Optimal Conservatism with Earnings Manipulation

Abstract

This paper examines the role of conservatism when an agent can manipulate upcoming earnings before all uncertainty is resolved. An increase in conservatism, by reducing the likelihood of favorable earnings, requires steeper performance pay to maintain the same level of incentives, which in turn increases the equilibrium earnings manipulation. Trade-offs between inducing effort and curbing manipulation predict an interior level of conservatism as optimal. The optimal level of conservatism is positively associated with enforcement, economic profitability and earnings quality, and negatively associated with agency frictions. In particular, we show that more economically profitable firms choose to be more conservative. We also establish that the association between performance pay and manipulation identifies whether conservatism is optimally chosen or exogenously imposed. In an application to debt contracting, we show that optimal conservatism is negatively associated with borrowers' bargaining power. Prudence optimale et manipulation des r esultats R ESUM ECette etude examine le rôle de la prudence comptable lorsqu'un g erant peut manipuler le compte de r esultat. Une mesure plus prudente est telle que, pour un certain risque economique, la probability d'un bon r esultat comptable est plus faible et, donc, se traduit par des bonus moins fr equents. Nous d emontrons que le contrat de compensation du g erant doit s'ajuster en augmentant le niveau du bonus, ce qui conduit le g erant a d'avantage manipuler les resultats pour atteindre le bonus plus elev e. Un exc es de prudence, par cons equent, peut donner lieu plus de manipulation. Notre th eorie pr edit un niveau de prudence optimal et, a l' equilibre, les entreprises avec de meilleures perspectives economiques, des mesures comptables de meilleure qualit e ou moins de pouvoir de n egociation avec leurs banques, choisissent un niveau de prudence sup erieur.

Effects of Increasing Enforcement on Financial Reporting Quality and Audit Quality

“…Laux and Laux [2009] study management compensation by the board of directors, which also decides on oversight effort, and show that these two decisions are related. Bertomeu, Darrough, and Xue [2017] consider production and earnings management choices and focus on the optimal bias (conservatism) of the underlying accounting system. Chan [2018] studies the effect of increasing internal controls on earnings management and auditing.…”

Disclosure and the Cost of Capital: A Survey of the Theoretical Literature

“…An alternative treatment of the effect of reporting asymmetry on the cost of capital is given in Suijs (2008). Other studies such as Gigler et al (2009), Goex and Wagenhofer (2009), Caskey and Laux (2013), or Bertomeu et al (2013) provide a rationale for asymmetry based on stewardship concerns. seller by C σ 2 u À Á where C(.)…”

Biases in Accounting and Nonaccounting Information: Substitutes or Complements?

“…Results when K < 1 mirror those for K > 1 and will be mentioned in footnotes wherever relevant. Hemmer, and Zhang [2007], Bertomeu, Darrough, and Xue [2014], and Li [2013], the bias in accounting information, denoted by δ, is modeled as in the following probability structure: 9…”

“…A nonexhaustive list of exceptions includesGigler and Hemmer [2001],Kwon, Newman, and Suh [2001],Chen, Hemmer, and Zhang [2007],Gigler et al [2009], Bertomeu, Darrough, andXue [2014],Li [2013], andGao [2013].5 Assuming risk aversion would not qualitatively change the results.6 In the binary case, subscript h refers to favorable realization of any signal while subscript l refers to unfavorable realization.…”