Optimal Conservative Accounting

31 Pages Posted: 16 Sep 2004

See all articles by Qi Chen

Qi Chen

Duke University - Fuqua School of Business

Thomas Hemmer

Rice University - Jesse H. Jones Graduate School of Business

Yun Zhang

George Washington University

Date Written: September 2004

Abstract

This paper studies the role of observable accounting biases in alleviating rational yet dysfunctional unobservable earnings manipulation. We regard accounting numbers as serving two important roles: the valuation role in which potential investors use accounting reports to assess a firm's expected future payoff, and the stewardship role in which current shareholders rely on the same reports to monitor their risk-averse manager. In our model where there is uncertainty about the future payoff of the firm, the current shareholders have incentives to engage in earnings management. Such manipulation is, however, socially inefficient, as it makes accounting numbers less informative about the manager's action and leads to inferior risk-sharing. We then show that social efficiency can be improved by committing to a conservative accounting system. Particularly, we show that only an accounting system with committed conservative noise can alleviate this social inefficiency by credibly reducing the benefit and thus the amount of earnings management given potential investors' belief. In contrast, an accounting system with added liberal noise is not able to reduce such inefficiency, as it can always be perfectly undone by earnings management.

Keywords: Conservatism, Earnings Management

Suggested Citation

Chen, Qi and Hemmer, Thomas and Zhang, Yun, Optimal Conservative Accounting (September 2004). Available at SSRN: https://ssrn.com/abstract=591306 or http://dx.doi.org/10.2139/ssrn.591306

Qi Chen

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
(919) 660-7753 (Phone)

Thomas Hemmer

Rice University - Jesse H. Jones Graduate School of Business ( email )

6100 South Main Street
P.O. Box 1892
Houston, TX 77005-1892
United States

Yun Zhang (Contact Author)

George Washington University ( email )

2121 I Street NW
Washington, DC 20052
United States

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