Product Market Competition and Conditional Accounting Conservatism

In this paper, we empirically evaluate two views on the relation between product market competition and conditional accounting conservatism. One view is that intense product market competition increases bankruptcy risk and consequently, exacerbates shareholder-bondholder conflict of interest and enhances the likelihood of litigation. In response, both bondholders and auditors demand a higher level of accounting conservatism. Under the second view, intense competition induces managers to strive to maximize firm profits, aligning the interests of both shareholders and bondholders and reducing auditor litigation risk. As such, it effectively reduces the demand for conditional conservatism. To disentangle which view is best supported by data, we conduct empirical tests using a sample of 99,315 firm-year observations covering the time period 1964-2006. Our results show a positive association between product market competition and accounting conservatism, which is consistent with more intense competition heightening litigation risk and bondholder-shareholder conflict of interest and as such, inducing greater demand by auditors and bondholders for more conservatism. Our findings are robust to the inclusion of a range of factors that have been identified to affect the demand for accounting conservatism. To further identify the causal relation, we assess and find an inter-temporal increase in accounting conservatism following industry deregulation. Overall, our evidence highlights the impact of product market competition on accounting properties. Prior research has highlighted the increase in the intensity of product market competition over the last four decades. Our findings suggest this increase in product market competition could also be viewed as a contributing factor to the increase in conditional accounting conservatism over time.