Accounting conservatism and managerial information acquisition

Abstract

We study the interaction between optimal financial reporting rules and managers' incentives to gather additional information about firm performance. Accounting-based covenants transfer control rights to lenders, allowing them to take corrective actions. After the accounting report is released, the manager can exert effort to uncover whether the report is a false alarm or unduly optimistic. The manager's incentive to gather information stems from optimal incentive contracts and private benefits of control that she loses when the project is liquidated. We derive conditions under which managerial information acquisition renders conservative reporting optimal for shareholders and show that these conditions relax when the manager derives greater private benefits from the project or the cost of information acquisition declines. Our model provides novel explanations for existing empirical findings and offers new predictions with respect to covenant waivers, debt contract renegotiations, and the frequency of corrective actions.