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Shareholders’ Demand for Conservatism? Accounting Conservatism, Earnings Management, and the Stewardship Value of Information
Abstract: This article aims to clarify the consequences of
accounting conservatism from a stewardship (principal-agent) point of view.
Prior literature argues that the limited liability of the agent always
results in a demand for conservatism, and that conservatism is beneficial
because it deters earnings management. I challenge both arguments. Firstly,
I show and derive the conditions under which an aggressive (or liberal)
accounting information system might be preferred to a conservative one when
the agent has limited liability. Risk aversion plays a crucial role, with a
higher degree of risk aversion encouraging increased aggressiveness.
Secondly, I provide the stylized example of choosing between rules-based
(Rules ) and principles-based (Principles ) accounting. The latter,
involving greater subjectivity, might increase the likelihood of earnings
manipulation, but enables the agent to communicate relevant, albeit
self-serving, private information. Both effects result in Principles being
less conservative than Rules. I show that Principles might, nonetheless, be
optimal, depending on the value of the likelihood ratio of manipulation
versus the provision of relevant information. Manipulation and self-serving
reports, which introduce an aggressive bias, might be the price to pay for
more informative accounts.
Keywords: Earnings management; Accounting conservatism; Limited liability; Ranking of accounting information systems; Principal Agent; (follow links to similar papers)
JEL-Codes: D82; M41; M52; (follow links to similar papers)
35 pages, June 15, 2016
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