Prudence Demands Conservatism

Abstract

We define accounting information systems as conditionally conservative if they produce finer information at lower expected earnings levels. We then study the preference for differing levels of conditional conservatism among decision-maker(DM)'s with varying attributes including risk aversion and prudence. Similar to risk aversion, prudence is a metric based on DM's indirect utility that measures the sensitivity of DM's' decisions to changes in risk; prudent DM's save more as income becomes riskier. In a model of precautionary savings with information, we show that prudent DM's (those with positive prudence measures) prefer more conservative accounting systems, that imprudent DM's (those with negative prudence measures) prefer liberal accounting systems. We also show that conservative accounting may be preferred to a perfect information system if they are costly. We provide cases demonstrating the generality of our results, including examples where conservatism is preferred with increasing, constant and decreasing risk aversion.

Keywords: Prudence, Consevatism, Accounting

JEL Classification: M41