Table 4. Again, we find a significantly

positive association between the market value of a change in cash holdings and accounting

conservatism. On average, the differential increases in market value between firms in the top

decile and those in the bottom decile of accounting conservatism that are associated with a

change of one dollar in cash holdings (3) are 27.5 and 17.3 cents, with t-values of 4.64 and

2.26 for CON-AC and CON-CR, respectively. Not surprisingly, the effect is weaker because

the timing of the conservatism measures is generally very distant from the timing of the

abnormal return and the change in cash holdings. However, the fact that we are still able to

document the effect strongly indicates that our inferences are not driven by the potential

effect of endogenous changes in conservatism.

4.8 Controlling for capital constraints

The marginal value of cash holdings depends on whether a firm is capital constrained

or not (Faulkender and Wang 2006). We control for capital constraints using two different

procedures. First, we condition our analysis on the degree to which a firm is capital

constrained.15 Second, we adjust the cash holdings for the level of cash that is presumably

necessary to meet the firms financing needs.

4.8.1 Conditioning on the capital constraint level

We determine the degree to which a firm is capital constrained using five variables: L,

leverage [beginning total debt scaled by the sum of beginning total debt and beginning

market value of equity]; BLC, bank lines of credit, an indicator variable taking the value of 1

15
One limitation of this analysis is that, under normal market conditions, firms with good projects should be able
to raise the necessary cash to finance these projects. Therefore, the notion of cash constrained firms assumes
some form of capital rationing.

19
if the firm has any outstanding syndicated loan deal with a revolver during the year and 0

otherwise;16 PAYOUT, payout ratio measured as total common dividends and repurchases

scaled by earnings;17 LOGSALES, the natural logarithm of beginning sales; and RATING, an

indicator variable taking the value 1 if the firm has debt (L > 0) but no bond or commercial

paper rating and 0 otherwise. The last three variables are similar to those used by Faulkender

and Wang (2006) to proxy for capital constraints. We add L because leverage is a strong

determinant of a firms ability to raise new funds. We add BLC because bank lines of credit

provide easy access to cash and reduce capital constraints. We assign weights to these

variables using a principal component analysis. We sort the sample into low, moderate, and

high capital constraint levels based on a composite of the two principal component analysis

factors.18 Because information on BLC is not available prior to 1990, we limit the analysis in

this section to the 1990 2006 period.

The results, reported in Table 5, are consistent with expectations. First, consistent with

the notion that firms are less likely to waste cash when they are capital constrained, the

coefficients on 1, the main effect of C, increases with the capital constraint level. More

specifically, it is 0.737, 1.099, and 1.342 for the low, moderate, and high capital constraint

levels, respectively, when conservatism is proxied by CON-AC; and 0.826, 0.981 and 1.696

when conservatism is proxied by CON-CR. The differences in 1 across the high and the low

capital constraint groups are statistically significant. Second, and more importantly, the effect

of conservatism on the marginal value of a change in cash holdings, 3, decreases with the

16
We obtain information on the availability of bank lines of credit from Dealscan (provided by the Loan Pricing
Corporation), which contains data on syndicated loan agreements at the time of their origination.
17
We set PAYOUT to zero if earnings are negative. The results do not qualitatively change if we instead remove
these observations.
18
The principal component analysis yields two factors based on the criterion that the eigenvalue of a factor
should be greater than one. The first factor has a strong negative loading on PAYOUT and strong positive
loadings on RATING and L, and is therefore positively correlated with capital constraints. The second factor has
strong positive loadings on LOGSALES and BLC, and is therefore negatively correlated with capital constraints.
We split the factors at the sample median. Capital constraint is deemed high if the first factor is above the
median and the second factor is below the median; it is deemed low if the first factor is below the median and
the second factor is above the median; and it is deemed moderate otherwise.

20
capital constraint level. More specifically, it is 1.229, 0.716, and 0.239 for the low, moderate,

and high capital constraint levels, respectively, when conservatism is proxied by CON-AC;

and 1.299, 1.058, and -0.318 when conservatism is proxied by CON-CR. The differences in

3 across the high and the low capital constraint groups are statistically significant.

4.8.2 Adjusting cash holdings for financing needs

Our analysis is to a large extent an extension of Faulkender and Wang (2006), where

we examine the effect of accounting conservatism on the association that they document

between change in cash holdings and change in firm value. However, it could be argued that

the decrease in the value of a change in cash holdings is more likely to be driven by the

excess component of the change in cash holdings and, therefore, unexpected change in cash

holdings could be a better construct in this setting than change in cash. We therefore extend

our analysis by examining the effect of conservatism on the association between stock returns

and unexpected change in cash holdings. We estimate unexpected change in cash as the

difference between a firms change in cash holdings [change in cash scaled by market value

of equity at the beginning of the year] and the average change in cash holdings of a matched

portfolio, using Fama and Frenchs (1993) benchmark portfolios.

The results, reported in Table 6, are qualitatively similar to those reported in Table 2,

where we use change in cash holdings (as opposed to unexpected change in cash holdings).

On average, the differential increases in market value between firms in the top decile and

those in the bottom decile of accounting conservatism that are associated with an unexpected

change of one dollar in cash holdings (3) are 30.3 and 43.5 cents, with t-values of 5.09 and

3.73 for CON-AC and CON-CR, respectively.

As an alternative procedure, we compute unexpected change in cash using an excess

cash model. Computing excess cash is quite difficult because many of the factors that

potentially determine the optimal cash holding are not observable. However, a definite

21
advantage with using excess cash is that it cannot be argued that a firm with excess cash is

cash constrained. We first estimate excess cash as the residual of the following regression

model, which is an extension of the model in Opler et al. (1999):

Ci = 1MBi + 2LOGMVEi + 3WCi + 4CFOi + 5Li + 6SIGMAi + 7R&Di + 8DIVi

+ 9BRi + 10CRi + 11LAGCi + 12BLCi + Industry fixed effectsi
+ Year fixed effectsi + i, (3)

where

C is cash plus marketable securities (Data1) at the end of year t scaled by beginning market
value of equity (Data54*Data199);

MB is total firm value at the beginning of the year (market value of equity (Data54*Data199)
plus total liabilities (Data181)) scaled by beginning total assets (Data6);

LOGMVE is natural logarithm of beginning market value of equity (Data54*Data199);

WC is beginning working capital accruals (Data4 Data5 Data1 + Data34) scaled by

beginning market value of equity (Data54*Data199);

CFO is cash flow from operations (Data308) in year t scaled by beginning market value of
equity (Data54*Data199) (if cash flow statement data are not available, we estimate CFO as
the difference between funds from operations (Data110) and WC in year t scaled by
beginning market value of equity (Data54*Data199));

L is leverage [beginning total debt (Data9 + Data34) scaled by the sum of beginning total
debt and beginning market value of equity];

SIGMA is the 10-year mean of standard deviations of CFO for firms in the same industry, as
defined according to Fama and Frenchs (1997) 48 industry classification;

R&D is research and development expenses (Data46 or zero if missing) in year t scaled by
sales (Data12);

DIV is an indicator variable taking the value of 1 if the firm pays dividends (Data21 > 0)
during the year t and 0 otherwise;

BR, a proxy for financing ability, takes the value of 1 if the firm has beginning debt (L > 0)
but no beginning bond rating (Data280) on COMPUSTAT and 0 otherwise;

CR, another proxy for financing ability, takes the value of 1 if the firm has beginning debt (L
> 0) but no beginning commercial paper rating (Data283) on COMPUSTAT and 0 otherwise;

LAGC is lagged cash plus marketable securities (Data1) scaled by beginning market value of
equity (Data54*Data199);

22
BLC is an indicator variable taking the value of 1 if the firm has any outstanding syndicated
loan deal with a revolver during the year t and 0 otherwise;

Industry fixed effects are defined according to Fama and Frenchs (1997) 48 industry
classification; and

all the continuous variables are winsorized at the top and bottom one-percentiles.

Model (3) differs from Opler et al.s (1999) model on a few aspects. In particular,

Model (3) does not include capital expenditure. Including capital expenditures in the model

does not change our inferences; however, the suboptimal managerial behavior that

conservatism constrains is presumably reflected in the firms investment policies. Because

excess cash is estimated as the regression residual, including capital expenditures in the

model is likely to bias the conservatism effect. We also control for the availability of bank

lines of credit (BLC). Firms with access to lines of credit have less of a need to hold large

cash balances. We therefore adjust the firms cash holdings by removing the component of

their cash holdings that is explained by the access to lines of credit (or lack thereof). We also

extend Opler et al.s (1999) model by including BR and CR to further control for variations in

the firms financing abilities.

We estimate the model over the 1990 to 2006 period because necessary data on bank

lines of credit are available on DealScan starting in 1990. We refer to the residual from the

Model (3) as excess cash (EC), which we use in Model (1) in lieu of the cash balance. The

results, reported in Table 7 under Column (1), are qualitatively similar to those reported in

Tables 2 and 6. On average, the differential increases in market value between firms in the

top decile and those in the bottom decile of accounting conservatism that are associated with

a change of one dollar in excess cash holdings (3) are 40.7 and 41.5 cents, with t-values of

5.05 and 2.46 for CON-AC and CON-CR, respectively.19 Therefore, we are confident that our

inferences are not due to some failure to control for capital constraints.

19
The t-values are likely smaller in this table because of the reduction in sample size.

23
 There is also a concern that our results could be affected by the potential effect of

conservatism on cash holdings. However, untabulated results show that the associations

between cash holdings and the conservatism proxies are very small. The Pearson correlations

between conservatism and change in cash holdings are 0.018 and -0.008 for CON-AC and

CON-CR, respectively, and the Pearson correlations between conservatism and change in

excess cash holdings are 0.024 and -0.010. We also estimate an alternative model of excess

cash where we include the conservatism proxies as additional explanatory variables in the

model. This specification ensures that excess cash is orthogonal to the conservatism proxies.

Untabulated results show that the marginal value of a change in excess cash still increases

with accounting conservatism.

5. Summary

Consistent with the free cash flow hypothesis, prior studies find that the market value of

an additional dollar in cash holdings is less than one dollar. Extant studies also suggest that

accounting conservatism can alleviate agency problems, providing managers incentives for ex

ante efficient investment decisions and facilitating ex post monitoring of managers

investment decisions. We therefore posit that accounting conservatism could mitigate the

value destruction associated with an increase in cash holdings.

Consistent with our conjectures, we find evidence that the market value of an additional

dollar in cash holdings increases in accounting conservatism. The evidence suggests that

accounting conservatism is associated with a more efficient use of cash holdings, mitigating

the value destruction associated with cash holdings. Therefore, our study supports the notion

that accounting conservatism serves as a substitute for external monitoring and reduces

agency conflicts between managers and shareholders.

Accounting conservatism can be associated with governance. We control for

governance using the governance proxies that Dittmar and Mahrt-Smith (2007) find to be

24
correlated with the market value of cash. We cannot completely rule out the possibility that

the accounting conservatism effect that we document might be related to some other

governance features for which we do not have readily available proxies. However, our results

are robust to controlling for firm fixed effects, indicating that they are not driven by some

specific firm characteristics that we fail to control for. They are also robust to controlling for

earnings quality, potential endogenous changes in conservatism, past stock performance, and

other relevant variables.

25
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28
Table 1: Descriptive statistics

Variable Mean 25% Median 75% Std. dev. N

RRET 0.166 -0.224 0.055 0.392 0.636 101,221
ABRET -0.006 -0.341 -0.087 0.193 0.573 101,221
C 0.014 -0.031 0.002 0.045 0.152 101,221
E 0.021 -0.032 0.011 0.056 0.235 101,221
NCA 0.089 -0.031 0.061 0.217 0.519 101,221
R&D 0.001 0.000 0.000 0.002 0.022 101,221
I 0.003 -0.002 0.000 0.008 0.033 101,221
D 0.001 0.000 0.000 0.001 0.007 101,221
NF 0.043 -0.033 0.001 0.075 0.264 101,221
LAGE 0.061 0.018 0.076 0.155 0.253 101,221
LAGC 0.177 0.035 0.096 0.219 0.231 101,221
LAGL 0.251 0.038 0.190 0.410 0.237 101,221
CON-AC 0.073 0.006 0.049 0.113 0.158 85,982
CON-CR 0.826 0.230 0.396 0.742 1.575 52,839

Notes: RRET is the raw cumulated monthly stock return over the year ending three months
after the fiscal year end; ABRET is the abnormal stock return over the year ending three
months after the fiscal year end, calculated as raw return minus Fama and French (1993) size
and book-to-market matched portfolio; C is the change in cash plus marketable securities
(COMPUSTAT Data1) over the fiscal year scaled by market value of equity
(Data54*Data199) at the beginning of the year; E is the change in earnings before
extraordinary items (Data18 + Data15 + Data50 + Data51) over the fiscal year scaled by
market value of equity at the beginning of the year; NCA is the change in noncash assets
(Data6 Data1) over the fiscal year scaled by market value of equity at the beginning of the
year; R&D is the change in research and development expenses (Data46 or zero if missing)
over the fiscal year scaled by market value of equity at the beginning of the year; I is the
change in interest expenses (Data15) over the fiscal year scaled by market value of equity at
the beginning of the year; D is the change in common dividends (Data21) over the fiscal
year scaled by market value of equity at the beginning of the year; NF is net financing [total
equity issuance (Data108) minus repurchases (Data115) plus debt issuance (Data111) minus
debt redemption (Data114)] for the fiscal year scaled by market value of equity at the
beginning of the year; LAGE is earnings before extraordinary items (Data18 + Data15 +
Data50 + Data51) at the beginning of fiscal year scaled by beginning market value of equity
(Data54*Data199); LAGC is cash plus marketable securities (Data1) at the beginning of the
fiscal year scaled by beginning market value of equity (Data54*Data199); LAGL is leverage
[total debt (Data9 + Data34) at the beginning of the fiscal year over the sum of total debt and
beginning market value of equity]; CON-AC, one of our accounting conservatism proxies, is
the negative of the ratio of nonoperating accruals to total assets cumulated over the preceding
three years [nonoperating accruals are defined as net income (Data172) plus depreciation
(Data14) minus cash flow from operations (Data308) minus change in accounts receivable
(Data2) minus change in inventories (Data3) minus change in prepaid expenses (Data160)
plus change in accounts payable (Data70) plus change in tax payable (Data71); if Data308 is
missing, we estimate cash flow from operations as funds from operations (Data110) minus

29
change in current assets (Data4) minus change in debt (Data34) plus change in current
liabilities (Data5) plus change in cash (Data1)]; and CON-CR, one of our accounting
conservatism proxies, is the conservatism ratio calculated according to Callen et al., (2010).
All the variables are winsorized at the top and bottom one-percentiles. This full sample
covers the period 1974 to 2006.

30
Table 2: The effect of accounting conservatism on the association between change in market
value and change in cash holdings

ABRETi = 1Ci + 2CONi + 3Ci*CONi + 4Ei + 5NCAi + 6R&Di + 7Ii + 8Di

+ 9NFi + 10LAGEi + 11LAGCi + 12LAGLi + 13Ci*LAGCi + 14Ci*LAGLi
+ Industry fixed effectsi + Year fixed effectsi + i

Variables (1) (2) (3) (4)

Base model 1 Base model 2 CON-AC CON-CR
C 1.149 0.652 0.919 0.947
(33.12) (35.14) (18.42) (13.39)
CON - - -0.001 -0.051
(-0.09) (-5.15)
C*CON - - 0.426 0.405
(6.37) (3.46)
E 0.612 0.609 0.772 1.018
(42.17) (41.88) (42.46) (50.44)
NCA 0.148 0.146 0.150 0.152
(22.25) (21.85) (19.17) (16.84)
R&D 0.475 0.521 0.462 0.410
(3.89) (4.26) (3.17) (2.32)
I -1.581 -1.617 -1.985 -1.947
(-20.17) (-20.58) (-20.55) (-18.20)
D 2.906 2.963 2.568 2.209
(13.03) (13.18) (10.97) (7.77)
NF -0.069 -0.053 -0.070 -0.127
(-6.08) (-4.63) (-5.30) (-8.52)
LAGE 0.219 0.208 0.215 0.504
(15.05) (14.31) (11.47) (24.28)
LAGC 0.169 0.207 0.164 0.079
(15.03) (19.10) (13.59) (6.14)
LAGL -0.023 -0.024 -0.006 -0.064
(-2.47) (-2.51) (-0.59) (-5.34)
C*LAGC -0.707 _ -0.615 -0.657
(-12.37) (-8.90) (-8.82)
C*LAGL -0.731 _ -0.712 -0.786
(-10.73) (-8.68) (-9.10)
Industry fixed effects Yes Yes Yes Yes
Year fixed effects Yes Yes Yes Yes
R2 0.132 0.127 0.139 0.230
N 101,221 101,221 85,982 52,839

Notes: CON is the respective conservatism measure, ranked into deciles annually and then
standardized such that observations in the bottom decile take the value zero and those in the
top decile take the value one. Industry fixed effects are defined according to Fama and

31
Frenchs (1997) 48 industry classification. The other variables are as defined in Table 1. All
the continuous variables are winsorized at the top and bottom one-percentiles. The sample
period is between 1974 and 2006. The t-statistics, reported in parentheses, are based on
standard errors adjusted for clustering at firm level.

32
Table 3: The effect of accounting conservatism on the association between change in market
value and change in cash holdings after controlling for earnings quality

ABRETi = 1Ci + 2CONi + 3Ci*CONi + 4EQi + 5Ci*EQi + 6Ei + 7NCAi

+ 8R&Di + 9Ii + 10Di + 11NFi + 12LAGEi + 13LAGCi + 14LAGLi
+ 15Ci*LAGCi + 16Ci*LAGLi + Industry fixed effectsi + Year fixed effectsi + i

Variables (1) (2) (3)

CON is excluded CON-AC CON-CR
C 1.096 0.972 0.997
(19.76) (15.22) (11.41)
CON - 0.009 -0.049
(1.31) (-4.37)
C*CON - 0.318 0.337
(4.06) (2.40)
EQ 0.006 0.007 0.015
(0.91) (1.04) (1.72)
C*EQ -0.108 -0.131 -0.014
(-1.39) (-1.69) (-0.16)
E 0.802 0.801 (
1.076
(36.34) (36.25) (45.43)
NCA 0.162 0.161 0.168
(17.59) (17.54) (15.69)
R&D 0.399 0.387 0.451
(2.23) (2.17) (2.24)
I -1.938 -1.936 -2.025
(-17.37) (-17.35) (-15.86)
D 2.033 2.011 1.614
(8.24) (8.15) (5.24)
NF -0.092 -0.093 -0.149
(-6.08) (-6.13) (-8.80)
LAGE 0.260 0.260 0.522
(11.56) (11.58) (21.28)
LAGC 0.123 0.123 0.068
(9.21) (9.25) (4.64)
LAGL -0.020 -0.019 -0.073
(-1.72) (-1.64) (-5.33)
C*LAGC -0.670 -0.624 -0.759
(-8.06) (-7.40) (-8.31)
C*LAGL -0.668 -0.657 -0.772
(-7.13) (-7.04) (-7.50)
Industry fixed effects Yes Yes Yes
Year fixed effects Yes Yes Yes
Adjusted R2 0.145 0.146 0.234
N 60,970 60,970 41,534

Notes: EQ is earnings quality measured as the negative of the standard deviation of the firms
residuals of Dechow and Dichevs (2002) model calculated from t-5 to t-1, ranked into

33
deciles, and standardized to be between 0 and 1. Industry fixed effects are defined according
to Fama and Frenchs (1997) 48 industry classification. The other variables are as defined in
Tables 1 and 2. All the continuous variables are winsorized at the top and bottom one-
percentiles. The sample period is between 1974 and 2005. The t-statistics, reported in
parentheses, are based on standard errors adjusted for clustering at firm level.

34
Table 4: The effect of accounting conservatism on the association between change in market
value and change in cash holdings after controlling for potential endogenous changes in
conservatism
ABRETi = 1Ci + 2CON_INITIALi + 3Ci*CON_INITIALi + 4Ei + 5NCAi
+ 6R&Di + 7Ii + 8Di + 9NFi + 10LAGEi + 11LAGCi + 12LAGLi
+ 13Ci*LAGCi + 14Ci*LAGLi + Industry fixed effectsi + Year fixed effectsi + i
Variables CON-AC CON-CR
C 1.006 1.012
(20.65) (19.20)
CON_INITIAL 0.006 -0.002
(1.10) (-0.41)
C*CON_INITIAL 0.275 0.173
(4.64) (2.26)
E 0.649 0.678
(41.64) (40.40)
NCA 0.150 0.151
(3.11) (20.04)
R&D 0.407 0.383
(3.11) (2.52)
I -1.654 -1.657
(-19.80) (-18.72)
D 2.714 2.369
(11.84) (9.79)
NF -0.073 -0.082
(-6.010 (-6.45)
LAGE 0.229 0.280
(14.47) (16.47)
LAGC 0.168 0.123
(14.39) (10.43)
LAGL -0.014 -0.016
(-1.41) (-1.59)
C*LAGC -0.642 -0.607
(-10.37) (-9.28)
C*LAGL -0.728 -0.702
(-9.96) (-9.12)
Industry fixed effects Yes Yes
Year fixed effects Yes Yes
Adjusted R2 0.135 0.146
N 90,169 73,655
Notes: Industry fixed effects are defined according to Fama and Frenchs (1997) 48 industry
classification. CON_INITIAL is the value of conservatism in the first year when it could be
calculated. The other variables are as defined in Tables 1 and 2. All the continuous variables
are winsorized at the top and bottom one-percentiles. The sample period is between 1974 and
2006. The t-statistics, reported in parentheses, are based on standard errors adjusted for
clustering at firm level.

35
Table 5: The effect of accounting conservatism on the association between change in market
value and change in cash holdings conditional on capital constraints

ABRETi = 1Ci + 2CONi + 3Ci*CONi + 4Ei + 5NCAi + 6R&Di + 7Ii + 8Di

+ 9NFi + 10LAGEi + 11LAGCi + 12LAGLi + 13Ci*LAGCi + 14Ci*LAGLi
+ Industry fixed effectsi + Year fixed effectsi + i

(1) (2)
CON-AC CON-CR
Capital Constraints LOW MODERATE HIGH LOW MODERATE HIGH
C 0.737 1.099 1.342+++ 0.826 0.981 1.696+++
(4.20) (9.73) (8.02) (2.82) (6.33) (7.03)
CON 0.002 0.015 -0.036 -0.012 -0.094 -0.096
(0.12) (1.15) (-1.74) (-0.54) (-4.29) (-2.89)
C*CON 1.229 0.716 0.239*** 1.299 1.058 -0.318***
(4.52) (4.58) (1.10) (2.46) (3.98) (-0.83)
E 1.407 0.768 0.735+++ 0.984 1.079 1.218+++
(13.71) (21.80) (14.08) (14.55) (27.15) (20.41)
NCA 0.153 0.206 0.226++ 0.155 0.224 0.232++
(6.25) (11.57) (8.07) (4.49) (11.26) (7.32)
R&D 1.022 0.457 0.308 1.384 -0.333 0.351
(2.04) (1.70) (0.98) (2.07) (-1.03) (0.89)
I -2.837 -2.798 -3.029 -3.801 -2.584 -2.689
(-4.52) (-10.62) (-6.61) (-4.40) (-8.92) (-5.56)
D 1.785 2.986 5.099 1.693 3.233 2.765
(2.29) (3.70) (3.31) (1.56) (3.71) (1.50)
NF -0.144 -0.157 -0.004++ -0.155 -0.227 -0.106
(-2.99) (-5.04) (-0.08) (-2.41) (-6.47) (-1.70)
LAGE 0.992 0.135 0.089+++ 1.278 0.493 0.548+++
(9.43) (3.26) (1.65) (8.23) (10.82) (8.90)
LAGC 0.192 0.237 0.343+++ 0.165 0.145 0.192
(4.69) (8.65) (8.16) (3.33) (5.26) (4.76)
LAGL -0.108 0.050 0.123+++ -0.193 0.001 0.159+++
(-3.09) (2.39) (2.80) (-4.20) (0.06) (3.23)
C*LAGC -0.413 -0.678 -0.825 -1.201 -0.780 -1.130
(-1.54) (-4.31) (-3.55) (-3.52) (-4.52) (-4.42)
C*LAGL -1.645 -0.953 -0.731++ -1.590 -0.948 -1.026
(-3.84) (-5.10) (-2.05) (-2.85) (-4.84) (-2.77)
Industry fixed effects Yes Yes Yes Yes Yes Yes
Year fixed effects Yes Yes Yes Yes Yes Yes
Adjusted R2 0.123 0.139 0.148 0.199 0.230 0.261
N 12,544 24,417 12,544 7,594 14,691 7,594

Notes: We determine the degree to which a firm is capital constrained using five variables: L,
leverage [beginning total debt scaled by the sum of beginning total debt and beginning

36
market value of equity]; BLC, an indicator variable taking the value of 1 if the firm has any
outstanding syndicated loan deal with a revolver during the year t and 0 otherwise; PAYOUT,
payout ratio measured as total common dividends and repurchases scaled by earnings;
LOGSALES, the natural logarithm of beginning sales; and RATING, an indicator variable
taking the value 1 if the firm has debt (L > 0) but no bond or commercial paper rating. We
assign weights to these variables using a principal component analysis, which yields two
factors. The first factor has a strong negative loading on PAYOUT and strong positive
loadings on RATING and L, and is therefore positively correlated with capital constraints.
The second factor has strong positive loadings on LOGSALES and BLC, and is therefore
negatively correlated with capital constraints. We split the factors at the sample median.
Capital constraint is deemed high if the first factor is above the median and the second factor
is below the median; it is deemed low if the first factor is below the median and the second
factor is above the median; and it is deemed moderate otherwise. Industry fixed effects are
defined according to Fama and Frenchs (1997) 48 industry classification. The other variables
are as defined in Tables 1 and 2. All the continuous variables are winsorized at the top and
bottom one-percentiles. Because information on BLC is not available prior to 1990, we limit
the analysis in this section to the 1990 2006 period. The t-statistics, reported in parentheses,
are based on standard errors adjusted for clustering at firm level. +++, ++ and + indicate that the
differences in the coefficients across LOW and HIGH groups are statistically significant at the
1%, 5%, and 10% levels, respectively, in a two-tailed test. *** indicates that the differences
are significant at the 1% level in a one-tailed test.

37
Table 6: The effect of accounting conservatism on the association between change in market
value and unexpected change in cash holdings
ABRETi = 1UCi + 2CONi + 3UCi*CONi + 4Ei + 5NCAi + 6R&Di + 7Ii
+ 8Di + 9NFi + 10LAGEi + 11LAGCi + 12LAGLi + 13UCi*LAGCi
+ 14UCi*LAGLi + Industry fixed effectsi + Year fixed effectsi + i
Variables CON-AC CON-CR
UC 0.928 0.905
(19.30) (12.91)
CON 0.005 -0.044
(0.89) (-4.40)
UC*CON 0.303 0.435
(5.09) (3.73)
E 0.774 1.020
(42.66) (50.58)
NCA 0.148 0.150
(19.06) (16.75)
R&D 0.468 0.418
(3.21) (2.36)
I -1.983 -1.943
(-20.52) (-18.16)
D 2.554 2.200
(10.89) (7.73)
NF -0.065 -0.123
(-4.96) (-8.30)
LAGE 0.217 0.504
(11.57) (24.32)
LAGC 0.152 0.070
(12.29) (5.26)
LAGL -0.018 -0.076
(-1.68) (-6.26)
UC*LAGC -0.607 -0.600
(-8.88) (-8.18)
UC*LAGL -0.705 -0.777
(-8.63) (-9.06)
Industry fixed effects Yes Yes
Year fixed effects Yes Yes
Adjusted R2 0.138 0.229
N 85,982 52,839
Notes: A firms unexpected change in cash (UC) is proxied by the difference between a
firms change in cash holdings [change in cash scaled by market value of equity
(Data54*Data199) at the beginning of the year] and the average change in cash holdings of a
matched portfolio, matched on size and book-to-market using Fama and Frenchs (1993)
benchmark portfolios. Industry fixed effects are defined according to Fama and Frenchs
(1997) 48 industry classification. The other variables are as defined in Tables 1 and 2. All the
continuous variables are winsorized at the top and bottom one-percentiles. The sample period
is between 1974 and 2006. The t-statistics, reported in parentheses, are based on standard
errors adjusted for clustering at firm level.

38
Table 7: The effect of accounting conservatism on the association between change in market
value and change in excess cash holdings

ABRETi = 1ECi + 2CONi + 3ECi*CONi + 4Ei + 5NCAi + 6R&Di + 7Ii + 8Di

+ 9NFi + 10LAGEi + 11LAGCi + 12LAGLi + 13ECi*LAGCi + 14ECi*LAGLi
+ Industry fixed effectsi + Year fixed effectsi + i

Variables CON-AC CON-CR

EC 0.571 0.648
(10.08) (7.91)
CON 0.003 -0.068
(0.29) (-4.22)
EC*CON 0.407 0.415
(5.05) (2.46)
E 0.902 1.356
(29.54) (38.55)
NCA 0.178 0.188
(11.94) (10.69)
R&D 0.912 0.493
(4.34) (1.85)
I -3.201 -2.961
(-12.68) (-10.26)
D 3.922 3.244
(5.97) (4.23)
NF 0.025 -0.111
(0.92) (-3.43)
LAGE 0.254 0.732
(7.80) (18.74)
LAGC 0.313 0.212
(13.01) (8.38)
LAGL 0.066 0.004
(3.63) (0.19)
EC*LAGC -0.153 -0.257
(-1.45) (-2.13)
EC*LAGL -0.643 -0.738
(-5.53) (-5.62)
Industry fixed effects Yes Yes
Year fixed effects Yes Yes
Adjusted R2 0.124 0.223
N 44,972 27,045

Notes: Industry fixed effects are defined according to Fama and Frenchs (1997) 48 industry
classification. EC is excess cash balance estimated as the residual from Model (3). The other
variables are as defined in Tables 1 and 2. All the continuous variables are winsorized at the
top and bottom one-percentiles. The sample period is between 1991 and 2006. The t-
statistics, reported in parentheses, are based on standard errors adjusted for clustering at firm
level.

39