An Agency Theory of Conservative Accrual Accounting

Abstract:     
This paper argues that accrual-based financial accounting, including the conservative recognition of anticipated cash flows, mimics the properties of an optimal multi-period incentive contract between a firm and a manager. I study a two-period principal-agent model in which a manager can be compensated based on an early signal of a future outcome of his action, or (later) based on the outcome itself. In this dynamic setting it is optimal to use both performance measures even if the signal is strictly noisier than the outcome. Accrual accounting enables the firm and the manager to "settle up" in each period, which is optimal if the manager cannot commit to a long-term contract. Conservative accruals attribute to a period only the portion of expected cash flows that is explained, in a Bayesian sense, by information available in that period. I relate these results to conventional accounting rules and the literature on conservatism.

Keywords: incentive contracts, accrual accounting,conservatism, unconditional conservatism

JEL Classifications: D86, G34, M41, M44, M46, M52

Working Paper Series