Accounting Conservatism and Its Role in Earnings Management

Abstract

This study investigates the role of accounting conservatism in constraining earnings management, employing a mixed-methods approach that integrates quantitative analysis of archival data with qualitative evidence from practitioner interviews. Using a panel of international firms between 2015 and 2022, conditional conservatism was measured through Basu’s asymmetric timeliness model, while accrual-based and real earnings management were assessed using the modified Jones and Roychowdhury models, respectively. The results reveal that conservatism significantly reduces accrual-based earnings manipulation by limiting managers’ discretion over income-increasing accruals. However, the findings also show a substitution effect, whereby managers increase reliance on real activity manipulation under stronger conservative regimes, particularly through adjustments to production and discretionary expenditures. Qualitative evidence further highlights that managers and auditors perceive conservatism as both a safeguard that enhances financial credibility and a reporting burden that restricts flexibility, particularly in conveying positive performance and pursuing innovation. Additionally, the study finds that conservatism enhances resilience during economic uncertainty, as observed during the COVID-19 period, but may simultaneously contribute to underinvestment in high-risk, long-term projects. Overall, the results demonstrate that conservatism acts as a governance tool with both benefits and limitations, constraining opportunism in one dimension while reshaping it in another. The integrated findings suggest that regulators and practitioners must carefully calibrate the use of conservatism to balance reliability, relevance, and managerial incentives in financial reporting.