Accountants’ Loss Functions and Induced Preferences for Conservatism

Abstract

The purpose of this paper is to analyze the properties of optimal incentive schemes, and their implications, for accountants in a simple model of the accountant’s role in the production of information for a user. We find that a key property of the optimal incentive scheme for the accountant is its asymmetry: typically, the accountant will be penalized differently for different types of errors. This asymmetry has implications for the structure of auditors’ legal liability and for accountants’ preferences for conservative accounting practices.

Helpful comments by Sidney Davidson, Joel Demski, Nicholas Dopuch, Jerry Feltham, Froystein Gjesdal, and workshop participants at the University of Chicago, Cornell University, and New York University are gratefully acknowledged, as is the financial support of the Institute of Professional Accounting at the University of Chicago (Antle) and the Accounting Research Center of the Kellogg Graduate School of Management at Northwestern University (Lambert).