Agency Costs of Equity and Accounting Conservatism: A Real Options Approach

22 Pages Posted: 22 Feb 2014 Last revised: 3 Mar 2014

See all articles by Tan (Charlene) Lee

Tan (Charlene) Lee

National Central University; University of Auckland

Date Written: February 12, 2014

Abstract

This paper investigates how conservative accounting system can mitigate the agency problem between the manager and shareholders of a firm, which arises from information asymmetry. In this study I assume that the firm has a privileged right to engage in an irreversible discrete project, i.e., it possess a valuable option to delay investment.

Using standard real options arguments, I first show the manager tends to invest earlier than optimal, when she owns information advantage over shareholders of the firm. In other words, the firm incurs agency costs of equity because the manager tends to over-invest. I then demonstrate that the application of accounting conservatism will induce the manager to report her private information more truthfully, and thus reduce the agency costs of equity. In addition, the reduction on agency costs will be more profound when the cash-flows of the investment project are highly uncertain.

Keywords: Accounting conservatism; Agency costs of equity; Investment hurdle rates; Real options

JEL Classification: G31; G32

Suggested Citation

Lee, Tan (Charlene), Agency Costs of Equity and Accounting Conservatism: A Real Options Approach (February 12, 2014). Available at SSRN: https://ssrn.com/abstract=2399329 or http://dx.doi.org/10.2139/ssrn.2399329

Tan (Charlene) Lee (Contact Author)

National Central University ( email )

No. 300, Zhongda Road
Chung-Li Taiwan, 32054
Taiwan

University of Auckland ( email )

Private Bag 92019
Auckland 1001
New Zealand

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