Conservative Accounting, Audit Quality, and Litigation

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