Adverse Selection, Diversion of Resources and Conservatism

Posted: 11 Dec 2020

See all articles by Pei-Cheng Liao

Pei-Cheng Liao

National Taiwan University - Department of Accounting

Guang Ma

McGill University - Desautels Faculty of Management

Suresh Radhakrishnan

JSOM, University of Texas at Dallas

Date Written: August 25, 2020

Abstract

We consider an investor’s choice of conservative reporting, bonus payments, and investment decisions in the presence of the hidden-information agency problem of a manager’s productivity and the hidden-action agency problem of a manager’s diversion of resources. It is important to consider the hidden-action and hidden-information agency problems in isolation and their interaction, to gain insights into the drivers of demand for conservatism. We show that the conservative (non-conservative) regime is optimal for the high-productivity (low-productivity) manager when both agency problems exist; even though the non-conservative regime is optimal for both the high- and low-productivity managers when only the hidden-action or the hidden-information problem exists. Essentially, the low-productivity manager can misrepresent as the high-productivity manager to obtain high investment levels and divert resources only in the presence of both agency problems. This added layer of agency problem creates the demand for conservatism and highlights the importance of the interaction between the hidden-action and hidden-information agency problems. Furthermore, we show that as the conservatism level increases: (a) the optimal investment level conditional on a good report for the high-productivity manager increases and approaches the first-best level, i.e., ex-post investment efficiency increases; (b) the expected optimal investment level for the high-productivity manager decreases and diverges from the expected first-best level, i.e., ex-ante investment efficiency decreases; and (c) the expected bonus payment to the high- and low-productivity managers decreases. These findings provide insights into how the demand for conservatism arises in the presence of both hidden-information and hidden-action agency problems and provide empirical guidance relating conservatism to investment efficiency.

Keywords: Screening, tunneling, resource diversion, conservatism

Suggested Citation

Liao, Pei-Cheng and Ma, Guang and Radhakrishnan, Suresh, Adverse Selection, Diversion of Resources and Conservatism (August 25, 2020). Contemporary Accounting Research, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3739757

Pei-Cheng Liao

National Taiwan University - Department of Accounting ( email )

1 Sec. 4, Roosevelt Road
Taipei 106, 106
Taiwan
+886-2-33661127 (Phone)
+886-2-23638038 (Fax)

Guang Ma

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St W
Montreal, Quebec h3A 1G5
514-398-5075 (Phone)

HOME PAGE: http://guangma.info

Suresh Radhakrishnan (Contact Author)

JSOM, University of Texas at Dallas ( email )

Mail Stop SM 41
800 West Campbell Road
Richardson, TX 75080
United States
972-883-4438 (Phone)
972-883-6811 (Fax)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Abstract Views
111
PlumX Metrics