A measurement approach to conservatism and earnings management

This paper formalizes a two-step representation of accounting measurement and uses it to formalize a general rationale for conservatism as a measurement principle. A transaction's economic substance manifests itself in characteristics of the transaction, and an accounting rule is a mapping from transaction characteristics to an accounting report. Managers who have stakes in the accounting report are able to influence transaction characteristics. Such earnings management is ex post rational for managers but ex ante inefficient. To safeguard against such ex post opportunism, the optimal ex ante accounting rule is conservative in the sense that it requires more verification of the transaction characteristics favorable to managers. Thus, this rationale for conservatism is as general as the managers' ability and incentive to inflate transaction characteristics. By opening the black box of accounting measurement, the two-step representation also formalizes some classic accounting concepts, such as relevance, reliability, verifiability, verification, and accounting-motivated transactions.