This paper examines how various revenue recognition rules affect the incentive properties of accounting information in a stewardship setting. Our analysis demonstrates that if revenues are recognized according to the realization principle, a single performance measure based on aggregated accounting information can be used to provide desirable production and effort incentives to the manager. In contrast, mark‐to‐market accounting does not provide efficient aggregation of raw information to solve the stewardship problem. Mark‐to‐market accounting, though sensible from a valuation perspective, fails to provide desirable incentives because it relies on the anticipated, rather than the actual, performance of the manager. We also consider a setting in which the manager can control the timing of the firm’s sales. It then becomes desirable to modify the realization principle and apply the lower‐of‐cost‐or‐market valuation rule. The desirable accounting thus exhibits a conservative bias.

When a firm practices conservative accounting, changes in the amount of its investments can affect the quality of its earnings. Growth in investment reduces reported earnings and creates reserves. Reducing investment releases those reserves, increasing earnings. If the change in investment is temporary, then current earnings is temporarily depressed or inflated, and thus is not a good indicator of future earnings. This study develops diagnostic measures of this joint effect of investment and conservative accounting. We find that these measures forecast differences in future return on net operating assets relative to current return on net operating assets. Moreover, these measures also forecast stock returns—indicating that investors do not appreciate how conservatism and changes in investment combine to raise questions about the quality of reported earnings.