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

On the Relation between Conservatism in Accounting Standards and Incentives for Earnings Management ABSTRACT 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. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Accounting Research Wiley

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

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Publisher
Wiley
Copyright
Copyright © 2007 Wiley Subscription Services, Inc., A Wiley Company
ISSN
0021-8456
eISSN
1475-679X
D.O.I.
10.1111/j.1475-679X.2007.00243.x
Publisher site
See Article on Publisher Site

Abstract

ABSTRACT 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.

Journal

Journal of Accounting ResearchWiley

Published: Jun 1, 2007

References

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