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Accounting Conservatism and Managerial Incentives

  • Young K. Kwon

    ()

    (School of Accountancy, Singapore Management University, Singapore 178900, and University of Illinois at Urbana--Champaign, Urbana--Champaign, Illinois)

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    There 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.

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    File URL: http://dx.doi.org/10.1287/mnsc.1050.0417
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    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 51 (2005)
    Issue (Month): 11 (November)
    Pages: 1626-1632

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    Handle: RePEc:inm:ormnsc:v:51:y:2005:i:11:p:1626-1632
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    1. Harris, Milton & Raviv, Artur, 1979. "Optimal incentive contracts with imperfect information," Journal of Economic Theory, Elsevier, vol. 20(2), pages 231-259, April.
    2. Paul R. Milgrom, 1979. "Good Nevs and Bad News: Representation Theorems and Applications," Discussion Papers 407R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    3. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
    4. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
    5. Zhang, Xiao-Jun, 2000. "Conservative accounting and equity valuation," Journal of Accounting and Economics, Elsevier, vol. 29(1), pages 125-149, February.
    6. Basu, Sudipta, 1997. "The conservatism principle and the asymmetric timeliness of earnings," Journal of Accounting and Economics, Elsevier, vol. 24(1), pages 3-37, December.
    7. Hao Li, 2001. "A Theory of Conservatism," Journal of Political Economy, University of Chicago Press, vol. 109(3), pages 617-636, June.
    8. Richard A. Lambert, 1986. "Executive Effort and Selection of Risky Projects," RAND Journal of Economics, The RAND Corporation, vol. 17(1), pages 77-88, Spring.
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