Optimal Conservative Accounting

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