Shareholders’ Demand for Conservatism? Accounting Conservatism, Earnings Management, and the Stewardship Value of Information

Larmande Larmande ()

No 1104, HEC Research Papers Series from HEC Paris

Abstract: This article aims to clarify the consequences of accounting conservatism from a stewardship (principal-agent) point of view. Prior literature argues that the limited liability of the agent always results in a demand for conservatism, and that conservatism is beneficial because it deters earnings management. I challenge both arguments. Firstly, I show and derive the conditions under which an aggressive (or liberal) accounting information system might be preferred to a conservative one when the agent has limited liability. Risk aversion plays a crucial role, with a higher degree of risk aversion encouraging increased aggressiveness. Secondly, I provide the stylized example of choosing between rules-based (Rules ) and principles-based (Principles ) accounting. The latter, involving greater subjectivity, might increase the likelihood of earnings manipulation, but enables the agent to communicate relevant, albeit self-serving, private information. Both effects result in Principles being less conservative than Rules. I show that Principles might, nonetheless, be optimal, depending on the value of the likelihood ratio of manipulation versus the provision of relevant information. Manipulation and self-serving reports, which introduce an aggressive bias, might be the price to pay for more informative accounts.

Keywords: Earnings management; Accounting conservatism; Limited liability; Ranking of accounting information systems; Principal Agent (search for similar items in EconPapers)
JEL-codes: D82 M41 M52 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2016-06-15
New Economics Papers: this item is included in nep-acc
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Persistent link: https://EconPapers.repec.org/RePEc:ebg:heccah:1104

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