Optimal Conservatism with Earnings Manipulation

Jeremy Bertomeu, Masako Darrough and Wenjie Xue

Contemporary Accounting Research, 2017, vol. 34, issue 1, 252-284

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.Cette etude examine le rôle de la prudence comptable lorsqu'un gérant peut manipuler le compte de résultat. Une mesure plus prudente est telle que, pour un certain risque économique, la probability d'un bon résultat comptable est plus faible et, donc, se traduit par des bonus moins fréquents. Nous démontrons que le contrat de compensation du gérant doit s'ajuster en augmentant le niveau du bonus, ce qui conduit le gérant à d'avantage manipuler les resultats pour atteindre le bonus plus élevé. Un excès de prudence, par conséquent, peut donner lieu plus de manipulation. Notre théorie prédit un niveau de prudence optimal et, à l’équilibre, les entreprises avec de meilleures perspectives économiques, des mesures comptables de meilleure qualité ou moins de pouvoir de négociation avec leurs banques, choisissent un niveau de prudence supérieur.

Date: 2017
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https://doi.org/10.1111/1911-3846.12247

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Persistent link: https://EconPapers.repec.org/RePEc:wly:coacre:v:34:y:2017:i:1:p:252-284

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