On the Relation between Conservatism in Accounting Standards and Incentives for Earnings Management

This paper studies the role of conservative accounting standards in alleviating rational yet dysfunctional unobservable earnings manipulation. We show that when accounting numbers serve both 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), current firm owners have incentives to engage in earnings management. Such manipulation reduces accounting numbers’ stewardship value and leads to inferior risk sharing. We then show that risk sharing, and hence contract efficiency, can be improved under a conservative accounting standard where, absent earnings management, accounting earnings represent true economic earnings with a downward bias, compared with under an unbiased standard where, absent earnings management, accounting earnings represent true economic earnings without bias. ∗Duke University; †University of Houston; ‡Duke University. We appreciate comments from seminar participants at Duke University, 2004 Duke/UNC Fall Camp, University of Houston, University of Maryland, the 15th FEA conference at University of Southern California, an anonymous referee, and Doug Skinner (the editor). We acknowledge the financial support of the Fuqua School of Business at Duke University (for Qi Chen and Yun Zhang) and the Bauer College of Business at University of Houston (for Thomas Hemmer).