A Wealth Based Explanation for Earnings Conservatism

Abstract

This paper investigates the relation between managers' wealth concerns and the degree of conservatism in reported earnings. The nature of accounting causes reported earnings to be inherently untimely. The timeliness is less prominent for gains than for losses, which results in conservatively reported earnings numbers. Earnings conservatism serves an important purpose, it reduces the likelihood of conflict about the ex-post distribution of a firm's cash flows among parties associating with a firm. Conservatism enables outside parties to learn efficiently about the quality of a firm's manager, which is beneficial for the manager. Unlike existing research, this paper assumes that managers value the benefits of conflict reduction differently. This paper hypothesizes that a manager's wealth concerns determine the degree of conservatism. The empirical results confirm this hypothesis: Risk averse managers report earnings more conservative than do less risk averse managers. These results shed a new light on the mechanism driving earnings conservatism.

Keywords: Financial Reporting, Capital Markets, Earnings Conservatism.

JEL Classification: G14, G38, M41, M43