Review of Accounting Studies, 6, 29–51, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
The Demand for Accounting Conservatism
for Management Control
YOUNG K. KWON
College of Commerce and Business Administration, University of Illinois
D. PAUL NEWMAN
McCombs School of Business, University of Texas at Austin
YOON S. SUH
School of Business Administration, Ajou University, Korea
Abstract. We show that conservative ﬁnancial reporting arises naturally in principal-agent settings as a means
of efﬁciently motivating agents when the penalties that can be imposed on agents are limited. We consider an
accounting system whose reports are used for contracting and whose parameters are controlled by the principal.
One advantage of our model is that the information system we describe has the accounting characteristic of
mapping unbiased underlying information about the ﬁrm into a reduced message space. The principal can choose
how that mapping operates, i.e., conservatively, liberally, or neutrally. When penalties are sufﬁciently limited (a
limited liability setting), we show that the accounting system designed by the principal is always conservative.
Alternatively, in an unlimited liability setting, any bias in the system depends on random circumstances, and we
would not expect accounting conservatism to arise as a pervasive and enduring phenomenon.
Keywords: accounting conservatism, moral hazard, limited liability
The pervasive characteristic of conservatism in accounting has long intrigued academics.
As a result, numerous rationales for conservatism have been advanced.
In 1993, a special
session of the American Accounting Association’s annual meeting was devoted to the
issue of conservatism, and a number of eminent scholars advocated research designed to
investigate the causes and effects of conservative ﬁnancial reporting.
The purpose of this paper is to introduce a new rationale for conservative accounting.
In particular, we show that under plausible conditions in an agency setting, the principal
designs the accounting system to be biased conservatively in order to efﬁciently motivate
the agent. While other agency explanations of conservatism have been advanced, they rely
on asymmetric information beyond the usual assumption that the principal cannot observe
(or, more strictly, cannot contract on) the agent’s action. In our model, no such additional
asymmetry exists. More speciﬁcally, our results show that if the contracting alternatives
available to the principal are sufﬁciently limited in terms of penalties, then the principal
will design a conservative reporting mechanism to motivate and compensate the agent.
Address correspondence to: D. Paul Newman, CBA 4M.202, Department of Accounting, University of Texas at
Austin, Austin, TX 78712.