Accounting Conservatism and the Efficient Provision of Capital to Privately Informed Firms

Abstract

This study addresses conservatism in financial reporting. Firms seek financing for an investment. Investors have access to an imperfect accounting signal that may also have a conservative tendency. If the firms have no private information, conservatism is desirable only for negative ex ante expected value investments, consistent with the spirit of the results of Gigler et al (2009) and other studies. Conservatism is not optimal for positive expected value investments because it denies financing to too many of them. If firms have private information, however, conservatism may be desirable even for positive expected value investments. Conservatism is useful in this setting because it increases the probability that privately informed good firms will be able to distinguish themselves from bad firms. Otherwise, good firms prefer not to invest and the financing market fails.

Keywords: accounting, conservatism, asymmetric information

JEL Classification: M41, M44, G31