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The Information Role of Conservatism

Ryan LaFond

Algert Global, LLC

Ross L. Watts

Massachusetts Institute of Technology (MIT) - Sloan School of Management

April 26, 2007

In this paper we argue that information asymmetry between firm insiders and outside equity investors generates conservatism in financial statements. Conservatism reduces the manager's incentives and ability to manipulate accounting numbers and so reduces information asymmetry and the deadweight losses that information asymmetry generates. This increases firm and equity values.

Our empirical tests are consistent with our proposition that information asymmetry is significantly positively related to conservatism after controlling for other demands for conservatism. Further, our tests are more consistent with our prediction that changes in information asymmetry between equity investors lead changes in conservatism than the FASB's proposition that conservatism produces information asymmetry among equity investors. An important implication is that, if the FASB was successful in meeting their stated goal of eliminating conservatism, they would increase information asymmetry between investors, not reduce it. This outcome is inconsistent with the objectives of the Securities Acts.

Number of Pages in PDF File: 59

Keywords: Conservatism, Accounting Standards, Earnings Management, Corporate Governance, Securities Litigation

JEL Classification: M41, M43, M44, G32, G33, G34, G35, K22

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Date posted: August 2, 2006  

Suggested Citation

LaFond, Ryan and Watts, Ross L., The Information Role of Conservatism (April 26, 2007). Available at SSRN: https://ssrn.com/abstract=921619 or http://dx.doi.org/10.2139/ssrn.921619

Contact Information

Ryan LaFond (Contact Author)
Algert Global, LLC ( email )
One Maritime Plaza
Suite 1525
San Francisco, CA 94111
United States
Ross L. Watts
Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )
Cambridge, MA 02142
United States
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