Accounting conservatism and bankruptcy

Abstract

This paper examines the relationship between accounting conservatism and bankruptcy. With 52,203 firm-year observations for 8,051 individual firms during 1986-2003, we show that accounting conservatism assists in predicting financial distress. All three different conservatism proxies (GAAP-mandated, accrual-based and market-bsed measures) provide significant and meaningful information for default forecasting. Firms with less conservatism are more likely to experience bankruptcy. Our findings support the economic role of conservatism and provide critical information regarding the debate whether conservatism should be eliminated in financial accounting.