The Impact of Conservative Accounting on the Speed of Leverage Adjustment in Response to Stock Price Crash Risk

This study aimed to investigate how companies adjust the speed at which they move toward their target financial leverage in response to stock price crash risk. Additionally, it examined the role of accounting conservatism in enhancing the speed of leverage adjustment under these risk conditions. The sample comprised data from 101 companies listed on the Tehran Stock Exchange (TSE) over a 10-year period (2013 to 2022) with analyses conducted using EViews and Stata software to test the hypotheses. The findings indicated that stock price crash risk had a negative and significant effect on the speed of leverage adjustment. Specifically, as the risk of a stock price crash increased, the companies tended to slow their adjustment toward target leverage. Conversely, the analysis of the second hypothesis revealed that accounting conservatism did not significantly moderate the relationship between stock price crash risk and the speed of leverage adjustment. However, accounting conservatism had a positive and significant direct effect on the speed of leverage adjustment.Keywords: Stock Price Crash Risk, Speed of Leverage Adjustment, Conservative Accounting.JLE: D25, D53, M41 IntroductionDebt is a critical financing instrument for companies and firms typically strive to adjust their leverage to an optimal level. According to trade-off theory, maintaining leverage at this optimal level maximizes a company's market value. One significant determinant of optimal leverage is information asymmetry. Companies operating in environments with high information asymmetry face elevated financing costs, which subsequently reduce both the frequency and speed of leverage adjustments. Dynamic trade-off theory further posits that companies seek to optimize their capital structures, with transaction costs playing a pivotal role in determining the speed of adjustment. Additionally, a positive relationship exists between stock price crash risk and information asymmetry, indicating that such risk can hinder the speed at which companies adjust their leverage. In situations characterized by information asymmetry, accounting conservatism can help alleviate these challenges and mitigate the likelihood of stock price crashes. Conservative accounting practices tend to communicate negative information to the market more promptly than positive news, thereby reducing the risk of misleading investors. Consequently, firms facing stock price crash risk may struggle to adjust their leverage swiftly due to the associated high financing costs. This study aimed to investigate whether accounting conservatism could enhance the speed of leverage adjustment in the context of stock price crash risk. Materials & MethodsThis study employed both experimental and statistical methods to test the hypotheses. By utilizing post-event observations, the study minimized the potential for variable manipulation. The findings were relevant not only to the academic community, but also to regulators, business practitioners, and stakeholders. Data were obtained from multiple sources: the Tehran Stock Exchange (TSE) database for stock returns, Rahvard software for financial statement information, and the IRI Central Bank's website for annual inflation data. The research period spanned a decade, from 2012 to 2021, encompassing 101 companies and generating a total of 1,010 firm-year observations. Data analysis was conducted using EViews and Stata software. FindingsThe results indicated that stock price crash risk had a negative and significant effect on the speed of leverage adjustment. Specifically, an increase in stock price crash risk hampered a company’s progress toward its target leverage, thereby inhibiting swift adjustments. This finding aligned with dynamic trade-off theory, which asserts that firms must consider transaction costs and suboptimal leverage ratios when making adjustments to their leverage (Fischer et al., 1989; Goldstein et al., 2001; Strebulaev, 2007). When the costs associated with rapid adjustments exceeded transaction costs, the firms might postpone such adjustments until the benefits justify the costs of recapitalization. Moreover, the companies facing substantial stock price crash risk often experienced increased information asymmetry between management and external investors, resulting in elevated financing costs. As financing costs rose, the speed at which companies adjusted their leverage toward an optimal level diminished (Kim & Zhang, 2016). Therefore, it was reasonable to conclude that high stock price crash risk impeded financial leverage adjustment. Interestingly, the findings also revealed that while accounting conservatism did not significantly moderate the relationship between stock price crash risk and leverage adjustment speed, it did have a positive and significant impact on leverage adjustment as an independent variable. Companies that employed conservative accounting practices might be more effective in adjusting their financial leverage in response to stock market risks. The literature on accounting conservatism supports this research's hypothesis. Prior studies suggested that accounting conservatism mitigates the accumulation and concealment of negative information, thereby reducing the likelihood of a sudden release of bad news into the market. As conservatism increases, the probability of hidden bad news decreases, which in turn diminishes the risk of stock price crashes and facilitates leverage adjustment. Additionally, conservatism limits managerial incentives to delay the disclosure of negative information, thereby expediting the release of positive news through voluntary disclosures. This not only reduces stock price crash risk, but also lessens the potential for price bubbles, which are a significant source of crash risk (Kim & Zhang, 2016). However, the findings indicated that accounting conservatism did not act as a moderator between stock price crash risk and leverage adjustment speed. Discussion & ConclusionAccounting conservatism involves a cautious approach to financial reporting, where losses and expenses are recorded more promptly, while revenues and gains are recognized at a later date. While this approach can enhance transparency and reduce reporting risks, it may also diminish managers' willingness to undertake bold financial decisions. In situations that require leverage adjustments, managers might hesitate to adopt risky or innovative strategies due to concerns about negative outcomes and increased risk (LaFond & Watts, 2008). Consequently, although accounting conservatism promotes transparency and mitigates the accumulation of negative information, it may not have an immediate and direct impact on the speed of leverage adjustment as it potentially reduces managerial incentives to take risks. Additionally, there may be a timing mismatch between conservative financial reporting and managerial decisions regarding leverage adjustments. The timing of financial reports may not align with decisions about leverage adjustments, thereby weakening the effect of conservatism on the speed of adjustment (Dechow & Sloan, 1991; Ball et al., 2000). In conclusion, stock price crash risk presents significant financial and economic challenges for companies that extend beyond the capacity of accounting conservatism to fully address. In scenarios of severe financial crises, conservatism alone may not adequately counterbalance the negative effects of crash risk. As Watts (2003) notes, the limitations of accounting conservatism become particularly evident in such extreme conditions and it may fall short of fully mitigating all associated challenges and risks.