Accounting Conservatism and Board Monitoring

Abstract

This paper provides a theoretical foundation for findings in empirical studies that document a positive association between conservatism and strong corporate governance through the board’s monitoring efficiency. We construct a model with a board that decides whether to replace the incumbent manager based on accounting information and the outcome of its monitoring strategy, which also depends on the accounting information. If accounting is used only for the replacement decision, conservatism is harmful. However, conservatism is beneficial if accounting is relevant to the monitoring decision because it enhances the net benefit of monitoring. The net benefit of conservatism increases if the board becomes more efficient in monitoring. We also discuss earnings management and specific empirical implications.

Keywords: conservative accounting; corporate governance; board of directors; board monitoring; management retention

JEL Classification: M41, G34, D82