The Market for Corporate Control and Accounting Conservatism

Abstract

This study explores the governance role of accounting conservatism by investigating changes in financial reporting conservatism before and after the passage of state anti-takeover laws. Passage of these laws introduced an exogenous shock to the takeover threat faced by firms and constitutes a natural experiment for investigating the relation between financial reporting and governance free of endogeneity concerns. Employing a difference-in-differences methodology, we find that conditional accounting conservatism increased significantly after the passage of state anti-takeover legislation consistent with accounting conservatism acting as a substitute internal governance mechanism for the weakened external governance environment. We further conjecture and document that the resulting increase in conservatism is greater for firms operating in less competitive industries, firms with superior managers, and firms with lower institutional ownership. This evidence sheds light on how the financial reporting system interacts with corporate governance mechanisms in alleviating potential agency problems. *Callen is at the Rotman School of Management, 105 St. George St., Toronto, M5S 3E6, Canada. Ph. 416-946-5641. e-mail :callen@rotman.utoronto.ca. Corresponding Author. **Guan is at the Faculty of Business, City University of Hong Kong, Kowloon, Hong Kong SAR, China. email:yyguan@cityu.edu.hk. ***Qiu is at the Degroote School of Business, McMaster University, and 1280 Main St., Hamilton, L8S 4L8, Canada. email: qiu@mcmaster.ca.