Auditor Conservatism, Management Incentives and Managerial Optimism

Posted: 7 Jul 1998

See all articles by Pradyot K. Sen

Pradyot K. Sen

University of Washington Bothell

Date Written: January 1996

Abstract

Managers tend to overstate firm value because their immediate payoffs are tied to it. An overstated disclosure may attract an audit qualification that adversely affects the firm value. The audit qualification may also be used by the managerial labor market to evaluate managerial performance, and thus manager's ability to command superior pay in the long run. Managers must, therefore, consider the two sets of offsetting incentives while deciding their disclosure strategy. In this environment, an increase in auditor's conservatism improves the informational efficiency of the market by reducing the incentives of the lower quality firms to mimic a higher quality firm's disclosure. Increased audit conservatism, thus, acts as an endogenized proprietary cost to the bad firms. An increase in firm value based (short run) incentives tends to increase a manager's propensity to overstate results, whereas an increase in (long run) payoffs associated with the managerial labor market achieves the opposite.

JEL Classification: M40, C72, D82

Suggested Citation

Sen, Pradyot K., Auditor Conservatism, Management Incentives and Managerial Optimism (January 1996). Available at SSRN: https://ssrn.com/abstract=2594

Pradyot K. Sen (Contact Author)

University of Washington Bothell ( email )

UWBB 104 E
Beardslee Bulevard
Bothell, WA 98011-8246
United States
425-352-5432 (Phone)

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