The Market for Corporate Control and Accounting Conservatism

Abstract

This study explores the governance role of accounting conservatism by investigating changes in financial reporting conservatism before and after the passage of state anti-takeover laws. Passage of these laws introduced an exogenous shock to the takeover threat faced by firms and constitutes a natural experiment for investigating the relation between financial reporting and governance free of endogeneity concerns. Employing a difference-in-differences methodology, we find that conditional accounting conservatism increased significantly after the passage of state anti-takeover legislation consistent with accounting conservatism acting as a substitute internal governance mechanism for the weakened external governance environment. We further conjecture and document that the resulting increase in conservatism is greater for firms operating in less competitive industries, firms with superior managers, and firms with lower institutional ownership. This evidence sheds light on how the financial reporting system interacts with corporate governance mechanisms in alleviating potential agency problems.

Keywords: conditional conservatism, corporate governance, state anti-takeover legislation, difference-in-differences

JEL Classification: M41