Reported Earnings Quality Under Conservative Accounting and Auditing

Abstract

While conservatism may lead to a reduction of the current period's income, a consistent use of conservative accounting builds a hidden reserve that can inflate future earnings when investment growth slows down. For the same reason, reported earnings may be of a lower quality in terms of predictability of future cash flow when investments are growing. Managers of a growing firm, therefore, must choose to report a conservative but lower quality number or to undo the effects of conservatism by less conservative current-period cost estimates to improve the quality of reported earnings. Such departure from conservatism in the current period may lead to a conflict with the auditor, which may affect firm value as well as the manager's own wealth. Managers of a steady-state investment firm, on the other hand, have an opportunity either to report conservative and high quality earnings or to slow down its investments and/or choose less conservative current period cost estimates to report higher earnings in order to effectively mimic the (high quality) report of the growing firm. In this environment, an increase in auditor's conservatism may improve the informational efficiency of the market by reducing the incentives of the nongrowing firms to mimic a growing firm's disclosure. An increase in incentives that are based on firm value tends to increase a growing firm manager's propensity to report higher quality earnings while increasing the nongrowing firm's manager's propensity to cut back investment. Thus, we are faced with a situation where improving incentives for reporting higher quality earnings may be associated with an incentive to reduce investments by some firms.