Optimal conservatism with earnings manipulation

This paper examines the role of conservatism when an agent can manipulate upcoming earnings before all uncertainty is resolved. An increase in conservatism, by reducing the likelihood of favorable earnings, requires steeper performance pay to maintain the same level of incentives, which in turn increases the equilibrium earnings manipulation. Trade-offs between inducing effort and curbing manipulation predict an interior level of conservatism as optimal. The optimal level of conservatism is positively associated with enforcement, economic profitability and earnings quality, and negatively associated with agency frictions. In particular, we show that more economically profitable firms choose to be more conservative. We also establish that the association between performance pay and manipulation identifies whether conservatism is optimally chosen or exogenously imposed. In an application to debt contracting, we show that optimal conservatism is negatively associated with borrowers’ bargaining power.