The Joint Effects of Monitoring and Incentive Alignment on Accounting Conservatism

Abstract

This paper investigates the joint impact of strong corporate governance and incentive alignment on accounting conservatism. Prior research has found that the higher the monitoring by the board, the higher the accounting conservatism (Garcia Lara et al., 2009). Prior research has also found that when the incentive alignment is high, the observed accounting conservatism in financial reports is low and redundant (Lafond and Roychowdhury, 2008).  This paper looks at the joint effects of these two countervailing forces of monitoring and the incentive alignment on conservatism and finds that the observed conservatism is high when both are present, thus suggesting that high corporate governance is a dominant and omitted variable which alters the relationship between the incentive role of corporate governance and conservatism. The findings suggest that selective strengthening of corporate governance and selective conservative reporting for low incentive aligned firms provide an even more effective option for managing agency conflicts. Further, these findings are relevant to the FASB’s debates on when and whether standards need to be conservative versus neutral.