Biases in Accounting and Non-Accounting Information: Substitutes or

Complements?

Xu Jiang*

Duke University

September 2016

*: Accepted by Haresh Sapra. Xu Jiang can be reached at xu.jiang@duke.edu.The paper develops one of
the ideas but is substantially different from an earlier paper Accounting Conservatism and Debt Contract
Efficiency: The Role of Soft Information, which was presented at workshops and conferences in various
places. I thank participants at those workshops for helping me to develop this paper. I appreciate valuable
discussions with Qi Chen, Frank Gigler, Chandra Kanodia, Mingzhu Li, Baohua Xin and Ming Yang and
valuable comments from an anonymous referee on various versions of this paper. I acknowledge financial
support from Duke University Fuqua School of Business. All errors are my own.

Electronic copy available at: http://ssrn.com/abstract=2833947

 Biases in Accounting and Non-Accounting Information: Substitutes or

Complements?

Abstract

This paper studies how bias in non-accounting and in accounting information should be

related. Bias in accounting information is modeled, as in some recent literature, as an alteration

in the relative information content of accounting numbers. The optimal bias in one type of

information is shown to be a complement of the bias in the other type. This result can be applied

in various settings to explain a number of phenomena.

Keywords: accounting bias, information system, complementary information

JEL codes: C72, D81, D86, M40, M41

Electronic copy available at: http://ssrn.com/abstract=2833947

I. Introduction

This paper examines the optimal relation between the properties of accounting information

specifically, the nature of biases in it and the properties of other information. 1 This question is

important and intrinsically interesting, in-as-much as accounting information is only a subset of

the information available to investors in making decisions. Non-accounting information signals,

as long as they are not completely uninformative, remain incrementally beneficial to decisions,

depending in part on the properties of the information, including the potentially non-trivial bias

embedded in it. Thus, it is not clear, a priori, how the bias in accounting and in non-accounting

information should be related from a decision-making standpoint. This is the theme of this paper.

I examine a setting in which the decision-making role of information arises naturally. In the

model, an investor conducts an investment project, meanwhile observing the realization of

accounting and non-accounting information signals. Based on those signals, the investor decides

whether to continue or to liquidate the project. This problem thus resembles a stylized depiction

of decision-making under uncertainty in which the investors expected payoff depends crucially

on the quality of the information on which the decision is based. This in turn depends on the

properties, including biases, of the systems that generate the accounting and the non-accounting

information signals. Consequently, the relationship between the bias in the accounting

information and that in the non-accounting information is non-trivial. One can think of

accounting information as earnings numbers that indicate future cash flows and of non-

accounting information as another noisy signal of future cash flows that is free of the bias

generated by the accounting system but may contain bias of its own.

I characterize the properties of an information system following the notion developed,

among others, by Gigler and Hemmer (2001), Venugopalan (2004), Chen et al. (2007) and
1
In this paper other information and non-accounting information are interchangeable.

2
Gigler et al. (2009). An information system is considered to be conservatively biased if the

favorable signals are more informative about the underlying fundamental than the unfavorable

ones, aggressively biased if the reverse holds. 2 In seeking to determine optimal bias in the

accounting information system, one may conjecture that its signals should counterbalance the

differential biases in the non-accounting signals. Such a conjecture would imply that optimally,

accounting information should be conservatively biased when the non-accounting information

system is aggressively biased.

I show that from the standpoint of social efficiency, when the accounting information is

conservative, then conservative non-accounting information too is desirable; that is, favorable

non-accounting signals should be more informative than unfavorable ones. Similarly, when the

accounting information is aggressively biased, the non-accounting system too should be

aggressive; i.e. its unfavorable signals should be more informative than the favorable ones. In

other words, the bias in accounting information and the bias in non-accounting information

should be complements.

To understand the intuition underlying this central result, note that the function of additional

information is to reduce the decision errors that the investor would have made relying on a single

information system. To start, suppose the decision whether to liquidate or to continue a project is

based on accounting information only. If this accounting signal is informative, it will be optimal

to liquidate upon observing a low (unfavorable) signal and continue when there is a high

(favorable) signal. Therefore, if the accounting information is conservatively biased, so that low

signals are less informative than high signals, decision errors are more likely when the

accounting signal is low. Now consider supplementing the accounting signal with non-

2
In this paper I use the terms favorable and high interchangeably to refer to good news as per Milgrom (1981)
and unfavorable and low interchangeably to refer bad news.

3
accounting information. This is most useful when it leads to the largest reduction in decision

errors. Since decision errors stemming from the accounting information are more likely when the

accounting signals are low (i.e., leading to inefficient liquidation decisions), the non-accounting

information is most valuable when it induces the investor to continue the project despite the low

accounting signals. This corresponds to the case when high non-accounting signals are more

informative, the defining characteristic of a conservatively biased system. The same intuition

implies that when the non-accounting information is conservatively or aggressively biased, the

accounting information too should be biased in the same direction.

This result, applied in different settings, carries interesting implications. For example, if the

non-accounting information signals are subject to managerial manipulation, then they are likely

to be aggressive, since favorable signals are less informative. On the basis of the conclusions

reached here, then, in this case accounting information should be aggressively rather than

conservatively biased. This runs counter to LaFond and Watts (2008) who argue that

conservative accounting is needed to overcome the optimistic bias of other information that is

exposed to manipulation by management. As another example, assume that it is costly to process

accounting information and that other information signals are aggressive, in the sense that high

signals are less informative than low signals. Our conclusion is that if the accounting information

is conservatively biased, investors are less likely to process it, i.e. they under-react to it. This

provides an alternative explanation for such well-known phenomena of under-reaction as post-

earnings announcement drift and accrual anomaly. 3

This paper contributes to the accounting and information economics literature along several

dimensions. First, it sheds light on the basic question of the optimal relation between bias in the

accounting and non-accounting information. For example, Chen et al. (2007) and Gao (2013)
3
See section III for more discussions of the implications.

4
show that conservative accounting standards are desirable when managers can manipulate the

signal to which the accounting standards apply. My paper shows that when accounting signals

cannot be manipulated, aggressive accounting standards can be desirable if managers can

manipulate other signals in a similar manner, as in Chen et al. (2007) and Gao (2013).

Second, the focus on the bias instead of the accuracy of information generates different,

more general implications than previous works that posit information as unbiased noisy signals

of some fundamental and focus on their optimal precision. 4 The focus on bias, which is one of

the qualitative properties of information, also connects with the growing literature on rational

inattention and flexible information acquisition (e.g., Sims [1998, 2003], Yang [2015]), whose

main insight is that to economize on the use of information, agents will focus on the information

that is relevant to their welfare and be rationally inattentive to other aspects. This paper generates

similar insights in an accounting setting. Given biased accounting information, investors will

prefer the bias in the non-accounting information that is most relevant to reducing decision errors

induced by the bias in the accounting information. The contribution to the literature consists in

this examination of how the two types of bias are related.

The remainder of the paper is organized as follows. Section II sets up the model, solves for

the optimal decision rule, and presents the main result on the optimal relation between the bias in

accounting information and the bias in non-accounting information. Section III discusses the

implications of the main result and Section IV concludes. Technical details, including all proofs,

are given in the appendix.

4
A non-exhaustive list of exceptions includes Gigler and Hemmer (2001), Kwon et. al. (2001), Chen et. al. (2007),
Gigler et. al. (2009), Bertomeu et. al. (2014), Li (2013) and Gao (2013).

5
II. The Model

II.A The Basic Setup

Consider a risk-neutral investor at date 0 with an investment project that will return an

uncertain cash flow two periods later. 5 The investors prior on has binary support { , }

with probability and 1 . In addition, an interim accounting signal { , } and

another signal { , } which is independent of conditional on will be observed at date

1. 6 For notational ease, throughout the paper refers to non-accounting information, although

both and can be more broadly interpreted as two noisy signals of the fundamentals, the noise

being reciprocally independent. As is made clear below, I allow the noise in and to be biased

and study how the property of the noise in affects that of the noise in .

At date 1, after observing the accounting signal and the non-accounting signal , the

investor chooses whether to liquidate the project for proceeds or to continue it until date 2. In

the latter case, the cash flow is realized at date 2. To make the problem interesting, I assume that

() > > () , where is the support of which, in the binary case, reduces to

> > .

As noted earlier, I focus on a single investors decision problem, in which the liquidation

and continuation decisions can be interpreted more broadly as actions that affect the investors

payoff (e.g., selling shares in an intermediate period versus holding them until the end). The fact

that liquidation generates a certain rather than an uncertain payoff can be justified by a debt

contracting setting. However, the stylized decision-making setting used here reflects an

5
Assuming risk aversion would not qualitatively change the results.
6
In the binary case, subscript refers to favorable realization of any signal while subscript refers to unfavorable
realization.

6
important characteristic of any setting with a continuation/termination decision, including selling

a firm, recalling a debt, firing a management team or terminating a project. 7

The timeline is shown in Figure 1.

-- Insert Figure 1 here.

II.B The Information Structure

Under binary support, there are four possible signal combinations: ( , ), ( , ), ( , )

and ( , ).

I also assume that the project has positive net present value, i.e. [] . In the binary

( )
case, it is equivalent to ( ) ( ). Further, denote 1. 8
( )

Following prior literature, such as Gigler and Hemmer (2001), Venugopalan (2004), Chen et al.

(2007), Bertomeu et al. (2014) and Li (2013), the bias in accounting information, denoted by ,

is modeled as in the following probability structure: 9

( | ) = + , ( | ) = 1 and

( | ) = 1 + , ( | ) = .

where (+1 , 1), [0 , 0 ] (+1 , 1 ) for some 0 > 0.

The probability structure and the assumptions imply that is good news relative to in

( | ) ( | )
the sense of Milgrom (1981) as > . and have the usual interpretation of the
( | ) ( | )

7
I thank an anonymous referee for making this point. In addition, the assumption of a certain payoff of upon
termination, while appropriate for a debt-contracting setting, may not be for other settings. When is uncertain but
its distribution is independent of the bias in both the accounting and the non-accounting signal, it is straightforward
to show that the main conclusion is unaltered. Whether it still holds when is uncertain and the distribution
depends on the signal biases is an interesting question left for future work.
8
The assumption of 1 has also been used in prior work, e.g. Gigler et al. (2009). The justification for this
assumption is that the project must be so promising that absent other information, a rational decision maker will not
want to start the project with the intention of liquidating it in the intermediate period. Results when < 1 mirror
those for > 1 and will be mentioned in footnotes wherever relevant.
9
Throughout the paper is used to denote probabilities.

7
 ( | )
informativeness and bias of the accounting signals. To see this, note that both and
( | )

( | )
are increasing in . Thus, when increases, both and become more informative.
( | )

( | ) (| )
On the other hand, is decreasing but is increasing in . Thus, when increases
( | ) ( | )

and accounting becomes more aggressive (or less conservative), becomes less informative but

is more informative.

The assumptions imposed on and warrant some discussion. First, as is noted in Lemma

A.1 in the appendix, the investor, upon seeing a signal , will continue (liquidate) the project

(| ) 1 ( | )
when (| )
> (<) . The assumptions that > +1 and > +1 result in ( | )
>

1 ( | ) 1

and ( | ) < . In other words, these two assumptions ensure that regardless of the

bias in the accounting information, the investor will liquidate on seeing and continue on

seeing if only accounting information is available. The assumptions rule out the uninteresting

cases in which the investor will always continue or always terminate regardless of , implying

that the accounting information is always informative. Second, when = 0 this captures the case

of neutral accounting with no bias when the informativeness of the favorable signal is equal to

( | ) ( | )
that of the unfavorable signal, i.e. = 1 = . The case of < 0 accordingly
( | ) ( | )

corresponds to conservatively biased accounting as the informativeness of the favorable signal is

( | ) + ( | )
greater than that of the unfavorable, i.e. = > 1 > = .
( | ) 1 + 1 ( | )

Similarly, > 0 corresponds to the case of aggressively biased accounting, where the

( | ) + ( | )
unfavorable signal is more informative, i.e. = > 1 > = .
( | ) 1 1 ( | )

Following the notion in Gigler et al. (2009), I therefore define an accounting system as

8
conservatively (aggressively) biased if < (>)0. Finally, the bias is assumed to lie in a

symmetrical interval around zero, ensuring that the favorable signal in the most conservatively

biased accounting system is equally informative as the unfavorable signal in the most

aggressively biased accounting system and conversely, i.e. that the unfavorable signal in the

most conservatively biased accounting system is equally uninformative as the favorable signal in

the most aggressively biased accounting system. In other words, the focus is on the effect of bias

on decision making, controlling for overall informativeness. 10

The bias in non-accounting information, denoted by , is modelled in the same spirit, as

reflected in the following probability structure:

( | ) = + , ( | ) = 1

and ( | ) = 1 + , ( | ) =

where (+1 , 1) and [0 , 0 ] (+1 , 1 ) for some 0 > 0

corresponding to bias in the non-accounting information.

Similarly, the probability structure and the assumptions imply that is good news

( | ) ( | )
relative to in the sense of Milgrom (1981) as > . and have the usual
( | ) ( | )

interpretation of the informativeness and bias of the non-accounting signals, respectively. To see

( | ) ( | )
this, note that both and are increasing in . Thus, when increases, both
( | ) ( | )

( | ) ( | )
and become more informative. On the other hand, is decreasing but is
( | ) ( | )

10
Note that while the literature has generally interpreted as informativeness and as bias, distributions with same
but different in fact have different levels of informativeness as gauged by common measures from information
theory, such as mutual information (see, e.g., Sims 2003 for more details on mutual information). Therefore I control
for the sum of + to ensure that the informativeness of the most conservatively biased signal is neither greater nor
less than that of the most aggressively biased signal. An alternative way of modelling the bias is to impose a
different probability structure ensuring that the variation in does not alter the informativeness of the distributions,
which is outside the scope of this paper.

9
increasing in . Thus, when increases and non-accounting information becomes more

aggressive (or less conservative), becomes less informative but is more informative.

Again, the assumptions on and ensure that the non-accounting information is always

useful to the decision if only the non-accounting information is available. Analogously with the

discussion of the bias in accounting information, = 0 represents the case in which the non-

accounting information is neutral, i.e. the favorable signal is equally informative as the

unfavorable. The case < 0 ( > 0) occurs when the non-accounting information is

conservative (aggressive), i.e. the favorable signal is more (less) informative than the

unfavorable.

The subsequent discussions focus on the case = in order to isolate the effect of

bias in the different information systems from the effect of informativeness. 11

Conditional independence then implies , = ( | )( | ) for , = , and

= , , which are functions of both and . We now address the question of the optimal

relation between and .

II.C Optimal Relation of Bias in Accounting and Non-Accounting Information

We first look at the optimal decision rule based on and , which is specified by {(, )}

where (, ) { , } { , }. The investor liquidates the project when (, ) (, ) and

continues otherwise, the payoff thus being

(,)(,) (, ) + (,)(,)[ ( |, ) + ( |, )](, )

(, ) is chosen so as to solve the following optimization problem:

11
Relaxing this assumption does not alter the results qualitatively, but it makes the algebra much messier.

10
 Program A:

{(,)} (, ) + [ ( |, ) + ( |, )](, )
(,)(,) (,)(,)

In Program A, the investor chooses the optimal decision rule to maximize his payoff.

The solution for the optimal relation between the bias in accounting and non-accounting

information is in three steps. First, solve for Program A and, correspondingly, the optimal

decision rule. Second, based on the optimal decision rule, write the maximized payoff, which is a

function of both and , in terms of the probabilities of terminating and continuing the project

explicitly. Finally, solve for the optimal that maximizes this maximized payoff given and the

optimal that maximizes this maximized payoff given . The results of the first step are

summarized in Proposition 1.

Proposition 1 The optimal contract that solves Program A results in termination of the

project whenever (|, ) < and continuation whenever (|, ) > . 12

Proposition 1 is intuitive. Any deviation from the efficient decision rule will lower the

expected payoff insofar as otherwise the rule will not be efficient. Although the decision rule is

always efficient, its effectiveness depends on how effective the available information is in

reducing decision errors, which in turn depends on its informational properties, i.e. and .

Given the optimal decision rule and the foregoing distribution assumptions, we can write out

the respective probabilities of termination and continuation, and hence the objective function,

explicitly as the second step. Lemma 1 sets out an intuitive characterization of the objective

function that helps to simplify the algebra.

Lemma 1. The optimal decision rule also minimizes (, ),

12
The project can be either terminated or continued when (|, ) = . Assuming either decision does not affect
any of the results.

11
 where (, ) = {(,):[(|,)<]} ( )(, | , , )

+ {(,):[(|,)>]} ( )(, | , , ) (1)

Lemma 1 says that the optimal decision rule must necessarily minimize the sum of decision

errors due to signal noise. The first term of represents the error of terminating a good project

(the false alarm error); the second term represents the error of continuing a bad one (undue

optimism error). Clearly, is a function of and . The final step examines how changes

with those two variables.

From Proposition 1 and the imposed assumptions, when only one of them is available the

project is continued if the signal is favorable (i.e. either or ), and terminated if it is

unfavorable ( or ). This implies that when both accounting and non-accounting information is

available, the project is always continued when ( , ) is observed (i.e. good news from both

systems) and terminated in case of ( , ), i.e. bad news from both systems, regardless of bias.

Therefore decisions may differ only when either ( , ) or ( , ) is observed.

Before presenting the main results, let us discuss a special case that better illustrates the
1
underlying intuition. In this case = 1, i.e. the project has zero net present value and (2 , 1);

the following lemma characterizes the decision rule when either ( , ) or ( , ) occurs.

Lemma 2. Assume that K=1. If + < (>)0, then the project is continued (terminated)

when either ( , ) or ( , ) is observed.

The lemma shows that in the two cases with conflicting signals the decision whether to

continue or terminate depends on the net bias of the accounting and the non-accounting

information, i.e. + . To see this, consider the case of < 0 , i.e. conservatively biased

accounting information. When < 0 or at most slightly positive, so that + < 0, then Lemma

2 implies that the project is continued when either ( , ) or ( , ) occurs. This is because

12
is highly informative when generated by a conservatively biased accounting system and is not

very informative when the non-accounting system is either conservatively biased (i.e < 0) or

just slightly aggressively biased (i.e. 0 < < ), so that the investor uses the more informative

and ignores the less informative . Similarly, since is not very informative when generated

by a conservative accounting system, then when non-accounting information is conservatively

biased (i.e. < 0) or only slightly aggressive (i.e. 0 < < ), the investor ignores the less

informative and continues the project on the basis of the more informative . But when is

very large, so that + > 0, the non-accounting information is so aggressively biased that

becomes more informative than and less informative than . In this case, the investor

relies on the more informative signals and , resulting in termination given either ( , ) or

( , ).

Once the decision rule has been determined, the benchmark case set forth in Lemma 3

below shows that when accounting (non-accounting) information is neutral, the investor is

indifferent between a conservatively biased non-accounting (accounting) information system and

an aggressively biased non-accounting (accounting) information system.

Lemma 3. Assume that K=1. When = 0 , the optimal bias of the non-accounting

information system is either 0 or 0 . When = 0 , the optimal bias of the accounting

information system is either 0 or 0 .

Lemma 3 illustrates that when one information system is neutral, then from the decision-

making perspective the other system can be either conservatively biased or aggressively biased.

The intuition is that when one system is neutral, its good-news signals are just as informative as

its bad-news signals. The errors generated by the high and low signals are therefore the same,

resulting in indifference between the other signal being more informative for high or for low

13
realizations. An interesting result from Lemma 3 is that the optimal bias of the other information

system is either maximally conservative or maximally aggressive when the existing information

system is neutral. To see the underlying intuition, note that from Lemma 2 when K=1 and

= = 0 , investors are indifferent when facing conflicting signals ( , ) and ( , ) ,

implying that lots of decision errors will be generated in those scenarios. Adding bias into either

direction will result in investors more certain about which direction to take when facing ( , )

and ( , ), thus reducing decision errors. The more bias added, the more confident investors

will be and the lower the decision errors.

Lemma 4 shows the result when one of the two information systems is biased.

Lemma 4. Assume K=1. If the accounting system is conservatively biased, i.e. < 0, it is

optimal for to be conservative; in other words, optimal is negative . Conversely, if the

accounting system is aggressively biased, i.e. > 0, it is optimal for to be aggressive (optimal

is positive). Similarly, when the non-accounting system is conservatively (aggressively) biased,

it is optimal for the accounting system too to be conservatively (aggressively) biased. In other

words, the optimal biases in and are complements to one another.

Only the intuition of the first part need be explained here; that behind the second part is

analogous. Note that is most valuable when it generates information that conflicts with that

generated by , information that ends up changing the decision that the investor would otherwise

have made. In the case of a conservative accounting system, by definition, is more

informative than . Thus, when is the only information, the decision to terminate (based on )

is likely to contain larger errors than the decision to continue (based on ). When is available,

Lemma 2 shows that it can be optimal either to continue or to terminate upon observing ( , )

or ( , ). In this case, a more informative is not as valuable as a more informative ,

14
because any improvement in the efficiency of the original decision thanks to adding the

observation of to must be relatively minor, in that the original decision based on the

informative has relatively less error to begin with. By contrast, a decision based on the less

informative is more likely to contain errors; that is, a more informative significantly

reduces the decision error caused by .

Similarly, with an aggressive accounting system the additional information signal is most

valuable in the case ( , ) where it changes the decision from continuation (without ) to

termination (observing ). Since is less informative with aggressive accounting, this change

is more likely to be welfare-improving when is more informative than , implying that

should be aggressive.

We can now present the main result, demonstrating that the result set out in Lemma 4

remains largely unchanged when > 1.

Proposition 2. Assume that 1. If the accounting system is conservatively biased, i.e.

< 0, then it is optimal for too to be conservative; that is, the optimal is negative. If the

accounting system is aggressively biased, i.e. > 0, then it is optimal for to be aggressive

when 0 and are sufficiently large. Similarly, when the non-accounting system is

conservatively biased, it is optimal to have a conservatively biased accounting system, while if it

is aggressively biased, then it is optimal for accounting to be aggressive when 0 and are

sufficiently large. 13

Note that the conclusion of Proposition 2 is essentially the same as that of Lemma 4, with

just one difference: the conditions under which complementary bias is optimal are stronger in

13
When < 1, if > 0, then it is optimal for to be aggressive. If < 0, then it is optimal for to be conservative
when the magnitude of 0 and are sufficiently large. Similarly, when > 0, it is optimal to have an aggressively
biased accounting system, while if < 0, then it is optimal for accounting to be conservative when 0 and are
sufficiently negative.

15
the case of aggressive than of conservative bias, in that in the former case the range of bias must

be sufficiently large. To understand the difference, look again at the case in which one of the

information systems is neutral. The following lemma shows that when > 1 and accounting is

neutral, a conservative non-accounting information system is optimal, implying a natural

preference for conservative bias when > 1.

Lemma 5. Assume that K>1. If the accounting system is neutral, i.e. = 0, then it is

socially optimal for to be conservative, i.e. the optimal is negative. If the non-accounting

system is neutral, i.e. = 0, then it is socially optimal for to be conservative, i.e. the optimal
14
is negative.

The intuition for lemma 5 15 is that when > 1, the prospects are so good that it is more

costly to terminate the project than to let it continue. Thus a socially optimal decision rule will let

the project continue as much as possible, i.e. also when and transmit conflicting signals.

Since is neutral, and are equally informative; the decision therefore depends on the

relative informativeness of and . Where is conservative, is the more informative,

resulting in continuation given either ( , ) or ( , ). By contrast, when is aggressive, is

the more informative, resulting in termination given either ( , ) or ( , ). Thus conservative

is socially optimal when > 1.

Note that Lemma 5 does not contradict the conclusion of Gigler et al. (2009), who find that

if only accounting information is available, then when > 1 the optimal bias must necessarily

be aggressive, because continuation generates fewer decision errors. In the present setting their

result still holds. When only one piece of information is available, the optimal bias can be shown

14
When < 1, if = 0, then it is socially optimal for to be aggressive. If = 0, then it is socially optimal for
to be aggressive.
15
Again we explicate the intuition for the first part only; that for the second part is essentially the same.

16
to be aggressive; but when both pieces are available and one is neutral, the other piece should be

conservatively biased for the same reason: it maximizes the likelihood of continuation, thus

generating fewer errors.

Lemma 5 says that conservative is preferable when > 1 and is unbiased. So when is

aggressive, the benefit from aggressive has to be large enough to overcome the advantage of

conservative bias driven by > 1 , which explains why and have to be sufficiently

aggressive, i.e. and have to be sufficiently large.

III. Extensions and discussions

III.A Ex-post preference on bias 16

The main result is for a decision problem where the bias has to be chosen ex-ante, i.e. before

observing the realization of any signals. But the information choice problems can also be posed

ex-post, i.e. after observing some realizations. This sub-section shows that the main intuition

remains valid in this case as well.

For algebraic simplicity, let us take the case where = 1 (the insight does not change

substantially when > 1). Assume that the investor can observe the realization of before

choosing the bias in . Corollary 1 summarizes the result.

Corollary 1. Assume that K=1. If the investor observes , he will prefer an aggressively

biased non-accounting system (i.e. choose 0 ) if 0 > . If the investor observes , he will

prefer a conservatively biased non-accounting system (i.e. choose 0 ) if 0 < .

The conditions concerning 0 and guarantee that the bias in is great enough to change

the decision when is observed; for otherwise the observation of changes nothing and the bias

in is irrelevant to the decision. Note that while Corollary 1 may look different from Lemma 4

16
I thank an anonymous referee for suggesting this extension.

17
or Proposition 2, the intuition behind them all is the same. When is observed, an unfavorable

that is not very informative will not be much help in informing decision makers to terminate,

because the realization of itself informs investors that the project is more likely to succeed.

Therefore, a highly informative, unfavorable is preferred, corresponding to being aggressive.

A similar intuition would suggest that conservative is preferred when is observed. Ex-ante,

given that a conservatively biased accounting system generates more often than , a

conservative non-accounting information system is preferred, since conservative is expected to

be preferred more often. Corollary 1 is thus consistent with the main result.

III.B Ex-ante manipulation of

In the main analysis, the property of is chosen by an investor in such a way as to maximize

the social efficiency of decision-making. In reality, though, we may have different parties with

conflicting interests, and the bias may not be chosen for that purpose. Specifically, a manager

may have interests that conflict with the shareholders say, private benefits from continuing the

project yet still be able to choose the property of . LaFond and Watts (2008) argue that

managers tend to be overly optimistic in disclosing other information, so the authors advocate

conservative accounting to help investors discount that bias. Here I show that this argument is

not necessarily correct, because the manager has an incentive to manipulate and add an

aggressive bias to non-accounting information, which means that accounting information should

be aggressive rather than conservative.

In particular, I assume a risk-neutral manager in charge of the project. The investor can sign

a debt contract with the manager, specifying not only the face value of the contract but also the

conditions under which the project is to be continued or liquidated in the intermediate period.

18
The manager enjoys a non-pledgeable private benefit > 0 from continuation. 17 I also assume

that + > and that + < , so that it is socially optimal to continue when the true

cash flow is and terminate when it is . I further assume that the manager can manipulate

at no cost by shifting its distribution to the right, in the sense of first order stochastic dominance

up to some maximum amount. 18 I use [0, ] to denote the managers ex-ante manipulation,

with higher values of representing sharper upward manipulation. Thus, a high value of

makes it more likely that low realizations of will be informative and high realizations

uninformative. The investor is assumed to be unable to verify . 19

First let us look at the optimal contract based on and . The contract is specified by

{, (, , )} where is the face value and (, , ) { , } { , } is the region in which

the investor takes control when (, ) (, , ) and the manager takes control otherwise. Note

that the choice of (, , ) also depends on the investors conjecture concerning the managers

choice of . 20 Without loss of generality I assume that the investor has all the bargaining

power. 21

Given the assumptions on the parameters, when the investor is in control he liquidates and

obtains , while the manager gets nothing. When the manager is in control, she continues the

project and receives + if it succeeds and if it fails. The investor gets if the project

17
This modeling approach follows Aghion and Bolton (1992) and Gao (2013).
18
The type of ex-ante manipulation technology posited in this paper has been used in Dye (2002), Chen et. al. (2007)
and Gao (2013), among others. Chen et. al. (2007) also assume zero cost for earnings manipulation up to some
maximum amount.
19
The ability to verify with some probability does not change the result qualitatively, as long as the penalty that
can be imposed on the manager is not too heavy.
20
The dependence of on is suppressed, as in the optimization problem is fixed.
21
Assuming that the manager has all the bargaining power or postulating a Nash bargaining outcome does not
change any of the results. As is shown below, the contract results in a Pareto-optimal decision rule and is therefore
renegotiation-proof.

19
succeeds and if it fails. Thus the managers payoff is

(,)(,,)[ + ( )( |, , )](, , ) and the investors payoff is

(,)(,,) (, , ) + (,)(,,)[( |, , ) + ( |, , )] (, , ) when the

manager chooses = .

The investor chooses { , (, , ), } to solve the following optimization problem:

Program B:

{,(,,),} (, , )
(,)(,,)

+ [( |, , ) + ( |, , )] (, , ) . .
(,)(,,)

(,)(,,)[ + ( )( |, , )](, , ) (IR)

(,)(,,)[ + ( )( |, , )](, , ) (IC)

= (Rational Expectations)

In Program B, the investor chooses the contract that maximizes his payoff, subject to three

constraints: the (IR) constraint, requiring that the manager receive at least his reservation utility;

the (IC) constraint, that the manager chooses his optimal action based on the investors

conjecture; and the (Rational Expectations) constraint, i.e. that the conjecture correspond to the

reality. The solution for Program B is summarized in Proposition 3.

Proposition 3 The optimal contract that solves Program B results in termination of the

project whenever ( + |, ) < and continuation whenever ( + |, ) > . 22

The

manager chooses = .

22
The project can be either terminated or continued when ( + |, ) = . Assuming either decision will not
affect any of the results.

20
 The logic underlying Proposition 3 is as follows. The manager always wants to continue and

the investor always wants to terminate, regardless of the signal. Since the socially optimal

solution is to continue when the signal realization is sufficiently good and terminate when it is

sufficiently bad, the optimal decision rule would give the power of decision to the manager when

the signals are good enough, so that he would continue. In the same way, when the signals are

sufficiently bad it would give the power of decision to the investor, in order to terminate.

Proposition 3 shows that the manager would manipulate the non-accounting signal. The

intuition is that whatever the investors belief about the distribution of , the manager has an

incentive to shift the distribution of rightward, because this increases the chances of

continuation. This means that the only sequential equilibrium is for the investor to conjecture

that the manager will choose = and the manager in fact does. 23 This is consistent with the

thesis of LaFond and Watts (2008) that managers tend to overstate information that they can

manipulate. It is also consistent with Gao (2013), who argues that managers have an incentive to

inflate signals to maximize the probability of continuation.

The fact that managerial manipulation results in an aggressively biased , combined with

Proposition 2, gives us Corollary 2, the proof of which is omitted as it follows directly from the

proposition itself.

Corollary 2. Managerial manipulation of non-accounting information results in

aggressively biased accounting being socially desirable if is sufficiently large.

In other words, the managers tendency to overstate other information makes less

conservative, not more conservative accounting desirable. Although in the presence of

managerial manipulation conservative accounting might have other benefits, my results suggest

23
Contracting on a report of will not solve the problem, as the manager can always claim to choose = 0. If the
investor naively believes that = 0, the manager still has the incentive to choose = 0 . Knowing this, the
investor will never believe the managers report and we are back to Program B.

21
that when managers overstate the non-accounting information conservative accounting may be

inefficient.

III.C Additional implications

First, Lemma 4 and Proposition 2, if applied in a different setting, also provide a rational

explanation for investors under-reaction to earnings announcements (e.g., Bernard and Thomas

1989, 1990) as well as for their inability to understand the accrual component of earnings (Sloan

1996).

To see this, consider a setting in which investors have some private information around the

earnings announcement date (say, reports from market analysts) and their information decision

problem is to whether to spend costly time and effort to digest/interpret the earnings

announcement data based on . 24 Assume that is neither too high nor too low, so that the

investors sometimes choose to process the accounting data and sometimes not. Depending on the

nature of the bias in the two sources of information, investors may rationally choose not to

process earnings data, i.e. to ignore the information given in the earnings announcement. This of

course is equivalent, in observational terms, to investors under-reacting to earnings

announcements or failing to understand the information contained in the accrual component of

earnings. 25 Investors will choose to process the accounting data only when the error reduction

thanks to the additional accounting information is large. If the private information signals are

aggressive, Proposition 2 says that a conservatively biased accounting signal generates more

errors than an aggressively biased one, so investors will be less likely to incur the processing cost

hence, more likely to ignore earnings numbers when the accounting data are more

conservatively biased. Assuming that the non-accounting information tends in general to be

24
This interpretation is adopted by Indjejikian (1991).
25
This is because the conservative bias of accounting earnings numbers is entirely embodied in the accrual
component.

22
aggressive, in that favorable signals are less informative than unfavorable ones, investors may

only have access to information that is aggressively biased. When this is the case, they are less

likely to sustain the processing cost for firms or industries that report more conservatively. My

model thus predicts that under-reaction to earnings announcements and/or the inability to process

the accrual component will be the greater, the more conservative the accounting practices of a

firm, an industry or a country. The literature offers some empirical evidence in support of this

conjecture. Kaserer and Klingler (2008) document that the accrual anomaly only exists for

German firms that use IFRS or U.S. GAAP, not for those that use German GAAP. To the extent

that German GAAP is less conservative than the other two accounting standards, these findings

are consistent with my results. Another example is Narayanamoorthy (2006) who finds that the

markets tend to ignore the information in earnings due to accounting conservatism, which again

is consistent with my prediction.

Secondly, the result also carries some implications concerning the behavior of investors in

acquiring private information. Consider a setting where investors have access to accounting

information and the possibility of acquiring private information at a cost . Assume that is

neither too high (so that the investor would never acquire the information) nor too low (so that

the investor always would). Private information acquisition then depends on whether the

consequent reduction in decision error is great enough to cover the cost . Proposition 2 then

implies that investors who have more conservatively biased accounting information will only

acquire other information that is conservative and will not acquire aggressively biased

information, insofar as conservatively biased non-accounting information reduces decision error

more sharply. On the assumption that the non-accounting information tends to be aggressive, in

23
that favorable signals are less informative than unfavorable, 26 informed investors may have only

the option of acquiring information that is aggressively biased. When this is the case, they are

less likely to acquire it for firms or industries that report more conservatively. To the extent that

private information acquisition is the source of information asymmetry among investors (see

Verrecchia 1982, and Bushman 1991, among others), this implies that more conservative

accounting should be associated with less information asymmetry. By the same token, for firms

or industries that report more aggressively (or less conservatively), informed investors are more

likely to acquire information, accentuating information asymmetry. These predictions relate to

the findings of earlier literature that information asymmetry increases around earnings

announcement (Lee et. al. 1993, Krinsky and Lee 1996), although the focus has mostly been on

the relationship between the accuracy of earnings information and information asymmetry (Gow

et. al. 2012), not on whether the increased information asymmetry is a function of the bias in

accounting information. More recently, DAugusta et. al. (2012) have found that firms with more

conservative accounting practices tend to produce less disagreement among investors around

earnings announcement dates. Insofar as less disagreement stems from the lesser likelihood of

informed investors acquiring private information, hence producing less information asymmetry,

their findings are consistent with the predictions of my model.

Finally, if we interpret as managerial disclosure of non-accounting information, then my

analysis shows that firms that report more conservative accounting numbers will also make more

conservative non-accounting disclosures. One example of such disclosures is management

discussion and analysis (MD&A) section in the annual report, which includes discussion of

factors that would affect future performance and consists mostly in non-accounting information,

26
According to LaFond and Watts (2008), this is the key reason why from the capital market perspective accounting
should be conservatively biased.

24
although in principle it can be applied to all types of disclosure of non-accounting information. It

is also plausible that managers find it difficult to manipulate the hard accounting numbers but

may well have more leeway to manipulate the mostly forward-looking and qualitative

information of the MD&A section. To the best of my knowledge, no study has conducted a direct

empirical test of the relationship between the conservative bias of financial reports and the bias

in non-accounting disclosures like MD&A. Assuming that habitual optimism is associated with

aggressiveness and pessimism with conservatism, 27 one may use the disclosure tone of past

MD&A as a proxy for the degree of conservatism, with a more optimistic tone representing more

aggressive voluntary disclosures. 28

IV. Conclusion

This paper examines the optimal relation between the nature of biases in non-accounting and

in accounting information. Information bias is modeled as a qualitative feature, namely which

part of information is more informative and which less. In this sense the paper differs from most

previous works, which focus on the overall informativeness (i.e. precision) of the information

signal. My paper shows that from the decision-making perspective, bias in accounting

information and bias in non-accounting information should be complements rather than

substitutes. That is, the effort to counteract the aggressive bias of non-accounting information

with countervailing accounting information could actually be detrimental to decision making

efficiency. Future research could explore the optimal relation between the biases of different

information sources in various settings in greater detail. The insights provided by the present

paper are likely, in any case, to continue to play an important role.

27
When disclosures tend to be optimistic, optimistic disclosures would not be very informative while pessimistic
ones would be highly informative, corresponding to disclosures being aggressive. By the same logic, habitually
pessimistic disclosures are associated with conservatism.
28
See, e.g., Rogers et al. (2011), for an example in which the disclosure tone in mandatory disclosures can be
used to capture optimism and pessimism.

25
 REFERENCES

AGHION, P. AND P. BOLTON. An Incomplete Contracts Approach to Financial Contracting. The

Review of Economic Studies 59 (1992): 473-494.
BASU, S. The Conservatism Principle and the Asymmetric Timeliness of Earnings. Journal of
Accounting and Economics 24 (1997): 3-37.
BERNARD, V. L. and J. K. THOMAS. Post-Earnings-Announcement Drift: Delayed Price Response or
Risk Premium? Journal of Accounting Research 27 (1989): 1-36.
BERNARD, V. L. and J. K. THOMAS. Evidence that stock prices do not fully reflect the implications of
current earnings for future earnings. Journal of Accounting and Economics 13 (1990): 305-340.
BERTOMEU, J.; M. DARROUGH AND W. XUE. Optimal Conservatism with Earnings Manipulation.
Working Paper, Baruch College and Carnegie Mellon University. 2014.
BUSHMAN, R. M. Public Disclosure and the Structure of Private Information Markets. Journal of
Accounting Research 29 (1991): 261-276.
CHEN, Q.; T. HEMMER AND Y. ZHANG. On The Relation Between Conservatism in Accounting
Standards and Incentives for Earnings Management. Journal of Accounting Research 45 (2007):
541-565.
D'AUGUSTA, C.; S. BAR-YOSEF and A. PRENCIPE. Conservative Reporting and Investors
Divergence of Opinion. Working Paper. Georgia State University and Bocconi University, 2012.
Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2144294.
DYE, R. Classifications Manipulation and Nash Accounting Standards. Journal of Accounting
Research 40 (2002): 1125-1162.
GAO, P. A Measurement Approach to Conservatism and Earnings Management. Journal of Accounting
and Economics 55 (2013): 251-268.
GIGLER, F.; C. KANODIA; H. SAPRA AND R. VENUGOPALAN. Accounting Conservatism and the
Efficiency of Debt Contracts. Journal of Accounting Research 47 (2009): 767-797.
GIGLER, F. AND T. HEMMER. Conservatism, Optimal Disclosure Policy, and the Timeliness of
Financial Reports. The Accounting Review 76 (2001): 471-493.
GOW, I. D.; D. J. TAYLOR and R. E. VERRECCHIA. On The Complementary Relation between
Earnings and Private Information. Working Paper, Harvard University and University of
Pennsylvania, 2012. Available at: http://www.usc.edu/schools/business/FBE/FEApapers/ACC-
4%20Manuscript%20102%20Dan%20Taylor%20Wharton.pdf .
INDJEJIKIAN, R. J. The Impact of Costly Information Interpretation on Firm Disclosure Decisions.
Journal of Accounting Research 29 (1991): 277-301.
KASERER, C. and C. KLINGLER. The Accrual Anomaly Under Different Accounting Standards
Lessons Learned from the German Experiment. Journal of Business Finance & Accounting 35
(2008): 837-859.
KRINSKY, I. and J. LEE. Earnings Announcements and the Components of the Bid-Ask Spread. The
Journal of Finance 51 (1996): 1523-1535.
KWON, Y.; D. NEWMAN AND Y. SUH. The Demand for Accounting Conservatism For Management
Control. Review of Accounting Studies 6 (2001): 29-52.
LAFOND, R. AND R. WATTS. The Information Role of Conservatism. The Accounting Review 83
(2008): 447-478.
LEE, C.; B. MUCKLOW and M. READY. Spreads, depths, and the impact of earnings information: an
intraday analysis. Review of Financial Studies 6 (1993): 345-374.
LI, J. Accounting Conservatism and Debt Contracts: Efficient Liquidation and Covenant Renegotiation.
Contemporary Accounting Research 30 (2013): 1082-1098.
MILGROM, P. Good News and Bad News: Representation Theorems and Applications. The Bell
Journal of Economics 12 (1981): 380-391.
NARAYANAMOORTHY, G. Conservatism and Cross-Sectional Variation in the PostEarnings
Announcement Drift. Journal of Accounting Research 44 (2006): 763-789.

26
ROGERS, J.; A. VAN BUSKIRK AND S. Zechman. Disclosure Tone and Shareholder Litigation. The
Accounting Review 86 (2011): 2155-2183.
SIMS, C. A. 'Stickiness.' Carnegie-Rochester Conference Series on Public Policy 49 (1998): 317-356.
North-Holland.
SIMS, C. Implications of Rational Inattention. Journal of Monetary Economics 50 (2003): 665-690.
SIMS, C. Rational Inattention: A Research Agenda. Discussion Paper Series 1: Economic Studies 2005,
34. Deutsche Bundesbank, Research Center.
YANG, M. Coordination with Flexible Information Acquisition. Journal of Economic Theory, 158
(2015): 721-738.

27
APPENDIX: PROOFS

Before proceeding, let us prove the following technical lemma, which will be used

repeatedly in subsequent analysis.

Lemma A.1 (, ) (|, ) (),

( )(, | ) () ( )(, | ),or, equivalently,

(,| )
().
(,| )

Proof of Lemma A.1:

When (|, ) (), we have ( |, ) + ( |, ) (), which can

be equivalently written as ( ) ( |, ) ()( ) ( |, ).

(,| )
By Bayes rule, ( |, , ) = for = , . Insert this into the above expression,
(,)

and cancelling out (, ) on both sides we obtain the expression.

Proof of Proposition 1:

The investor chooses the decision rule that maximizes his expected payoff conditional on all

the information he may have. Since the investor always have the option to liquidate, then if he

wants to continue, the expected continuation payoff must be greater than . Thus, based on his

information set at date 1, he will terminate any project that results in (|) < and continue

any project that results in (|) > .

Proof of Lemma 1:

Following the optimal decision rule of Proposition 1, we can write the objective function in

Program A as

(, , , )
{(,):[|,]<}

+ {(,):[|,]>} ( |, , , )

28
 + {(,):[|,]>} ( |, , , ) (A-1)

(,| ,,)
Using Bayes Rule, we can write ( |, , , ) = (,)
for = , . Note that we

also have (, , , ) = (, | , , ) + (, | , , ) . Inserting these into (A-1), we

now have the objective function as

[(, | , , ) + (, | , , ) ]
{(,);[|,]<}

+ {(,);[|,]>} (, | , , )

+ {(,):[|,]> (, | , , ) (A-2)

Finally, note that

{(,):[|,]<} (, | , , ) + {(,);[|,]>} (, | , , ) =

= (,) (, ) = 1

for = , .

Thus

{(,):[|,]<} (, | , , ) = 1 {(,):[|,]>} (, | , , ) for = , .

Inserting this into the first and second terms of (A-2), we now have the objective as

{(,):[|,]< (, | , , ) +

{(,);[|,]>} (, | , , )

{(,):[|,]<} (, | , , ) + {(,):[|,]>} (, | , , )

= +

[{(,):[|,]<}( )(, | , , ) + {(,):[|,]>( )(, | , , ) ]

= + (, ) (A-3)

29
 Since the first two terms are independent of and , maximizing the objective function is

equivalent to minimizing .

Proof of Lemma 2:

Lemma A.1 says that the decision maker should terminate (continue) at ( , ) if

( , | ) + 1
( , | )
= 1+
< (>)1 and the decision maker should terminate (continue) at ( , )

( , | ) 1 +
if ( , | )
= 1+
< (>)1 . Solving for the two inequalities gives + > (<)0 and

+ > (<)0 , respectively. Hence the decision maker should terminate (continue) at both

( , ) and ( , ) if + > (<)0.

Proof of Lemma 3:

We prove the case when = 0; the proof when = 0 is analogous. Since = 0, we know

from Lemma 2 that the decision maker should terminate (continue) at both ( , ) and ( , ) if

> (<)0. When > 0, the project is continued at ( , ) and terminated otherwise. The

summation of errors then becomes

() = ( )( , | ) + ( )1 ( , | )

= ( )[( , | ) + 1 ( , | )]

= ( )[(1 )(1 + ) + 1 ( + )]

= ( )[2(1 ) (2 1)]

Since () is decreasing in , () achieves the minimum when = 0, resulting in

(0 ) = ( )[2(1 ) 0 (2 1)].

When < 0, the project is terminated at ( , ) and continued otherwise. The summation

of errors then becomes

() = ( )(1 ( , | )) + ( )( , | )

30
 = ( )[1 ( , | ) + ( , | )]

= ( )[1 ( ) + (1 )(1 )]

= ( )[2(1 ) + (2 1)]

Since () is increasing in , () goes to the minimum when = 0, resulting in

(0 ) = ( )[2(1 ) 0 (2 1)]. Thus we have (0 ) = (0 ) and the

decision maker is indifferent between being conservative and aggressive.

Proof of Lemma 4:

We prove the first part only; the proof of the second part is analogous. When < 0 and

+ > 0, the project is continued at ( , ) and terminated otherwise. If 0 + > 0, this

case is possible. When this condition is satisfied, the summation of errors then becomes

(, ) = ( )( , | ) + ( )1 ( , | )

= ( )[( , | ) + 1 ( , | )]

= ( )[(1 + )(1 + ) + 1 ( + )( + )]

= ( )[2(1 ) (2 1) (2 1)]

Since (, ) is decreasing in , (, ) achieves the minimum when = 0 , resulting

in (0 , ) = ( )[2(1 ) 0 (2 1) (2 1)].

When + < 0, which is always possible when < 0, the project is terminated at ( , )

and continued otherwise. The summation of errors then becomes

(, ) = ( )(1 ( , | )) + ( )( , | )

= ( )[1 ( , | ) + ( , | )]

= ( )[1 ( )( ) + (1 )(1 )]

= ( )[2(1 ) + (2 1) + (2 1)]

31
 Since (, ) is increasing in , (, ) achieves the minimum when = 0 , resulting

in (0 , ) = ( )[2(1 ) 0 (2 1) + (2 1)]. Since < 0, even when

the case + > 0 is possible, (0 , ) > (0 , ). Thus the decision maker will choose

= 0 < 0, i.e. a conservatively biased non-accounting information system.

Proof of Proposition 2:

Lemma A.1 says that the decision maker should terminate (continue) at ( , ) if

( , | ) + 1 1 ( , | )
( , | )
= 1+
< (>) and should terminate (continue) at ( , ) if ( , | )
=

1 + 1
1+
< (>) . Solving for the two inequalities yields

[( + 1) 1] + [( + 1) ] + ( 1) > (<)( 1)(1 ) (A-4)

and

[( + 1) ] + [( + 1) 1] + ( 1) > (<)( 1)(1 ), (A-5)

respectively.

We only prove the first part, as the second part can be proved analogously.

Before we proceed, note that the left-hand sides of (A-4) and (A-5) are all strictly increasing

in . To see this, take the derivative of the left-hand side of (A-5) with respect to ; this results in

( + 1) + ( 1) > ( + 1) + ( 1) = 2 +1 > 0.
+1

The derivative of the left-hand side of (A-4) with respect to is [( + 1) 1] +

( 1) > [( + 1) ] + ( 1) > 0 where the last inequality follows from the

foregoing.

We first consider the case < 0.

When = 0, both the left-hand sides of (A-4) and (A-5) are negative, which is smaller than

their right-hand sides. Thus when < 0, both the left-hand sides of (A-4) and (A-5) are smaller

32
than the right hand side. Since the left-hand side of (A-4) is strictly greater than that of (A-5)

when = 0 and it increases with at a faster pace, we know that when > 0, the left-hand side

of (A-4) is strictly greater than that of (A-5). This leaves us with the following cases:

Case a1: when 0, continue at both ( , ) and ( , ).

Case a2: when > 0, depending on the parameters, it is possible that only the left-hand side

of (A-4) or else both the left-hand sides of (A-4) and (A-5) are greater than the right-hand sides.

This results in either terminating at ( , ) but continuing at ( , ) or terminating at both

( , ) and ( , ).

When the project is continued at both ( , ) and ( , ),

(, , ) = ( )(1 ( , | )) + ( )( , | )

= ( )[1 ( , | ) + ( , | )]

= ( )[1 ( )( ) + (1 )(1 )]

= ( ){2(1 ) + ( 1)(1 )2

+[( + 1) ] + [( + 1) ] + ( 1)}

Note that (, , ) is increasing in , as its derivative with respect to , ( + 1) +

( 1), is positive as shown above. Thus, its minimum is achieved at = 0, resulting in

(0 , , ) = ( ){2(1 ) + ( 1)(1 )2 0 [( + 1) ] +

[( + 1) ] ( 1)0 }.

When the project is terminated at both ( , ) and ( , ),

(, , ) = ( )( , | ) + ( )(1 ( , | ))

= ( )[( , | ) + (1 ( , | ))]

= ( ){(1 + )(1 + ) + [1 ( + )( + )]}

= ( ){2(1 ) + ( 1)(1 2 )

33
 [( + 1) 1] [( + 1) 1] ( 1)}

Note that is decreasing in , as its derivative with respect to , [( + 1) 1]

( 1), is negative, as shown above. Therefore, achieves its minimum at = 0 (if both

the left-hand sides of equations (A-4) and (A-5) are larger than the right-hand sides when =

0 ) , resulting in

(0 , , ) = ( ){2(1 ) + ( 1)(1 2 ) 0 [( + 1) 1]

[( + 1) 1] ( 1)0 }.

When the project is terminated at ( , ) but continued at ( , ), then

(, , ) = ( )( | ) + ( )( | )

= ( )( | ) + ( | )

= ( )[1 + + (1 )]

= ( )[( + 1)(1 ) ( 1)]

Since > 1, (, , ) is decreasing in and thus achieves its minimum when = 0 (if

the termination/continuation decision is satisfied when = 0 ), this results in (0 , , ) =

( )[( + 1)(1 ) ( 1)0 ].

We now compare the decision errors.

We first compare (0 , , ) and (0 , , ).

(0 , , ) (0 , , )

= ( ){( 1)2(1 ) + ( 1)0 + ( + 1)(2 1)} (A-6)

The right-hand side of equation (A-6) is negative. The reason is that, first, the term ( +

1)(2 1) is negative as < 0. Secondly, ( 1)2(1 ) + ( 1)0 < (

1)2(1 ) + ( 1)(1 ) = ( 1)(1 )(2 1) < 0. Thus (0 , , ) <

(, , ).

34
 We then compare (0 , , ) and (0 , , ).

(0 , , ) (0 , , )

= ( ){( 1)(1 ) + 0 [2 1 ( + 1)]

+[( + 1) ] ( 1)0 } (A-7)

2+1
Since [0 , 0 ] (+1 , 1 ), when (+1 ) < 1 , or, equivalently, < 2(+1),

2+1
0 < +1. Otherwise when 2(+1), 0 < 1 .

2+1
When < 2(+1),

[( + 1) ] ( 1)0

= [( + 1) ( 1)0 ]

The coefficient of ,

(1)
( + 1) ( 1)0 > ( + 1) ( 1) = 2 + =
+1 +1

2 +1 > 0. Therefore [( + 1) ] ( 1)0 < 0.

( 1)(1 ) + 0 [2 1 ( + 1)]

< ( 1)(1 ) + +1 [2 1 ( + 1)]

(2+1)
= 2( ) +1
.

1 2+1 (2+1) 2+1 1 (2+1) 2+1

Since 2 < < 2(+1), 2( ) < 2 2(+1) 2 = 2(+1) < 0.
+1 +1

Therefore ( 1)(1 ) + 0 [2 1 ( + 1)] < 0 and (0 , , )

(0 , , ) < 0.

2+1
When 2(+1), The coefficient of ,

35
 ( + 1) ( 1)0 > ( + 1) ( 1)(1 ) = 2 (2 1) > 0 as

2+1 21
2(+1) > 2
.

( 1)(1 ) + 0 [2 1 ( + 1)]

< ( 1)(1 ) + (1 )[2 1 ( + 1)]

21
= 2(1 ) 2
< 0

2+1 21
as 2(+1) > 2
. Therefore we have (0 , , ) (0 , , ) < 0.

Thus (0 , , ) is always the smallest. Moreover, = 0 always results in the

decision rule of continuing at both ( , ) and ( , ). Thus, the optimal solution is = 0,

i.e. non-accounting information is conservative.

We now consider the case > 0. Recall that the two inequalities concerning the termination

(continuation) condition at ( , ) and ( , ) are

[( + 1) 1] + [( + 1) ] + ( 1) > (<)( 1)(1 ) (A-4)

and

[( + 1) ] + [( + 1) 1] + ( 1) > (<)( 1)(1 ), (A-5)

respectively.

We divide the discussion into cases:

Case b1: When 0 < . Note that the left-hand side of (A-4) minus the left-hand side of (A-

5) is equal to ( 1)( ). Thus, if 0 < the left-hand side of (A-4) is always smaller than

the left-hand side of (A-5). We further divide the discussion into subcases.

Case b1(i): When [( + 1) ]0 + [( + 1) 1] + ( 1)0 < ( 1)(1

). In this case, the left-hand side of (A-5) is always smaller than the right-hand side. Since the

left-hand side of (A-4) is always smaller than the left-hand side of (A-5), it must be that the left-

36
hand side of (A-4) is always smaller than the right-hand side. Thus, the decision will always be

continuation when observing both ( , ) and ( , ), resulting in the decision error of

(, , ). Since (, , ) is always increasing in , we should choose = 0 , i.e. non-

accounting information should be conservative.

Case b1(ii): When [( + 1) ]0 + [( + 1) 1] + ( 1)0 > ( 1)(1

) > [( + 1) 1]0 + [( + 1) ] + ( 1)0 . In this case the left-hand side of (A-

5) is greater than the right-hand side at = 0 but the left-hand side of (A-4) is smaller than the

right-hand side at = 0 . Thus, the left-hand side of (A-4) is always smaller than the right-hand

side, resulting in always continuing at ( , ). At = 0 , the left-hand side of (A-5) is greater

than the right-hand side, resulting in termination at ( , ). However, when becomes smaller,

it is possible that the left-hand side of (A-5) is smaller than the right-hand side, resulting in

continuation at ( , ). We thus need to compare the decision error of (, , ) with the

(possible) decision error of (, , ). Note that (, , ) goes to its minimum at = 0

whereas (, , ) does so at = 0 . We thus need to compare (0 , , ) and

(0 , , ). Recall that

(0 , , ) (0 , , )

= ( ){( 1)(1 ) + 0 [2 1 ( + 1)]

+[( + 1) ] ( 1)0 } .

Note that since > +1, 2 1 ( + 1) < ( + 1) 1. Thus

( 1)(1 ) + 0 [2 1 ( + 1)] + [( + 1) ] ( 1)0

< ( 1)(1 ) + 0 [( + 1) 1] + [( + 1) ] ( 1)0

< ( 1)(1 ) + 0 [( + 1) 1] + [( + 1) ] + ( 1)0 < 0

37
 where the last inequality is due to the fact that ( 1)(1 ) + 0 [( + 1) 1] +

[( + 1) ] + ( 1)0 is the left-hand side of (A-4) evaluated at = 0. Therefore in

this case the optimal solution is = 0, i.e. conservative bias if the left-hand side of (A-5) is

smaller than the right-hand side when = 0 , i.e. [( + 1) ]0 + [( + 1) 1]

( 1)0 < ( 1)(1 ). If this inequality is not satisfied, then = 0 is optimal.

Case b1(iii): when [( + 1) 1]0 + [( + 1) ] + ( 1)0 > ( 1)(1

). In this case both the left-hand sides of (A-4) and (A-5) are greater than their right-hand sides

when evaluated at = 0 . This results in termination at both ( , ) or ( , ) when = 0.

Also note that the left-hand side of (A-4) is always smaller than that of (A-5). Thus there are

three possibilities when becomes smaller: 1) both the left-hand sides of (A-4) and (A-5) are

greater than their right-hand sides, resulting in termination at both ( , ) or ( , ); 2) both the

left-hand sides of (A-4) and (A-5) are smaller than their right-hand sides, resulting in

continuation at both ( , ) or ( , ); 3) only the left-hand side of (A-4) is smaller than the

right-hand side, resulting in continuation at ( , ) but termination at ( , ).

For possibility 1) we only have (, , ), which achieves its minimum at = 0 , so

that aggressive bias is optimal.

For possibility 2) we need to compare (, , ), (, , ) and the summation of

decision errors under continuation at ( , ) but termination at ( , ), denoted as (, , ).

Recall that (, , ) goes to its minimum at = 0 and (, , ) at = 0 . From above

(0 , , ) (0 , , )

= ( ){( 1)2(1 ) + ( 1)0 + ( + 1)(2 1)}

Note that ( 1)2(1 ) + ( 1)0 < 0 but ( + 1)(2 1) > 0. Thus

(0 , , ) (0 , , ) increases with . Also, when 1 and 0 1 ,

38
( 1)2(1 ) + ( 1)0 + ( + 1)(2 1) 2(1 )(2 1) > 0. This implies

that (0 , , ) (0 , , ) will be positive when > (0 , ) where (0 , ) =

(1)2(1)(1)0
(+1)(21)
. Clearly we also need 0 to be sufficiently large.

Under this possibility there also exists an , [0 , 0 ] such that the project is

continued at ( , ) but terminated at ( , ) when , .

The decision error can be calculated as

(, , ) = ( )( | ) + ( )( | )

= ( )( | ) + ( | )

= ( )[1 + + (1 )]

= ( )[( + 1)(1 ) ( 1)]

Note that (, , ) is independent of . Thus any , generates the same decision

error. We now compare (0 , , ) and (, , ):

(0 , , ) (, , )

= ( ){( 1)(1 ) 0 [( + 1) 1] [( + 1) ] ( 1)0 }

Note that since it is optimal to terminate at ( , ) when = 0 , [( + 1) 1]0 +

[( + 1) ] + ( 1)0 > ( 1)(1 ), resulting in (0 , , ) (, , ) <

0. Thus, under this possibility, either > (0 , ) when = 0 is optimal or < (0 , )

when = 0 is optimal.

For possibility 3) the comparison is between (0 , , ) and (, , ).We have already

shown that (0 , , ) (, , ) < 0. Thus, under this possibility = 0 is optimal.

As a summary of case b1, = 0 is optimal when [( + 1) ]0 + [( + 1)

1] + ( 1)0 < ( 1)(1 ) or when [( + 1) ]0 + [( + 1) 1]

39
( 1)0 < ( 1)(1 ) < [( + 1) ]0 + [( + 1) 1] + ( 1)0 or

when [( + 1) 1]0 + [( + 1) 1] + ( 1)0 > ( 1)(1 ) but [( +

1) ]0 + [( + 1) 1] ( 1)0 < ( 1)(1 ) and < (0 , ), which

requires and 0 to be sufficiently small. For all other cases, aggressive bias is optimal.

Case b2: When 0 . Note that in this case the left-hand side of (A-4) is greater than the

left-hand side of (A-5) when [, 0 ]. We further divide the discussion into sub-cases.

Case b2(i): When [( + 1) 1]0 + [( + 1) ] + ( 1)0 < ( 1)(1

). In this case, both left-hand sides of (A-4) and (A-5) are always smaller than their right-hand

sides for all . This results in the optimal decision rule being always to continue under both

( , ) and ( , ). Thus the decision error is (, , ). Since (, , ) is always

increasing in , we should choose = 0 , i.e. non-accounting information should be

conservative.

Case b2(ii): When [( + 1) 1]0 + [( + 1) ] + ( 1)0 > ( 1)(1

) > [( + 1) ]0 + [( + 1) 1] + ( 1)0 . In this case the left-hand side of (A-

4) is greater than the right-hand side at = 0 but the left-hand side of (A-5) is smaller than the

right-hand side at = 0 . Thus, the left-hand side of (A-5) is always smaller than the right-hand

side, resulting in always continuing at ( , ). At = 0 , the left-hand side of (A-4) is greater

than the right-hand side, resulting in termination at ( , ). However, when becomes smaller,

it is possible for the left-hand side of (A-4) to be smaller than the right-hand side, resulting in

continuation at ( , ). In fact, since the left-hand side of (A-4) is smaller than the left-hand side

of (A-5) when < , the project will be continued at both ( , ) and ( , ) at least when

< . We thus need to compare the decision errors of (, , ) and (, , ). Note that

40
 (, , ) is a constant of whereas (, , ) goes to its minimum at = 0 . We thus

need to compare (, , ) and (0 , , ). Note that

(0 , , ) (0 , , )

= ( ){( 1)(1 ) 0 [( + 1) ]

+[( + 1) 1] ( 1)0 } < 0.

The reason is that ( 1)(1 ) 0 [( + 1) ] +[( + 1) 1]

( 1)0 is the left-hand side of (A-5) minus the right-hand side of (A-5) evaluated at

= 0 . Since the left-hand side of (A-5) is always smaller than the right-hand side of (A-5),

( 1)(1 ) 0 [( + 1) ] +[( + 1) 1] ( 1)0 < 0 and

(0 , , ) < (, , ).

Therefore in this case the optimal solution is = 0 , i.e. conservative bias if the left-hand

side of (A-4) is smaller than the right-hand side when = 0.

Case b2(iii): when [( + 1) ]0 + [( + 1) 1] + ( 1)0 > ( 1)(1

). In this case both the left-hand sides of (A-4) and (A-5) are greater than their right-hand sides

when evaluated at = 0 . This results in termination at both ( , ) and ( , ) when = 0.

Also note that the left-hand side of (A-4) is greater (smaller) than that of (A-5) when > (<).

Hence, there are four possibilities when becomes smaller: 1) both the left-hand sides of (A-4)

and (A-5) are always greater than their right-hand sides, resulting in termination at both ( , )

or ( , ) for all ; 2) both the left-hand sides of (A-4) and (A-5) are smaller than their right-

hand sides, resulting in continuation at both ( , ) or ( , ); 3) only the left-hand side of (A-

4) is smaller than the right-hand side, resulting in continuation at ( , ) but termination at

( , ); 4) only the left-hand side of (A-5) is smaller than the right-hand side, resulting in

continuation at ( , ) but termination at ( , );

41
 For possibility 1) we only have (, , ), which has its minimum at = 0 , so that in

this case aggressive bias is optimal.

For all the other possibilities we need to compare (, , ), (, , ), (, , ) and

(, , ). Recall that (, , ) has its minimum at = 0, (, , ) and (, , )

has its minimum at = 0 and (, , ) is a constant of . From the above, (0 , , ) <

(, , ) and (0 , , ) < (0 , , ). Thus we only need to compare (0 , , ) and

(0 , , ). Since the expression of (0 , , ) and (0 , , ) is the same, the

conclusion will be the same as above. So under this possibility, either > (0 , ) when

= 0 is optimal or < (0 , ) when = 0 is optimal.

As a summary of case b2, when 0 , = 0 is optimal if either

[( + 1) 1]0 + [( + 1) ] + ( 1)0 < ( 1)(1 )

or

[( + 1) 1]0 + [( + 1) ] + ( 1)0 > ( 1)(1 ) > [( + 1)

]0 + [( + 1) 1] + ( 1)0

or

[( + 1) ]0 + [( + 1) 1] + ( 1)0 > ( 1)(1 ) and <

(0 , ). For all other cases = 0 is optimal.

Overall, when > 0, = 0 is optimal if

( 1)(1 ) > min([( + 1) 1]0 + [( + 1) ] + ( 1)0 , [( +

1) ]0 + [( + 1) 1] + ( 1)0 )

or if

[( + 1) ]0 + [( + 1) 1] ( 1)0 < ( 1)(1 ) <

[( + 1) ]0 + [( + 1) 1] + ( 1)0

42
 or if

( 1)(1 ) <

min([( + 1) 1]0 + [( + 1) ] + ( 1)0 , [( + 1) ]0 +

[( + 1) 1] + ( 1)0 ) but < (0 , ). Note that all of these inequalities require

0 and to be sufficiently small, or, equivalently, < (0 , ) and 0 < for some and .

Otherwise, = 0 is optimal when 0 and are sufficiently large.

Proof of Lemma 5:

Again we prove only the first part. When = 0, equations (A-4) and (A-5) now become

[( + 1) 1] > (<)( 1)(1 ) (A-8)

and

[( + 1) ] > (<)( 1)(1 ), (A-9)

since ( + 1) > ( + 1) 1. We can divide our discussion into the following three

cases:

Case 1, when [( + 1) ] > ( 1)(1 ). This results in both the left-hand sides

of (A-8) and (A-9) being greater than the right-hand sides, thus termination when observing both

( , ) and ( , ). The summation of errors is thus (, 0, ) = ( ){2(1 ) +

( 1)(1 2 ) [( + 1) 1]}. Clearly this is decreasing in and has its minimum at

= 0 , resulting in (0 , 0, ) = ( ){2(1 ) + ( 1)(1 2 ) 0 [( + 1)

1]}. Note that we also require [( + 1) ]0 > ( 1)(1 ).

Case 2, when [( + 1) ] < ( 1)(1 ) < [( + 1) 1]. This results in the

left-hand side of (A-8) being greater than its right-hand side but the left-hand side of (A-9) being

smaller than its right-hand side. As a result, the project is terminated when observing ( , ) but

continued when observing ( , ). The summation of errors is thus (, 0, ) = (

43
 )[( + 1)(1 ) ( 1)]. Since (, 0, ) is increasing in 0 it is minimized when

= 0 , resulting in (0 , 0, ) = ( )[( + 1)(1 ) ( 1)0 ]. Note that we

also require [( + 1) ]0 < ( 1)(1 ) < [( + 1) 1]0

Case 3, when [( + 1) 1] < ( 1)(1 ). This results in both the left-hand sides

of (A-8) and (A-9) being smaller than their right-hand sides. Hence, the project is continued

when observing both ( , ) and ( , ). The summation of errors is thus

(, 0, ) = ( ){2(1 ) + ( 1)(1 )2 + [( + 1) ]}

Since (, 0, ) is decreasing in 0 it is minimized when = 0 resulting in

(0 , 0, ) = ( ){2(1 ) + ( 1)(1 )2 0 [( + 1) ]}. Note that

= 0 satisfies the constraints for case 3.

Now we compare decision errors among various cases.

(0 , 0, ) (0 , 0, ) = ( )[( 1)2(1 ) + ( 1)0 ] < 0

as ( 1)0 < ( 1)(1 ) < ( 1)2(1 ).

(0 , 0, ) (0 , 0, ) = ( ){( 1)(1 ) + 0 [(2 1) ( + 1)]}

2+1
Since [0 , 0 ] (+1 , 1 ), when (+1 ) < 1 , or, equivalently, < 2(+1),

2+1
0 < +1. Otherwise when 2(+1), 0 < 1 .

2+1
When < 2(+1),

( 1)(1 ) + 0 [2 1 ( + 1)]

< ( 1)(1 ) + +1 [2 1 ( + 1)]

(2+1)
= 2( ) +1
.

44
 1 2+1 (2+1) 2+1 1 (2+1) 2+1
Since 2 < < 2(+1), 2( ) < 2 2(+1) 2 = 2(+1) < 0.
+1 +1

Therefore ( 1)(1 ) + 0 [2 1 ( + 1)] < 0 and (0 , , )

(0 , , ) < 0.
2+1
When 2(+1),

( 1)(1 ) + 0 [2 1 ( + 1)]

< ( 1)(1 ) + (1 )[2 1 ( + 1)]

21
= 2(1 ) 2
< 0

2+1 21
as 2(+1) > 2
. Therefore we have (0 , , ) (0 , , ) < 0.

Thus (0 , , ) is always the smallest. Moreover, = 0 always results in the

decision rule of continuing at both ( , ) and ( , ). Thus, the optimal solution is = 0,

i.e. non-accounting information should be conservative.

Proof of Corollary 1:

We prove only the first half; the proof of the second half is analogous. Suppose investor

observes . Then he will continue when observing ( , ) and may choose to terminate when

he observes ( , ). Lemma 2 states that he will continue when observing ( , ) if + < 0

but terminate when he observes ( , ) if + > 0.

The decision error of continuing when observing ( , ) is

1 (, ) = ( )[( , | ) + ( , | )]

= ( )( | ) = ( )(1 + )

which is independent of . Thus, so long as < , for any , 1 (, ) = ( )(1

+ ).

The decision error of terminating when observing ( , ) is

45
 1 (, ) = ( )( , | ) + ( )( , | )

= ( )[( , | ) + ( , | )]

= ( )[(1 + )(1 + ) + ( + )(1 )]

= ( )[1 + 2(1 ) (2 1)]

Thus, 1 (, ) is decreasing in and will achieve its minimum whenever = 0 . Thus, so

long as 0 , 1 (, ) has its minimum at 1 (0 , ) = ( )[1 + 2(1 )

0 (2 1)].

We now compare the decision errors.

1 (, ) 1 (0 , ) = ( )(2 1)(0 + ) > 0. Thus, so long as 0 , the

optimal bias is = 0; that is, the bias should be aggressive.

Proof of Proposition 2:

For convenience I rewrite Program B here.

Program B:

{,(,,),} (, , )
(,)(,,)

+ [( |, , ) + ( |, , )](, , )
(,)(,,)

. .

(,)(,,)[ + ( )( |, , )](, , ) (IR)

(,)(,,)[ + ( )( |, , )](, , ) (IC)

= (Rational Expectations)

First note that (IR) must be binding, as otherwise we could decrease all payments to the

manager by the same amount without violating any of the constraints. Thus {(,)(,,)[ +

46
( )( |, , )](, , ) = . Inserting this into the objective function, the objective

function now becomes

(,)(,,) (, , ) + (,)(,,)[ + ( |, , ) + ( |, , )](, , ) .

Given , for any and , the investor either chooses to liquidate and get or chooses

to continue and get [ + |, ] . Clearly liquidation (continuation) is optimal for those

(, ) s.t. [ + |, ] < (>) . This implies that the optimal decision rule results in

(, , ) = {(, ): [ + |, ] < } and that (, , ) = {(, ): [ + |, ] > }.

Finally, we look at the (IC) constraint to solve for the optimal . From the optimal

decision rule we can write the objective function in the (IC) constraint as

{(,):[+|,]>}[ + ( )( |, , )](, , )

= {(,):[+|,]>}[( |, , ) + ( + )( |, , )](, , ).

(,| ,)
Using Bayes Rule, ( |, , ) = for = , . Inserting this into the above
(,,)

expression, we have

{(,):[+|,]>}[( |, , ) + ( + )( |, , )](, , )

= {(,):[+|,]>} (, | , ) + {(,):[+|,]>} ( + )(, | , )

Since [( + )|, ] is increasing in , (, , )contains high values of and . By

assumption, ( , ) does not belong in (, , ). Since higher values of increases ( | )

and ( | ), it can be verified that for any (, , ) that excludes ( , ), both terms of the

last expression are increasing in and the first term is strictly increasing. We thus have the

objective function strictly increasing in , resulting in = = .

47
 As a summary, the optimal decision rule is such that the project is continued (terminated)

whenever the accounting report and the managers report are such that [( + )|, ] < (>

) and = . Proposition 3 is thus proved.

48
Figure 1. Timeline of the model

49