Accounting Conservatism and Bankruptcy Risk
Gary C. Biddle
The University of Hong Kong
City University of Hong Kong
Mary L. Z. Ma
Frank M. Song
The University of Hong Kong - School of Economics and Finance
July 29, 2015
This study examines the relation between accounting conservatism and bankruptcy risk using a large sample of U.S listed firms from fiscal year 1989 to 2007. We present evidence that unconditional and conditional conservatism generally mitigate subsequent bankruptcy risk by creating cushions for bad times and reducing information asymmetry about bad news. We identify two channels for accounting conservatism to mitigate bankruptcy risk: enhancing cash holdings and constraining earnings management. The effect of accounting conservatism does not change for firms with extreme distress and income smoothing, but weakens for firms with debt contracts referenced by credit default swaps (CDS), consistent with CDS lowering debtholder monitoring. Results are robust to reverse causality, relations between unconditional and conditional conservatism, and alternative measures of bankruptcy risk and accounting conservatism. These findings extend research on accounting conservatism, bankruptcy risk and debt contracting, and help inform debates regarding conservatism’s role as a pervasive property and long-standing tenet of financial accounting.
Number of Pages in PDF File: 55
Keywords: Accounting conservatism, bankruptcy risk, unconditional conservatism, conditional conservatism
JEL Classification: M41, G32, G33
Date posted: June 6, 2010 ; Last revised: September 29, 2015
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