An Agency Theory of Conservative Accrual Accounting

37 Pages Posted: 13 Jan 2009 Last revised: 26 Aug 2009

See all articles by Michael Raith

Michael Raith

University of Rochester - Simon Business School

Date Written: August 23, 2009

Abstract

This paper argues that accrual-based financial accounting, including the conservative recognition of anticipated cash flows, mimics the properties of an optimal multi-period incentive contract between a firm and a manager. I study a two-period principal-agent model in which a manager can be compensated based on an early signal of a future outcome of his action, or (later) based on the outcome itself. In this dynamic setting it is optimal to use both performance measures even if the signal is strictly noisier than the outcome. Accrual accounting enables the firm and the manager to "settle up" in each period, which is optimal if the manager cannot commit to a long-term contract. Conservative accruals attribute to a period only the portion of expected cash flows that is explained, in a Bayesian sense, by information available in that period. I relate these results to conventional accounting rules and the literature on conservatism.

Keywords: incentive contracts, accrual accounting,conservatism, unconditional conservatism

JEL Classification: D86, G34, M41, M44, M46, M52

Suggested Citation

Raith, Michael, An Agency Theory of Conservative Accrual Accounting (August 23, 2009). Simon School Working Paper No. FR 09-11, Available at SSRN: https://ssrn.com/abstract=1326089 or http://dx.doi.org/10.2139/ssrn.1326089

Michael Raith (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States
585-275-8380 (Phone)
585-273-1140 (Fax)

HOME PAGE: http://works.bepress.com/michael_raith/

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