A Signaling Theory of Accounting Conservatism
Richard Zhe Wang
Eastern Illinois University
Ciaran Ó Hogartaigh
University College Dublin (UCD) - College of Business and Law
Tony Van Zijl
Victoria University of Wellington - Faculty of Commerce and Administration
June 6, 2009
In this paper, we offer a new theory for the economic demand of accounting conservatism, which emphasizes the signaling role of conservatism in a debt market with asymmetric information. In our model, accounting conservatism serves as a signal by which the borrower firm can convey their private information about its own operating risk to the lenders, prior to signing the debt contract. In developing this signaling theory of conservatism, our paper achieves two major outcomes: (1) we analytically derive four basic properties of accounting conservatism, based on Basu's (1997) asymmetric timeliness of earnings definition of conservatism; (2) we develop a signaling model of the debt market, where accounting conservatism serves as a signaling device.
Our conservatism-signaling model has a dominant separating equilibrium, in which the low risk firms choose a high level of conservatism and the high risk firms choose a low (zero) level of conservatism. We show that this is the only stable equilibrium in our model that can pass Cho and Kreps's Intuitive Criterion (1987). Our results indicate that conservatism benefits the debt market by reducing the information asymmetry in the debt market.
Number of Pages in PDF File: 50
Keywords: accounting conservatism, Basu, asymmetric timeliness, risk, signaling, game theory
JEL Classification: G82, G30, M41working papers series
Date posted: June 8, 2009 ; Last revised: May 20, 2011
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