Accounting Conservatism and Managerial Information Acquisition

We study the interaction between strategic managerial information acquisition and shareholders' optimal degree of conservative accounting. Conservative accounting results in more frequent early warnings that allow lenders or corporate boards to take corrective actions, but also increases the risk of false alarms and excessive interventions. Managers' ability to gather additional evidence changes this trade-off because managers have an intrinsic incentive to obtain and disclose evidence that prevents intervention. Managers' incentives to refute low accounting reports, but not high reports, reduces the negative consequences of conservative reporting without altering its benefits. In addition, conservatism increases the likelihood that managers find favorable evidence after an early warning and hence induces greater effort in gathering evidence. Our model provides a novel explanation for the empirical observations that conservatism plays a positive role in debt contracts and that covenant violations frequently trigger debt contract renegotiation and covenant waivers