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Accounting Conservatism and Board Efficiency

Yanmin Gao, Alfred Wagenhofer, University of Graz, Austria

18th Mar 2014  11:30 am - 12:30 pm Boardroom, Darlington Centre

This paper establishes a positive relation between board efficiency and conservative accounting. With that, it provides a theoretical underpinning for empirical studies that find a positive association between strong corporate governance and conservatism. Our model includes a board that has a monitoring and an advisory role and decides to retain or replace the incumbent manager based on accounting information. The optimal decisions trade off the cost of monitoring and the cost of replacing the manager. Conservatism is desirable because it makes monitoring more effective, but only if the board can monitor efficiently. We also find that earnings management tends to undo the benefit of conservative accounting and show the interaction between board composition and conservatism. We derive empirical predictions and discuss several extensions of the model.