Optimal Conservatism with Earnings Manipulation

36 Pages Posted: 20 May 2013 Last revised: 5 Feb 2021

See all articles by Jeremy Bertomeu

Jeremy Bertomeu

Washington University in St. Louis - John M. Olin Business School

Masako N. Darrough

Baruch College - CUNY

Wenjie Xue

National University of Singapore

Date Written: September 29, 2015

Abstract

This paper examines the role of conservatism when an agent can manipulate upcoming earnings before all uncertainty is resolved. An increase in conservatism, by reducing the likelihood of favorable earnings, requires steeper performance pay to maintain the same level of incentives, which in turn increases the equilibrium earnings manipulation. Trade-offs between inducing effort and curbing manipulation predict an interior level of conservatism as optimal. The optimal level of conservatism is positively associated with enforcement, economic profitability and earnings quality, and negatively associated with agency frictions. In particular, we show that more economically profitable firms choose to be more conservative. We also establish that the association between performance pay and manipulation identifies whether conservatism is optimally chosen or exogenously imposed. In an application to debt contracting, we show that optimal conservatism is negatively associated with borrowers’ bargaining power.

Keywords: accounting conservatism; reporting bias; managerial incentives; principal agent theory

JEL Classification: D82, D86, G30, M41

Suggested Citation

Bertomeu, Jeremy and Darrough, Masako N. and Xue, Wenjie, Optimal Conservatism with Earnings Manipulation (September 29, 2015). Contemporary Accounting Research (2017). https://doi.org/10.1111/1911-3846.12247, Available at SSRN: https://ssrn.com/abstract=2267104 or http://dx.doi.org/10.2139/ssrn.2267104

Jeremy Bertomeu

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Masako N. Darrough

Baruch College - CUNY ( email )

One Bernard Baruch Way
New York, NY 10010
United States
646 312 3183 (Phone)
646 312 3161 (Fax)

Wenjie Xue (Contact Author)

National University of Singapore ( email )

1E Kent Ridge Road
NUHS Tower Block Level 7
Singapore, 119228
Singapore

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