Type I and Type II Errors of Conservatism
Posted: 27 Nov 2009 Last revised: 24 Jan 2014
Date Written: April 19, 2010
Abstract
This paper shows that accounting conservatism could generate two types of effects on the accounting information as to type I error and type II error. In this limited sense, there exist two types of accounting conservatism, and the rise of conservative financial reporting as an efficient motivating agent in a contract setting depends on the type of conservatism. This paper prepares two different accounting information systems in order to make comparative analyses between the different types of conservatism. One advantage of this model is that these systems are especially well suited for comparative analysis because they have common parameters that indicate the extent of conservatism and informativeness. The analysis shows that, in a simple moral hazard setting, one type of conservatism arises conditionally while the other does not. The former type of conservatism, the V system, is what is discussed in recent research, while the latter type, the N system, is what is recognized as traditional conservatism. If the available penalties are sufficiently limited, the former type always arises while the latter never does.
Keywords: Financial Accounting, conservatism, moral hazard, limited liability
JEL Classification: M41
Suggested Citation: Suggested Citation