Conservative Accounting, Audit Quality, and Litigation

Sebastian Kronenberger () and Volker Laux ()
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Sebastian Kronenberger: Area Accounting and Taxation, University of Mannheim, 8131 Mannheim, Germany
Volker Laux: McCombs School of Business, University of Texas at Austin, Austin, Texas 78705

Management Science, 2022, vol. 68, issue 3, 2349-2362

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 auditor’s cost of detecting misstatements is relatively high but promotes less conservative reporting when the auditor’s cost of auditing is low.

Keywords: conservative accounting; litigation; audit quality (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (2)

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