Product Market Competition and Accounting Conservatism

Abstract

This study examines the relation between product market competition and accounting conservatism. Extant research offers three reasons why intense competition can lead to more timely recognition of economic losses in accounting income. First, intense product market competition improves the flow of firm-specific information and hence limits managers' ability to conceal bad news. Second, product market competition, by increasing liquidation risk, contributes to a firm's demand for accounting conservatism to achieve more efficient contracting. For instance, it allows for better debt contracting and hence enables firms in a competitive setting to obtain funds at a lower cost. Third, intense product market competition induces greater demand for conservatism because sub-optimal managerial decisions contrary to shareholders' interest can quickly lead to costly firm liquidation. Timely loss recognition serves to discourage negative net present value investments and to encourage quicker abandonment of loss-making projects. An alternative prediction is that product market competition reduces the severity of agency conflicts and hence limits the demand for accounting conservatism. We attempt to shed light on the competing views by investigating the association between product market competition and the asymmetric timeliness of economic loss recognition. Using a sample of 99,315 firm-year observations over the period 1964-2006, we find asymmetric timeliness of economic loss recognition to increase with the intensity of product market competition. Moreover, this relation is not qualitatively affected by the inclusion of various controls for the demand for conservatism, in particular, managerial ownership. We also find an inter-temporal increase in asymmetric timely recognition of economic losses following industry deregulation. Overall, our evidence points to a relation between product market competition and properties of accounting numbers.