Earnings Management, Conservatism, and Earnings Quality

Earnings Management, Conservatism, and Earnings Quality reviews and illustrates earnings
management, conservatism, and their effects on earnings quality in an economic modeling
framework. Both earnings management and conservative accounting introduce biases to
financial reports. The fundamental issue addressed is what economic effects these biases
have on earnings quality or financial reporting quality.

Earnings Management, Conservatism, and Earnings Quality reviews analytical models of
earnings management and conservatism and shows that both can have beneficial or
detrimental economic effects, so a differentiated view is appropriate. Earnings management
can provide additional information via the financial reporting communication channel, but it can
also be used to misrepresent the firm's position. What the authors find is that similar to
earnings management, conservatism can reduce the information content of financial reports if
it suppresses relevant information, but it can be a desirable feature that improves economic
efficiency. The approach to study earnings management, conservatism, and earnings quality
is based on the information economics literature. A variety of analytical models are reviewed
that capture the effects and subtle interactions of managers' incentives and rational
expectations of users. The benefit of analytical models is to make precise these, often highly
complex, strategic effects. They offer a rigorous explanation for the phenomena and show that
sometimes conventional wisdom does not apply. The monograph is organized around a few
basic model settings, which are presented in simple versions first and then in extensions to
elicit the main insights most clearly.

Section 2 presents the basic rational expectations equilibrium model with earnings
management and rational inferences by the capital market. Section 3 is devoted to earnings
quality and earnings quality metrics used in many studies. Section 4 studies conservatism in
accounting. Finally, the authors examine the interaction between conservatism and earnings
management. Each section ends with a section containing a summary of the main findings
and conclusions.