Corporate Governance, Accounting Conservatism, and Manipulation

Prior studies have portrayed accounting conservatism as a tool that enables boards to perform their monitoring duties. We develop a model that suggests that the empirical association between conservatism and governance can also run in the opposite direction —only well-governed firms with suffi cient monitoring in place can fully utilize the benefits of conservative accounting. In our setting, conservatism is advantageous because it enables boards to reject unprofitable investments. This feature of conservatism, however, causes the manager to manipulate the system in an attempt to distort boards’investment decisions. Well-governed firms curtail the manager’s ability to manipulate, reducing the negative side effects of conservatism. Our model predicts that stronger corporate governance is associated with greater accounting conservatism, greater manipulation, and higher firm value.