Conservative Accounting Choices

Abstract

Managers have sufficient discretion under generally accepted accounting principles (GAAP) to adopt more or less conservative financial reporting policies. In this paper, we develop a signaling model to provide insight into managers' decisions to be conservative in their accounting. We provide conditions under which the market can use the manager's exercise of discretion to infer her private information about the future prospects of the firm and thus firm value. Under these conditions, we also show that there are meaningful differences between earnings response coefficients for firms whose managers choose a conservative reporting policy and those whose managers do not. Finally, we use our theoretical model to provide intuition for some established empirical results on earnings response coefficients.conservatism, asymmetric information, signaling

Accounting Conservatism and Managerial Incentives

“…As a result, they provide little insight regarding the effects of accounting conservatism on agency costs of type (2) or trade-offs between agency costs of types (1) and (2). Watts (2005) investigate empirically the demands for conservative accounting on the basis of stock market reactions. For an extensive survey, see Watts (2002).…”

Performance of Quoted and Non-quoted Companies in the Europe

“…Although Bagnoli and Watts (2005) prove analytically, and Boulton and Smart and Zutter (2007) empirically confirm that users of the financial statements are able to filter the distortions, we think that on the base of the financial scandals in last eight years (Enron, Parmalat, KPN Qwest) that caution is necessary, even though most of the scandals had American roots (Coffee, 2005).…”

“…But the question is always the effect, i.e. the ability of the market to unveil this mimicking behavior 2 and also the penalties to managers either in form of leaving 2 Kwon and Newman and Suh (2001) prove theoretically that under certain (we think acceptable) conditions that the existence of principalagent relationship (management is different from owners) is the determinant of the requirement for conservativeness of financial statements, whereas the need of conservativeness grows with the falling penalty for managers for distortion of financial statements. In the case of non-quoted companies is the separation of management and ownership rather less usual and from this also follows a lower probability of information asymmetry and smaller need for prudence, which is theoretically proven by the above mentioned paper by Kwon and Newman and Suh.…”

Market Exit Through Divestment—The Effect of Accounting Bias on Competition

“…Accounting conservatism thus plays the role of a coordination mechanism and leads to less competition. 1 This e¤ect arises primarily through the investors'divestment decisions, which are based on the accounting signals reported for the projects they invest in. The accounting conservatism contained in …nancial reports could lead the investors to abandon the projects, thus softening competition or even completely shutting down the product market.…”