Academics and practitioners, including lawyers, emphasize the importance of conservative accounting to lenders and corporate boards, allowing them to intervene and take corrective actions at an early stage. However, conservative accounting may also increase the risk of false alarms and prompt excessive interventions. In light of this downside, the overwhelming and in many cases unconditional support that conservative accounting often receives is puzzling.
We aim to reconcile the support for conservatism with the concern for false alarms by showing that managers’ ability to gather additional evidence following accounting reports changes the balance between the benefits and costs of conservative accounting. Managers’ desire to prevent intervention by boards or lenders after a negative report induces them to acquire information in the hope of discovering evidence that shows the accounting report is too pessimistic. In contrast, if the accounting report is positive, managers have no incentive to gather information to show the accounting report is too optimistic. The incentive to rectify false negative reports, but not false positive reports, renders conservative accounting more desirable for shareholders.
We focus on a setting where a board of directors, acting in the interest of shareholders, raises debt to finance a new project. The manager who runs the project enjoys private benefits of control as long as the project is continued. (For a discussion of managerial private benefits see, for example, Aghion and Bolton (1992) and Dessein (2005).)
At some point the accounting system generates a report about the quality of the project, and the project is either continued or liquidated. The optimal debt contract includes a covenant that the firm breaches if the report is negative. Following a covenant breach, the lender receives control and decides whether to continue the project. Conservative reporting increases the likelihood of an early warning but makes the early warning less precise. (See, e.g., Gigler and Hemmer (2001), Gigler et al. (2009), and Jiang (2016).) The early warning is nevertheless sufficiently informative so that liquidation is optimal in the absence of additional information. If the accounting system is the only source of information, our setting resembles the one in Gigler et al. (2009), and shareholders’ optimal degree of conservatism trades off the expected costs of false positive and false negative accounting reports. For profitable projects that are more valuable continuing than liquidating absent any accounting and managerial information, the expected cost of false alarms dominates, and a conservative accounting system destroys firm value due to unnecessary intervention.
A manager’s proximity to the project puts her in a good position to gather and present additional information about the project’s prospects. The manager’s incentive to acquire and present information is asymmetric. If the accounting report is negative, the lender gains control. The threat of liquidation induces the manager to search for additional information, hoping to uncover favorable evidence that prevents the lender from intervening. By providing information that is sufficiently favorable, the manager can convince the lender to continue the project and waive the covenant, potentially for an increase in the face value of the debt. In contrast, if the accounting report is positive, there is no covenant violation, and the manager has no reason to gather information to change the status quo.
The manager’s acquisition of information affects the optimal degree of conservative accounting for two distinct reasons. First, it changes the trade-off between the costs and benefits of conservatism. In particular, since the manager is eager to refute negative reports, the lender is less likely to act on false alarms, which reduces the cost of conservatism. In contrast, the benefit of conservatism (from reducing the probability of false positive reports) remains unchanged. Second, conservative accounting increases incentives for information acquisition following a covenant violation. The reason is that early warnings are less precise if they come from a more conservative reporting system, which increases the manager’s chances of uncovering favorable evidence that prevents liquidation. Overall, these effects imply that the manager’s acquisition of information increases the benefit of conservative reporting for shareholders.
Our model predicts that the degree of conservative accounting is higher if managers’ private benefits of control are larger. The reason is that managers’ preference for project continuation spurs information acquisition following a negative report and thereby reduces the downside of conservatism, and conservatism, in turn, strengthens incentives for acquiring information. Ball (2001) argues that conservatism constrains managers’ investment behavior in their pursuit of private benefits. The goal of the optimal accounting system in our model is not merely to keep the manager from pursuing private benefits, but to exploit these benefits as an incentive to collect information.
Empirical studies find that renegotiations and contract adjustments are more common when firms breach debt covenants (e.g., Dichev and Skinner, 2002; Nini et al., 2012). Our model suggests that the asymmetry in renegotiation is a consequence of the asymmetry in the manager’s information acquisition incentive. Negative accounting reports, but not positive ones, encourage the manager to obtain additional information, which creates the opportunity for welfare-enhancing renegotiations.
Our model predicts that lenders are more likely to waive debt covenants following a covenant breach in firms with more conservative reporting policies. This prediction follows because conservative accounting reduces the information content of early warnings, which increases both the manager’s incentive to gather additional evidence and her chances of obtaining favorable evidence, holding effort constant.
Although we focus on debt contracting, the main insights of our model apply to more general corporate governance settings. Accounting information enables corporate boards and shareholders to monitor managers. The timely recognition of negative information allows the board to intervene, but the timeliness comes at the cost of less precision, potentially causing unnecessary board interventions. Conservatism alone is therefore no panacea for corporate governance problems. Managers’ incentives to show that negative reports are too pessimistic, but not that positive reports are too optimistic, can play an important role in explaining why conservative accounting is beneficial for corporate governance.
Aghion, P., and P. Bolton. 1992. “An Incomplete Contracts Approach to Financial Contracting.” Review of Economic Studies 59 (3): 473-494.
Ball, R. 2001. “Infrastructure Requirements for an Economically Efficient System of Public Financial Reporting and Disclosure.” Brookings-Wharton Papers on Financial Services: 127-169.
Dessein, W. 2005. “Information and Control in Ventures and Alliances.” Journal of Finance 60 (5): 2513-2549.
Dichev, I., and D. Skinner. 2002. “Large-Sample Evidence on the Debt Covenant Hypothesis.” Journal of Accounting Research 40 (4): 1091-1123.
Gigler, F., and T. Hemmer. 2001. “Conservatism, Optimal Disclosure Policy, and the Timeliness of Financial Reports.” The Accounting Review 76 (4): 471-493.
Gigler, F., C. Kanodia, H. Sapra, and R. Venugopalan. 2009. “Accounting Conservatism and the Efficiency of Debt Contracts.” Journal of Accounting Research 47 (3): 767-797.
Jiang, X. 2016. “Biases in Accounting and Nonaccounting Information: Substitutes or Complements?” Journal of Accounting Research 54 (5): 1297-1330.
Nini, G., D. Smith, and A. Sufi. 2012. “Creditor Control Rights, Corporate Governance, and Firm Value.” Review of Financial Studies 25 (6): 1713-1761.
This post comes to us from professors Christian Laux at Vienna University of Economics and Business and Volker Laux at the University of Texas at Austin’s McCombs School of Business. It is based on their recent article, “Accounting Conservatism and Managerial Information Acquisition,” available here.