Accounting Conservatism and Real Options

I address the interaction between accounting conservatism and real options in both a staged investment and abandonment model. An accounting policy biased toward classifying a Good (Bad) project as Bad (Good) is conservative (aggressive). The accounting signal is optimally conservative when the ex ante unconditional expected terminal value is less than the second investment (staged investment) or value of the asset in its alternative use (abandonment). The relative size of the second investment is a proxy for the degree of sequentiality of the project. Because research and development projects typically require more sequential investment than fixed assets projects, the staged investment results are consistent with the differential treatment of these types of investment under U.S. Generally Accepted Accounting Principles.