Conservative Accounting, Audit Quality, and Litigation

42 Pages Posted: 5 Aug 2016 Last revised: 28 Nov 2020

See all articles by Sebastian Kronenberger

Sebastian Kronenberger

University of Mannheim

Volker Laux

University of Texas at Austin - McCombs School of Business

Date Written: November 23, 2020

Abstract

Investors are much more likely to sue corporations and their auditors for overstated earnings reports than for understated reports. This asymmetry in litigation exposure is viewed as an important driver for conservative accounting practices in corporations because conservatism reduces the probability of overstatements and hence investor litigation. This argument is incomplete, however, because it ignores that litigation concerns also affect the incentives of the auditor, which, in turn, affect the firm's optimal reporting system. We find that the threat of litigation encourages firms to report more conservatively only when the cost of auditing is relatively high, but promotes less conservative reporting when the cost of auditing is low.

Keywords: Accounting Conservatism, Litigation, Audit Quality

Suggested Citation

Kronenberger, Sebastian and Laux, Volker, Conservative Accounting, Audit Quality, and Litigation (November 23, 2020). Available at SSRN: https://ssrn.com/abstract=2818038 or http://dx.doi.org/10.2139/ssrn.2818038

Sebastian Kronenberger

University of Mannheim ( email )

Mannheim, 68161
Germany

Volker Laux (Contact Author)

University of Texas at Austin - McCombs School of Business ( email )

2317 Speedway
Austin, TX 78712
United States

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