Is Accounting Conservatism Due to Debt or Equity Markets? An International Test of “Contracting” and “Value Relevance” Theories of Accounting

Acknowledgments We gratefully acknowledge the comments of Sudipta Basu, Christian Leuz and Jerry Zimmerman, the referee, and workshop participants at the Universities of Amsterdam and Chicago. We are grateful for financial support from the University of Chicago, Graduate School of Business. Abstract We provide a simple test of " costly 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, a proxy for which is greater sensitivity of earnings to negative returns than to positive returns. Contracting theory also predicts 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 (equity markets) theory implies 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 all of the predictions of " costly contracting " theory.