Accounting Conservatism, Aggregation, and Information Quality
19 Pages Posted: 4 Dec 2007 Last revised: 2 Jul 2015
Date Written: November 1, 2007
We study the optimal accounting policy when a firm can control the information quality through costly and noncontractible action. It is shown that the desirable accounting has two features: (i) the accounting report aggregates, rather than reporting directly, the underlying information; (ii) the accounting has a conservative bias. By invoking the conservatism principle, which serves as a commitment to an apparently inefficient accounting scheme given the ex post information quality, firms are induced to spend more effort in controlling information quality ex ante. As a result, a biased accounting system improves the overall information quality and enhances the welfare of accounting information users. In equilibrium the information users' welfare decreases with a firm's private cost of information quality control and increases with a firm's benefits from favorable accounting reports.
Keywords: Accounting Conservatism, Information Aggregation, Information Quality
JEL Classification: M41, M44
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