Shareholders’ Demand for Conservatism? Accounting Conservatism, Earnings Management, and the Stewardship Value of Information
35 Pages Posted: 9 Jul 2014 Last revised: 12 Sep 2015
Date Written: March 1, 2015
This article aims to clarify the consequences of accounting conservatism from a stewardship (principal-agent) point of view. Prior literature argues that the limited liability of the agent always results in a demand for conservatism, and that conservatism is beneficial because it deters earnings management. I challenge both arguments. Firstly, I show and derive the conditions under which an aggressive (or liberal) accounting information system might be preferred to a conservative one when the agent has limited liability. Risk aversion plays a crucial role, with a higher degree of risk aversion encouraging increased aggressiveness. Secondly, I provide the stylized example of choosing between rules-based (Rules ) and principles-based (Principles ) accounting. The latter, involving greater subjectivity, might increase the likelihood of earnings manipulation, but enables the agent to communicate relevant, albeit self-serving, private information. Both effects result in Principles being less conservative than Rules. I show that Principles might, nonetheless, be optimal, depending on the value of the likelihood ratio of manipulation versus the provision of relevant information. Manipulation and self-serving reports, which introduce an aggressive bias, might be the price to pay for more informative accounts.
Keywords: Earnings management, Accounting conservatism, Limited liability, Ranking of accounting information systems, Principal Agent
JEL Classification: D82, M41, M52
Suggested Citation: Suggested Citation