55 Pages Posted: 27 Jun 2016 Last revised: 6 Sep 2017
Date Written: September 5, 2017
In this study, we exploit exogenous variations in auditor conservatism arising from staggered changes in state-level auditor legal liability and examine whether an increase in auditor conservatism leads to adverse real effects. We hypothesize that conservative auditors constrain managerial ability to meet earnings thresholds and that managers in turn resort to real earnings management. Using a difference-in-differences regression approach with firm fixed effects and a neighboring-state matched-sample design, we find evidence that an increase in auditor conservatism induces managers to engage in greater myopic R&D underinvestment as well as other forms of real activities manipulations in an attempt to meet earnings thresholds. Importantly, we find that the effect of auditor conservatism on myopic R&D underinvestment as well as other forms of real earnings management is greater when the ex-ante incentives to meet earnings thresholds are stronger. Our findings are robust to alternative explanations, changes in sample periods, alternative measures of innovation, and a battery of other sensitivity tests.
Keywords: Auditor conservatism; Auditor litigation; Innovation; Real effects; State liability laws; Patents; R&D; Going-concern opinions; Earnings management; Real earnings management
JEL Classification: M41, O31, O32, G31, G38
Suggested Citation: Suggested Citation
Chy, Mahfuz and Hope, Ole-Kristian, Real Effects of Auditor Conservatism (September 5, 2017). Rotman School of Management Working Paper No. 2801183. Available at SSRN: https://ssrn.com/abstract=2801183 or http://dx.doi.org/10.2139/ssrn.2801183