Accounting conservatism among firms: Cross -sectional tests of the litigation and contracting cost hypothesis

This study distinguishes the effects of litigation and contracting costs on accounting conservatism from a set of competing factors, by cross-sectional tests at the firm level. Using a book value measure and an accruals measure of conservatism, I find that firms with greater litigation risks and auditor liabilities and firms with stronger equity and debt governance mechanisms tend to choose a higher level of accounting conservatism. These results obtain while controlling for factors discouraging conservatism (both market- and contracting-based incentives for overstatements) and other factors encouraging conservatism (regulation costs and tax savings). The results are robust to alternative measures, samples, and specifications, including a simultaneous equation system that controls for endogeneity. The findings provide evidence at the firm level that litigation and contracting costs are both important factors that influence firms' choices of conservatism level, even with the presence of other factors influencing conservatism.