Managerial Risk Aversion and Accounting Conservatism

Abstract

This paper investigates the delegation of financial reporting policy to a manager as a shareholder commitment device to achieve an ex-ante preferred level of conservatism. It especially explores how managerial traits – specifically the level of risk aversion and overconfidence – facilitate efficient implementation of the preferred level of conservatism. The potential benefit of a conservative reporting policy has been demonstrated in the literature, but if firms have some freedom to set the level of conservatism and it is not perfectly observable, the enforcement of a commitment to conservative reporting could be a concern (firms may claim to be conservative while in fact being aggressive). Therefore, the delegation of the reporting policy and the design of an appropriate incentive scheme could be a possible commitment device. We present a model in which to obtain better funding terms, a firm has an ex-ante preference for a given level of conservatism. Hiring a more risk-averse manager lowers the cost of implementing a conservative reporting policy, but increases the agency cost linked to the productive effort. We show that, for a plausible range of parameter values, the optimal level of managerial risk aversion which minimizes the overall agency cost is increasing with respect to the level of conservatism the firm wants to induce. Similar results hold for the degree of overconfidence – in the opposite direction: the optimal level of overconfidence is decreasing with respect to the desired level of conservatism. These results suggest an alternative explanation for recent empirical evidence linking CEO and CFO characteristics to the level of conservatism: firms deliberately choose managers with specific personality traits for efficient implementation of shareholders’ ex-ante preferred level of conservatism.