A Signaling Theory of Accounting Conservatism

Abstract

In this paper, we offer a new theory for the economic demand of accounting conservatism, which emphasizes the signaling role of conservatism in a debt market with asymmetric information. In our model, accounting conservatism serves as a signal by which the borrower firm can convey their private information about its own operating risk to the lenders, prior to signing the debt contract. In developing this signaling theory of conservatism, our paper achieves two major outcomes: (1) we analytically derive four basic properties of accounting conservatism, based on Basu's (1997) asymmetric timeliness of earnings definition of conservatism; (2) we develop a signaling model of the debt market, where accounting conservatism serves as a signaling device. Our conservatism-signaling model has a dominant separating equilibrium, in which the low risk firms choose a high level of conservatism and the high risk firms choose a low (zero) level of conservatism. We show that this is the only stable equilibrium in our model that can pass Cho and Kreps's Intuitive Criterion (1987). Our results indicate that conservatism benefits the debt market by reducing the information asymmetry in the debt market.