Information Quality

Conservatism and Accounting Information Quality

Qintao Fan Xiao-Jun Zhang

Walter A. Haas of Business University of California, Berkeley March 2006 Abstract We study the optimal accounting policy when a firm can control the information quality through costly and uncontractable action. It is shown that the desirable accounting generally has two key featues: (i) the accounting report aggregates, rather than reporting directly, the raw information; (ii) the accounting has a conservative bias. Invoking the conservatism principle leads to inefficient inforamtion processing ex post. But it can improve information quality ex ante. We show that the desirability of conservative accounting depends on the degree of uncertainty associated with the underlying information. In addition it is shown that the information user's welfare decreases with a firm's private cost of information quality control and increases with a firm's private benefits from a more favorable report.

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The authors wish to thank Qi Chen, Sunil Dutta, Edward Riedl, Jim Wahlen, Yun Zhang, and participants at the 2005 UNC-Duke Fall Camp for their comments and suggestions.

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Introduction

Accounting processes and summarizes underlying economic events into decision-useful information via the recognition and measurement of assets and liabilities. In this paper we study two key features of accounting, namely, aggregation and conservatism. Aggregation refers to the summarizing of raw data into key …nancial measures and limited amount of disclosures. Such a process involves data compression and, inevitably, loss of

information. Data reduction is needed, as is often argued, to reduce the information processing cost for the end users (Butterworth 1972). It is assumed that aggregation reduces the overall accuracy of information. Such loss in information quality is weighted against the saving from information processing cost determine the optimal degree of data...