Accounting Conservatism and Board Efficiency

Abstract:     
This paper studies the efficiency of the board in monitoring management and its interaction with conservative accounting. Accounting is closely related to corporate governance. Accounting provides information, and thus transparency, which supports other corporate governance mechanisms. The paper focuses on the board of directors, which plays a crucial role in the corporate governance of firms and it depends to a large extent on accounting information. In a two-period model, the board of directors decides to retain or remove the incumbent manager and to monitor the manager. The characteristics of the accounting system influence both decisions. We solve for the optimal board monitoring strategy and the bias of the accounting system that complements this strategy. Our main result is that if board monitoring is relatively effective, then the optimal accounting system generally is conservative. The reason is that conservatism makes the favorable signal a very precise indicator that the manager is actually a good fit. In contrast, monitoring for a favorable signal would not reveal much additional information, but nevertheless incurs the monitoring cost. If the board is less effective or incurs a high monitoring cost, the optimal accounting system generally is liberal. We consider several extensions, such as earnings management, moral hazard, and board incentives. In sum, the paper establishes that conservative accounting complements (rather than substitutes) effective board monitoring and provides a theoretical underpinning for empirical findings that find a positive association between strong corporate governance and conservatism.

Number of Pages in PDF File: 46

Keywords: conservative accounting, corporate governance, board of directors, monitoring, management retention

JEL Classification: M41, G34, D82

working papers series