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An Evolutionary Risk Basis for the Differential Treatment of Gains and Losses

An Evolutionary Risk Basis for the Differential Treatment of Gains and Losses. Venky Nagar Madhav Rajan Korok Ray. Conservatism. Asymmetric Verification Standards Recognize probable losses Recognize surer gains. This study’s 3-step approach.

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An Evolutionary Risk Basis for the Differential Treatment of Gains and Losses

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  1. An Evolutionary Risk Basis for theDifferential Treatment of Gains and Losses Venky Nagar MadhavRajan Korok Ray

  2. Conservatism • Asymmetric Verification Standards • Recognize probable losses • Recognize surer gains

  3. This study’s 3-step approach • Individuals display risk-aversion in gains, but risk-tolerance in losses They prefer a sure gain to a gain gamble They prefer a loss gamble over sure loss • Preferences drive demand for verification More verification for probable gains Less verification for probable losses 3. Accounting responds to this demand Conservatism

  4. Prior Studies • Analytical studies • Empirical Studies • Reasoned conjectures on monitoring • Gigler et al. (2009) • Scott et al. (1926)

  5. An Evolutionary Problem in Two Parts • First, hunt for food • Second, prevent a stealer from stealing it • Private information on “strength” state of the hunter • Equilibrium outcome: • Conservative in hunting • Aggressive in defending the catch • Hard-wired preference

  6. Evolutionary Psychology • We house stone-age minds that are hardwired to solve evolutionary survival problems • How did this happen? • Gamma rays strike the earth • Errors in meiosis • Innate ability to deal with small numbers • Counting bears • Stock market • Is it all hocus-pocus? • God and the watchmaker

  7. Model Basics The hunt • Prey size y • Benefit of catch B(y) The steal • Producer type θ = {WEAK, TOUGH} • Producer info Perfect • Stealer info Correct with probability qs

  8. Timeline

  9. Equilibrium Results

  10. Preference Implications

  11. Back to the Modern World • What do the roles of stealer and producer mean today?

  12. Verification Implications

  13. Conservatism • Utility function concave over gains and convex over losses implies: • Higher verification standard for gains than losses

  14. Equilibrium Properties • Robust Nash Equilibrium • Evolutionarily stable • Hinges crucially on information asymmetry • Stealer does not know producer’s state as well as the producer does

  15. Information Sharing: Sharing is Caring

  16. Empirical Implications • Prior theory on conservatism • All about explicit contracting • Prior empirical research on conservatism • Anything but… • Private firms • R&D • Management ownership • SEO • Legal norms and institutions

  17. Our Interpretation • Information asymmetry between managers and investors • Sharing is caring • All cross-sectional variation in conservatism • Loss side

  18. Bushman and Piotroski

  19. Conclusion in Three Steps • Endogenous Preferences • Risk-aversion in gains, but risk-seeking in losses • Verification Implications • Lower verification standards in losses • Conservatism

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