Accounting Discretion and Managerial Conservatism: An Intertemporal Analysis
38 Pages Posted: 7 Jul 2006
Date Written: August 2005
Abstract
Accounting discretion and the principle of conservatism are two salient features embedded in financial reporting systems. Arguably, the practice of conservative accounting choices can never be well understood without incorporating their effect on future periods (the intertemporal effect). This paper provides one explanation for managerial conservatism in a two-period agency model with hidden information (a binary project type) and hidden actions (the agent's efforts). A piece-wise linear incentive scheme with accounting earnings as the performance measure is employed. The agent's discretion is the choice of a depreciation method. Discretion is valuable if and only if the agent's marginal productivity of a bad project is greater than that of a good project but not to an extreme degree. A conservative depreciation method decreases current compensation in exchange for a bet on future compensation and, hence, serves as a commitment device for the agent to signal the prospect is indeed good. The accounting mechanism replicates the performance of the optimal direct mechanism.
Keywords: discretion, managerial conservatism, communication, accounting mechanism
JEL Classification: D82, M41, M44
Suggested Citation: Suggested Citation
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