The impact of psychological biases on accounting choices: from evidence of managerial sentiment and asymmetric timely loss recognition

Psychological biases in the form of sentiment can affect various economic decisions including accounting choices. Broadly defined, the term sentiment refers to unjustified beliefs about the future cash flow prospects of the firm (Baker and Wurgler 2006). Accounting conditional conservatism is particularly prone to managerial sentiment. Conditional conservatism refers to an accounting phenomenon in which firms tend to recognize economic losses earlier than economic gains. Because the decision to recognize gains and losses is based, in part, on managers’ beliefs about the likelihood of future economic events affecting the firms, conditional conservatism offers an ideal setting to study the impact of psychological biases on accounting choices. In this study, I find that conditional conservatism is lower as managers become more overly optimistic about the future performance of their companies. This lower level of conditional conservatism during periods of high managerial sentiment results in the lower concurrent write-offs and higher subsequent write-offs. This study enhances the implications of sentiment on firms’ accounting choices by identifying a time-varying macroeconomic determinant of conditional conservatism that is based on psychological biases about future performance.