An Evolutionary Risk Basis for Differential Treatment of Gains and Losses

Abstract:     
This study generates Watts's (2003a) asymmetric verification concept of conservatism endogenously, using evolutionary biology as a foundation. A producer has diminishing marginal returns to output and is thus risk averse in gains. After production, the producer faces a stealer who seeks to expropriate the output. The producer, for fear of being perceived as weak, will never share his output with the stealer, but will launch an all-out fight. This all-or-nothing gamble reflects the producer's risk-seeking in losses. These endogenously derived asymmetric risk-profiles towards gains and losses, when applied to choice theory, generate Watts's (2003a) demand for higher verifiability standards for probable gains than losses. Crucially, the driving force behind this result is information asymmetry between the two parties. Since this asymmetry is a central feature of modern investor-manager settings, the model can explain empirically observed conservatism patterns in institutional settings well beyond the purview of other models. Moreover, the model suggests that a key consequence of these considerations is that a firm's overall disclosure practice (mandatory plus voluntary) may not be conservative (e.g., Kothari, Shu, and Wysocki 2009).

Number of Pages in PDF File: 42

Keywords: Evolutionary economics, financial accounting, conservatism, prospect theory, game theory

JEL Classification: D00, M40, E11, C7

working papers series