Is Accounting Conservatism Due to Debt or Share Markets? A Test of “Contracting” Versus “Value Relevance” Theories of Accounting

We provide a simple comparative test of contracting and value relevance theories of accounting, using data on the importance of countries’ debt and equity markets. Contracting (debt markets) theory predicts conditional conservatism, in the Basu (1997) sense of asymmetrically timelier loss recognition than gain recognition, as proxied by a stronger relation between earnings and negative returns. Contracting theory also predicts that the degree of asymmetry increases in the importance of a country’s debt markets, but not in the importance of equity markets. In contrast, value relevance (stock markets) theory suggests a symmetric and strong relation between earnings and returns, regardless of the sign of returns. Furthermore, contracting theory predicts that unconditional conservatism, in the sense of unconditionally low earnings and book values, does not increase contracting efficiency, and thus is unrelated to debt market importance. Data from a small cross-sectional sample of 22 countries are consistent with these predictions.