Conservatism in Financial Reporting: Contractual Benefits Versus Distortion of Information

The role of conservatism in firms’ financial flexibility and their financial decisions is considerable from two aspects. First, with respect to the contractual benefits, greater reporting conservatism cause more financial flexibility. Because by facilitating investors’ monitoring on contracts, conservatism makes them more willing to invest. Second, because conservatism leads to distortion of information and understatement of assets in balance sheet, it may reduce firms’ financial flexibility. This study tests these two opposing views of the relation between conservatism and financial flexibility and its resultant effect on corporate financial decisions such as liquidity management, savings, choice of loan or equity financing and payout policies. This study includes 150 firms in Tehran exchange market from 1380 to 1388. Research findings indicated that firms with greater reporting conservatism exhibit more financial flexibility in their cash management decisions, savings and payout policies, and less financial flexibility in their external financing decisions. Likewise, firms with greater reporting conservatism hold less precautionary cash, and distribute more dividends and are willing to issue loan as compared to equity.