Accounting Conservatism and Managerial Incentives

Abstract

T here are two sources of agency costs under moral hazard: (1) distortions in incentive contracts and (2) implementation of suboptimal decisions. In the accounting literature, the relation between conservative accounting and agency costs of type (1) has received considerable attention (cf. Watts 2002). However, little appears to be known about the effects of accounting conservatism on agency costs of type (2) or trade-offs between agency costs of types (1) and (2). The purpose of this study is to examine this void. In a principal-agent setting in which the principal motivates the agent to expend effort using accounting earnings, this study shows that accounting earnings become more useful for reducing agency costs of type (2) when measured conservatively than when measured aggressively. Combined with the result in Kwon et al. (2001) that agency costs of type (1) decrease with accounting conservatism, this analysis suggests that conservative accounting enhances the incentive value of accounting signals with respect to both types of agency costs.

The implications of research on accounting conservatism for accounting standard setting

“…So, for example, Kwon et al (2001) model accounting conservatism in a principal agency context and conclude that, in a limited liability context, the optimal accounting system will always be conservative, 9 and show that conservatism has no role in an unlimited liability context. Kwon (2005) studies a more general principal agent model that focuses on the effect of conservative accounting on the agency costs of the agent's suboptimal effort choice under moral hazard. His results show that there are logically possible worlds where conservatism can be beneficial, and logically possible worlds where conservatism may be harmful.…”

“…His results show that there are logically possible worlds where conservatism can be beneficial, and logically possible worlds where conservatism may be harmful. Balakrishnan et al (2013) extend the work of Kwon (2005). Their basic model, which focuses on the effort motivation role, finds that the optimal level of conservatism varies with the acuteness of the agency problem.…”

Does Corporate Governance Matter? Evidence from Accounting Conservatism Practices among Jordanian Listed Companies

“…Additionally, prior studies suggested that conservatism limits the opportunistic behavior of managers (Brown, He &Teitel, 2006;Chen, Hemmer & Zhang, 2007;Watts, 2003a) and decreases information asymmetry among outside shareholders and managers (LaFond& Watts, 2008). Moreover, conservatism is more beneficial in monitoring the cost of suboptimal managerial decisions than if the earnings were measured liberally or neutrally (Kwon, 2005). The usefulness of conservatism in the agency relationship, ultimately enhance the usefulness of financial reports (Ball & Shivakumar, 2006) and improve firm value (Watts, 2003b).…”

Endogenous Accounting Bias when Decision Making and Control Interact

“…k l þ d h (yielding LR 1 (m) = 0), to fully exploit the moving support feature of the distribution. This notion that moral hazard considerations can justify conservative biases (given LL) is similar in spirit to that in Kwon et al 2001 andKwon 2005. In our setup, another consideration arises because the information system is also used for the principal's decision-making purpose. Thus the optimal cutoff weighs the desire for conservatism (m large) driven by moral hazard concerns and the desire for unbiasedness (m equal to k h ) dictated by decisionmaking concerns.…”

“…1 We distinguish two types of stewardship uses of accounting information: one is to motivate the (standard) managerial efforts that affect the first moment (mean) of the firm output, and the other is to motivate the managerial efforts that facilitate the principal's decision making by affecting the second moment of the firm output (we refer to such efforts as the decision-facilitating efforts). We find that, while conservative bias may be optimal when accounting information is used only to motivate mean-increasing efforts (Kwon, Newman, and Suh 2001;Kwon 2005), liberal bias is necessary when decision making and control interact in the sense that accounting information is also used to motivate decision-facilitating efforts.…”