On the Relation Between Conservatism in Accounting Standards and Incentives for Earnings Management

Journal of Accounting Research, Vol. 45, No. 3, pp. 541-565, June 2007

25 Pages Posted: 11 Dec 2007

See all articles by Qi Chen

Qi Chen

Duke University - Fuqua School of Business

Thomas Hemmer

Rice University - Jesse H. Jones Graduate School of Business

Yun Zhang

George Washington University

Multiple version iconThere are 2 versions of this paper

Abstract

This paper studies the role of conservative accounting standards in alleviating rational yet dysfunctional unobservable earnings manipulation. We show that when accounting numbers serve both the valuation role (in which potential investors use accounting reports to assess a firm's expected future payoff) and the stewardship role (in which current shareholders rely on the same reports to monitor their risk-averse manager), current firm owners have incentives to engage in earnings management. Such manipulation reduces accounting numbers' stewardship value and leads to inferior risk sharing. We then show that risk sharing, and hence contract efficiency, can be improved under a conservative accounting standard where, absent earnings management, accounting earnings represent true economic earnings with a downward bias, compared with under an unbiased standard where, absent earnings management, accounting earnings represent true economic earnings without bias.

JEL Classification: M40, M41, M43, M46, G34, G32

Suggested Citation

Chen, Qi and Hemmer, Thomas and Zhang, Yun, On the Relation Between Conservatism in Accounting Standards and Incentives for Earnings Management. Journal of Accounting Research, Vol. 45, No. 3, pp. 541-565, June 2007, Available at SSRN: https://ssrn.com/abstract=1065876 or http://dx.doi.org/10.1111/j.1475-679X.2007.00243.x

Qi Chen (Contact Author)

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
(919) 660-7753 (Phone)

Thomas Hemmer

Rice University - Jesse H. Jones Graduate School of Business ( email )

6100 South Main Street
P.O. Box 1892
Houston, TX 77005-1892
United States

Yun Zhang

George Washington University ( email )

2121 I Street NW
Washington, DC 20052
United States

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