An Information-based Model for the Differential Treatment of Gains and Losses

Abstract

This study defines reporting conservatism as a higher verification standard for probable gains compared to losses and builds a model that endogenously generates optimal behavior resembling an asymmetric preference for gains versus losses. Our model considers the setting where one party produces a resource and another tries to expropriate it. The key factor determining the extent of the gain-loss asymmetry is the level of information asymmetry or trust between the two parties. The information asymmetry-based results of our model provide a simpler explanation for the vast empirical literature on conservatism where the bulk of the economic relationships among the parties appear to be information-based with little direct relation to explicit debt contracts, a factor that has been the focus of prior theoretical arguments. We also suggest new empirical analyses.

Keywords: Evolutionary economics, financial accounting, conservatism, prospect theory, game theory

JEL Classification: D00, M40, E11, C7