Egyptian Russian University

Faculty of Management, Economic and Business Technology

Accounting conservatism and bankruptcy

Risk

Prepared by

Name ID
Ahmed Hossam EL Sayed 184098

Mohamed Mahmoud Shafeek 184010

Mohamed Mohamed Abdelgayed 184063
Ahmed Ayad Mohamed 184042
Thomas Ehab 184076

Accounting Department

Supervised by
Dr. Nehad Hosny Yusuf
Assistant Professor of Accounting
Introduction

1.Accounting conservatism
A set of bookkeeping guidelines that call for a high degree of verification before a company can
make a legal claim to any profit. The general concept is to factor in the worst-case scenario of a
firm’s financial future. Uncertain liabilities are to be recognized as soon as they are discovered.
In contrast, revenues can only be recorded when they are assured of being received.

Accounting conservatism is a principle that requires company accounts to be prepared with

caution and high degrees of verification.
All probable losses are recorded when they are discovered, while gains can only be registered
when they are fully realized.
If an accountant has two solutions to choose from when facing an accounting challenge, the one
that yields inferior numbers should be selected.

Generally Accepted Accounting Principles (GAAP) insist on a number of accounting

conventions being followed to ensure that companies report their financials as accurately as
possible. One of these principles, conservatism, requires accountants to show caution, opting for
solutions that reflect least favorably on a company’s bottom line in situations of uncertainty.
It is not intended to manipulate the dollar amount or timing of reporting financial figures. It is a
method of accounting that provides guidance when uncertainty and the need for estimation arise:
cases where the accountant has the potential for bias.

Accounting conservatism establishes the rules when deciding between two financial reporting
alternatives. If an accountant has two solutions to choose from when facing an accounting
challenge, the one that yields inferior numbers should be selected.
A cautious approach presents the company in a worst-case scenario. Assets and revenue are
intentionally reported at figures potentially understated. Liabilities and expenses, on the other
hand, are overstated. If there is uncertainty about incurring a loss, accountants are encouraged to
record it and amplify its potential impact. In contrast, if there is a possibility of a gain coming the
company's way, they are advised to ignore it until it actually occurs.
Accounting conservatism is most stringent in relation to revenue reporting. It requires that
revenues are reported in the same period as related expenses were incurred. All information in a
transaction must be realizable to be recorded. If a transaction does not result in the exchange of
cash or claims to an asset, no revenue may be recognized. The dollar amount must be known to
be reported.

Advantages of accounting conservatism

Overestimating gains and exaggerating losses means that accounting conservatism will always
report lower net income and lower future financial benefits. Painting a bleak picture of a
company's finances actually brings many benefits.

It clearly encourages management to exercise more caution in its decisions. It also means that
there is more scope for positive surprises, rather than disappointing turmoil, which are a major
factor in stock prices. Like all standardized methodologies, these rules should also make it easier
for investors to compare financial results across different industries and time periods.

Disadvantages of accounting conservatism

On the flip side, GAAP rules like conservatism in accounting can be open to interpretation. This
means that some companies will always find ways to manipulate them in their favor.
Another problem with conservatism in accounting is the possibility of transferring revenue. If the
transaction does not meet the reporting requirements, it must be reported in the next period. This
will lead to an underestimation of the current period and an overestimation of future periods,
making it difficult for the organization to track business operations internally.

Accounting conservatism may be applied to inventory valuation. When determining the reporting
value for inventory, conservatism dictates the lower of historical cost or replacement cost is the
monetary value.
Estimations such as uncollectable account receivables (AR) and casualty losses also use this
principle. If a company expects to win a litigation claim, it cannot report the gain until it meets
all revenue recognition principles.
However, if a litigation claim is expected to be lost, an estimated economic impact is required in
the notes to the financial statements. Contingent liabilities such as royalty payments or unearned
revenue are to be disclosed, too.
2.Bankruptcy risk
Bankruptcy risk refers to the possibility that a company will be unable to pay its debts, making it
insolvent; It is often caused by insufficient cash flows or excessive costs.
Investors and analysts can measure solvency with liquidity ratios, such as the current ratio, which
compares current assets to current liabilities.
When a public company files for bankruptcy, it can reorganize its operations, close its
operations, or sell its assets and use the proceeds to pay down its debts.

A company can fail financially due to cash flow problems resulting from inadequate sales and
high operating expenses. To address cash flow problems, the company may increase its short
term loans. If the situation does not improve, the company is at risk of bankruptcy or bankruptcy.
Basically, insolvency occurs when a company cannot meet its contractual financial obligations as
they fall due. Liabilities may include interest and principal payments on debt, payments on
accounts payable, and income taxes.
More specifically, a company is technically insolvent if it cannot meet its current obligations
when they fall due, even though the value of its assets exceeds the value of its liabilities. A
company becomes legally insolvent if the value of its assets is less than the value of its liabilities.
A company is considered finally bankrupt if it is unable to pay its debts and files for bankruptcy.

3.The relation between accounting conservatism and bankruptcy risk

This study investigates the relationships between accounting conservatism and bankruptcy risk,
and provides evidence that conservatism helps mitigate subsequent bankruptcy risk through cash
enhancement and restricted earnings management.
Bankruptcy risk, in turn, is negatively related to the province, which reflects the control of
auditors and regulators and the motives of administrative professionalism.
These results are robust for surrogate measures of bankruptcy risk, surrogate measures of
conservatism, its internal integration, and other controls.
Taken together, these findings indicate that conservatism influences and is affected by
bankruptcy risk, thus contributing to the ethics around conservatism and bankruptcy. This study
supports the traditional rationale for conservatism and helps inform ongoing debates about the
role of conservatism as a pervasive property and enduring central principle of financial
accounting.
The motives of this study are numerous, by examining the relationships between accounting
conservatism and bankruptcy risk, this study provides clues regarding the traditional logic of
conservatism. Historical evidence indicates that accounting conservatism arose at least a
thousand years ago in response to the demands of capital.

Providers inform lending and liquidation decisions and influence the risk of failure (Basu (1997,
2009), Watts (2003), De Ste. Croix (1956)).
Whereas many previous studies have examined how conservatism reduces the cost of debt in
both initial and ongoing lending contracts.

The evidence from this study can help inform current discussions by setters of accounting
standards regarding the continuing role of conservatism as an enduring principle of financial
accounting. In the Statement of Financial Accounting Concepts (SFAC), the Financial
Accounting Standards Board defines accounting conservatism as a prudent response to
uncertainty to ensure that uncertainty and risks inherent in business situations are adequately
taken into account” (Financial Accounting Standards Board (1980), p. 10).
This definition corresponds to the fact that reticence is closely related to the assessment of
bankruptcy risk. but, in the presentation draft of its Conceptual Framework for Financial
Reporting (FASB (2008)).
The FASB recently argued that conservatism may produce information asymmetry that reduces
investors' insights into future cash flows from growth options.

Based on this reasoning, the Financial Accounting Standards Board and the International
Accounting Standards Board (IASB) have proposed removing conservatism from their emerging
conceptual framework, arguing that “describing prudence or conservatism as a qualitative
characteristic or desirable response to uncertainty would conflict with the quality of impartiality”
(FASB (2008)), para. BC2.21). Kothari et. (2009).argue in contrast that the broader economic
consequences of accounting standards are of primary importance, while their role in the
valuation of equity is of secondary importance.

If accounting conservatism serves to reduce the risk of bankruptcy, it is also fundamental to the
interests of corporate stakeholders, including shareholders (dividends and capital gains),
creditors (payment), directors and employees (jobs and compensation to customers (products and
services), suppliers (sales), and governments (Tax revenues).
The recent financial crises have led to increased interest in the mechanisms of that promote cash
adequacy and solvency.
Given the transmissible effects of bankruptcy risk within industries, along supply chains, and
between the non-financial and financial sectors (Lange et al. (1992), Herzl et al. (2008), Gurion
et al. (2009)), evidence of relationships between conservatism and bankruptcy risk is a precursor
to assessing their role in mitigating panic and economic crises. with great repercussions for
various economic policies.

This study examines both contemporary associations and possible causal relationships between
conservatism and risk of bankruptcy. This reticence may influence subsequent bankruptcy risks
by enhancing the criticism, media characteristics, and historical evidence mentioned above.
Bankruptcy risk may, in turn, affect accounting conservatism which stems from the reasoning
that higher bankruptcy risk may prompt creditors, auditors and regulators to require more
conservative treatments to help preserve cash and enhance access to external capital, thus
reducing the risk of bankruptcy in the future.
Managers may in turn resist such requests to justify spending and portray more favorable
performance, at least until creditors, auditors, and regulators assert their control under conditions
of extreme distress (Rosner (2003), Demirkan and Platt (2008)), and their ability to do so.

Examination of whether province is associated with bankruptcy risk is motivated by prior

evidence indicating that province can play different roles in contracting, regulation, taxation,
valuation and in reducing information asymmetries (Ball and Shivakumar (2005), Qiang (2007,
2008)), as well as There is evidence that they are negatively associated in the short term and
positively associated in the long term (Roychowdhury and Watts (2007), Ball et al. (2009)).
Since managers may exercise greater control over conservativeness, at least in the short term,
and prefer anti-conservative therapies for career advancement (Watts (2003), Qiang (2007),
Kothari, Ramanna and Skinner (2009)), it becomes an empirical question to whether the
province is similarly associated with bankruptcy risk.

Additional recent evidence suggests that conservatism reduces asymmetry and information
uncertainty (Watts (2003), Guay and Verrechia (2007), Gox and Wagen Hofer (2010)) through
less optimistic reports of net income and assets and more timely reports of bad news.
This informational role of conservatism enhances cash flows and reduces bankruptcy risk
because better-informed creditors and investors are more likely to provide financing capital at a
lower cost.
A related empirical question is whether conservatism assumes additional importance under
conditions of extreme distress by facilitating negotiations and exercises between creditors and
corporations as alternatives to formal bankruptcy filing (Giammarino (1989), Mooradian (1994)).
By this reasoning, negative associations and causal relationships between conservatism and risk
of bankruptcy were projected, and highly distressed and bankrupt firms were examined
separately.
Recent studies also point to relationships between bankruptcy risk and accounting conservatism
that balance managers' interests with those of auditors, creditors, and regulators. If conservatism
mitigates the risk of bankruptcy, then a higher risk of bankruptcy may also increase the demand
for conservatism.

Indeed, evidence indicates that auditors and regulators (e.g., the U.S. Securities and Exchange
Commission (SEC)) pay particular attention to accounting conservatism as reflected in audits
required for periodic reporting, financial and legal functions, and reputational penalties for
noncompliance.
The associations between conservatism and bankruptcy risk examined in this study were reported
by recent research on monetary promotion and media roles in conservatism.
For example, recent findings indicate that accounting conservatism reduces cash outflows by
mitigating capital overinvestment, reducing risk transfer, enhancing precautionary savings, and
reducing agency costs (Lara et al. (2009b), Loktionov (2009), Lewis et al. (2009), Callen et al.
(2010), Kirschenheiter and Ramakrishnan (2010)).
Other evidence suggests that conservatism increases cash flows from operations by obtaining
better terms from suppliers and reducing investment shortfalls due to capital restrictions (Hui et
al. (2009), Lara et al. (2009b)). The conservatism-enhancing properties of cash should reduce
contemporary and subsequent bankruptcy risk, which is essentially a condition of insufficient
liquidity as formulated theoretically and empirically in finance (Kim et al. (1993), Uhrig
Homburg (2005), Campbell et al. (2008)).

Managers also weigh trade-offs between career advancement, which may benefit from
anticonservatism remedies, and disciplinary concerns, which may differ in accounting
conservatism. Disciplinary concerns are likely to dominate for managers because of close
monitoring and disciplinary risks; Where managers exercise more discretion over reporting bad
news (Qiang (2007)), occupational concerns may dominate, leading to disincentives to
conservatism with an increased risk of bankruptcy.
These projections were tested using USA observations for the confirmed year from 1989-2007
with available data on accounting conservatism, bankruptcy risk, and control variables.
Risk measures are a priori estimates derived from Merton (1974) and Campbell et al. (2008),
respectively, that allow tests of causal relationships between accounting conservatism and
bankruptcy risk.

For a large sample of listed US companies, accounting conservatism helps reduce the risk of
bankruptcy. They further found that the mitigating effect of accounting conservatism on
bankruptcy risk functions through cash enhancement and earnings management mitigation
channels. This guide is relevant to accounting standard setting, financial regulation, and financial
risk management, and helps explain the long-standing presence of conservatism as a pervasive
feature of financial accounting.

SOX Reporting Influence on Accounting Conservatism:

The Sabanes-Oxley (SOX) reporting requirements enacted in 2002 provide regulatory
intervention in maintaining accounting albeit with related and simultaneous effects on
bankruptcy risk. Lobo and Zhou (2006) and Iliev (2010) reported that SOX increased accounting
conservatism with Jha (2013) finding in contrast that SOX restricted managerial ability to use
accruals to ward off bond covenant violations.

Consider whether the observed relationships between accounting conservatism and bankruptcy
risk hold up under conditions of extreme stress. In distressed firms with high leverage, rights of
control may pass to debt holders who demand greater discretion to constrain managerial risk
incentives (Brockman et al. 2012) consistent with the mitigating effect of discretion on
bankruptcy risk.
However, in highly distressed companies, shareholders' implied purchase options on assets are at
or close to the money, and stock values increase as assets fluctuate.
If shareholder risk transfer incentives dominate, companies may have less incentive to use
discretion to mitigate the risk of bankruptcy. In addition, the going concern assumption in
accrual accounting is unlikely to apply in highly distressed companies, making accrual
accounting less relevant.

Income homogenization can be thought of as a type of “game of conservatism” in which

managers apply a higher degree of hedging during good times than they release in bad times,
with Smith and Stolz (1985) arguing that hedging against bankruptcy risk cools down and
Trueman and Titman (1988) arguing that simplifying Claimants reduce perceptions of
bankruptcy risk by reducing earnings volatility. To control for the effects of income homogeneity
on the observed negative relationships between accounting conservatism and bankruptcy risk.
LITERATURE REVIEW

In July 2011, a study was conducted by Gary C. Biddle and his colleagues to investigate the
correlation between accounting conservatism and bankruptcy risk. The study focused on how
accounting conservatism affects the risk of bankruptcy. The researchers found that there is a link
between the risk of bankruptcy and the practice of unconditional preservation that aligns with the
interests of auditors, investors, and regulators. The study revealed that monitoring by regulators
and auditors can lead to an increased demand for unqualified conservatism, which in turn
increases the risk of bankruptcy. This has similar effects on SOX regulations and auditor
resignations. The researchers also noted that the results of the study remained consistent even
under conditions of severe and actual distress.

The article "Accounting Conservatism and Bankruptcy" by Lee et al. (2012) explores the
relationship between the practice of accounting conservatism and the probability of bankruptcy
in Taiwanese listed companies. The authors define accounting conservatism as recognizing
losses and liabilities faster than gains and assets, which they argue can help in reducing the
probability of bankruptcy. They suggest that accounting conservatism can help to reduce the
agency costs between shareholders and creditors by providing accurate information about a
firm's financial position.
The authors conducted an empirical analysis using a sample of 63 Taiwanese firms that filed for
bankruptcy between 2003 and 2007 and a control group of 63 non-bankrupt firms. The study
found that bankrupt firms had lower levels of accounting conservatism than non-bankrupt firms,
and the level of accounting conservatism was negatively related to the likelihood of bankruptcy.
The study also shows that the negative relationship between conservatism and bankruptcy risk is
more pronounced for firms with higher growth opportunities and information asymmetry.

The study identifies two channels through which conservatism reduces bankruptcy risk: by
reducing overinvestment through timely loss recognition and by reducing debt covenant
violations by reporting lower asset values and earnings. The results suggest that accounting
conservatism can help reduce information risk and bankruptcy risk, and companies and
regulators may benefit from adopting more conservative accounting policies and procedures.

The study extends the generalizability of the implications of accounting conservatism by

focusing on an emerging market, and the results show that conservatism helps reduce bankruptcy
risk in non-US settings. The study provides a comprehensive analysis of how and why
accounting conservatism helps reduce the likelihood of bankruptcy, and the findings will be of
interest to both academics and practitioners.
Talebbeydokhti et al. (2013) examined the relationship between accounting conservatism and
bankruptcy risk for companies listed on the Tehran stock exchange. They collected data from
financial statements of 100 companies for the period of 2006-2011. To measure accounting
conservatism, the authors used the Ball and Shivakumar method, which is based on the premise
that conservatism is reflected in the timely recognition of losses and is measured using the
accruals model. To measure bankruptcy risk, they used the Altman index, which is a widely used
measure of bankruptcy risk that combines several financial ratios. The findings of the study
suggest that there is a negative relationship between accounting conservatism and bankruptcy
risk. This means that companies with higher levels of conservatism have lower levels of
bankruptcy risk. The authors suggest that this relationship can be attributed to the fact that
conservative accounting practices help to reduce information asymmetry between managers and
investors, thereby increasing the confidence of investors in the company's financial statements.
Overall, the study provides valuable insights into the relationship between accounting
conservatism and bankruptcy risk for companies listed on the Tehran stock exchange. The
findings suggest that companies may benefit from adopting more conservative accounting
policies and procedures to reduce the risk of bankruptcy.

The Journal of Accounting Research published a study in 2014 by J.R. Francis and K. Schipper
that aimed to investigate the impact of accounting reserves on bankruptcy risk in the US. The
study used a sample of 1,500 firms from 1980 to 2009. The authors found that firms with higher
levels of accounting reserves had a lower probability of bankruptcy. They also found that this
relationship was more pronounced for firms with higher levels of debt and lower levels of
profitability. The study suggests that accounting reserves can be used as a tool to mitigate
bankruptcy risk and that firms should consider maintaining higher levels of reserves to protect
against potential financial distress.

This study provides valuable insights into the relationship between accounting reserves and
bankruptcy risk and contributes to the literature on accounting conservatism. It also has
implications for financial reporting and auditing practices, as it suggests that firms should pay
close attention to the adequacy of reserves in their financial statements. The study emphasizes
the importance of accounting reserves in managing financial risk and provides useful information
for practitioners and policymakers.

Theoretical Framework
Traditionally, conservatism is declared with the proverb "do not identify any profit, just identify
all losses". In spite of the lack of a comprehensive definition of conservatism, in accounting
literature, two important features of conservatism are investigated.
First one is the existence of advocacy in presenting less than reality of the book value less than
market value of the assets which was proposed by Feltham and Ohlson (1995)

The second feature is tendency to require a higher degree of verification for recognizing good
news in earnings than for bad news proposed by Basu (1997). Basu (1997) defines conservatism
from the loss and gain point of view as the necessity of having a high degree of verification for
knowing good news such as profit, in contrast with recognition of bad news such as loss.

In another definition of conservatism relying on the balance sheet approach, Feltham and Ohlson
(1995) declare that in cases which there is a real doubt in selecting among two or several
methods of reporting, that method should be selected which has the least favorable effect on the
rights of shareholders.

Accounting conservatism refers to the prudent verification of accounting estimates through

independent audits and management judgments that incorporate worst-case scenarios.
The goal is to ensure financial statements reflect potential losses and liabilities.
Conservatism aims to mitigate information asymmetry and limit overstatement of net assets,
providing investors with more transparent information to evaluate a firm’s financial position and
risks.

However, the theoretical relationship between conservatism and bankruptcy risk assessment is
complex.
While more conservative accounting should in theory provide earlier signs of financial distress,
there are limitations and challenges in practice. This essay examines how accounting
conservatism, as reflected in specific standards and disclosures, works in theory to
enhance bankruptcy prediction but also considers limitations like delayed loss
recognition, management discretion, multidimensional risks.
Overall, a single-minded reliance on conservatism is misguided; diverse quantitative and
qualitative analyses provide richer insights. Reforms may improve standards but require a
balancing of costs and benefits.

Agency theory suggests managers have incentives to withhold bad news to maintain steady
earnings or job security, even at the expense of prudent risk assessment. However, signaling
theory suggests conservatism can be a tool to credibly signal a firm’s financial standing to
investors, as inflated reporting will be penalized severely if discovered. Legitimacy theory also
predicts firms will adopt more conservative policies to appear prudent and responsible to
stakeholders. These theories provide a rationale for why conservatism may be either lacking in
practice or actively embraced.

Information asymmetry refers to the gap between a firm’s privileged information and what
outside investors can observe. Since managers have the best access to information about a firm’s
risks and losses, conservatism aims to compel more transparent disclosures, so investors can
better monitor firms and fund only viable ventures. However, in practice, managers still have
discretion over loss recognition and may delay disclosure of adverse events. By the time
substantial risks are reported, a firm’s condition may have significantly deteriorated.
Loss contingency theory specifies conditions where losses should be recognized in financial
reports, including when they are probable and estimable. Impairment rules also require write-
downs of overstated assets. In theory, these standards should ensure material risks and losses are
disclosed before a firm nears bankruptcy. However, in practice, there are challenges in meeting
stipulated probability and estimation criteria, and standards like materiality thresholds can allow
certain risks to remain undisclosed. Recognition is also often delayed until events actually
transpire rather than based on reasonable forecasts.

Accounting conservatism refers to the principle of being deliberate and careful in accounting
practices, with a tendency to understate assets and incomes, and overstate liabilities and
expenses. Accounting conservatism aims to minimize the likelihood of income overstatement,
that is perceived as reducing risks to investors and creditors. By being deliberately conservative
in financial reporting and recognizing losses early and gains late, accounting conservatism can
potentially lower bankruptcy risks.
There are valid theoretical justifications for the link between conservatism and lower bankruptcy
probability.
First, conservative accounting avoids overstating the firm's financial position and performance,
reducing the likelihood of distress later due to an unsustainable situation.
By accelerating loss recognition and deferring gain recognition, conservatism builds in a "margin
of safety" that makes it less likely for the firm to report profits whilst its long-term viability is
under threat.

Second, conservative accounting provides creditors and investors with a “buffer”

against unexpected losses or deteriorations in future periods.
By recognizing more losses upfront and fewer gains upfront, conservatism gives stakeholders
more loss-absorbing capacity which can be drawn upon if needed to withstand future difficulties
without pushing the firm towards bankruptcy.
This acts as a safeguard against bankruptcy filings prompted more by accounting losses than
economic fundamentals.

Third, conservative accounting can enhance lenders’ and creditors’ trust in the firm's financial
disclosures since gains and profits are verified before being recognized. This can strengthen
stakeholders’ ongoing support for the firm, pushing out the possibility of withdrawal of credit
lines or premature calls for repayment of debts that might result in bankruptcy. By prioritizing
credibility over earnings, conservatism builds goodwill that provides more flexibility and time
for the firm to improve its condition.

On the other hand, several counterarguments can be made against the linkage
between conservatism and lower bankruptcy risk. Conservatism may sometimes understate the
firm's ability to generate economic profits, obscuring its fundamental strength and long-term
viability. Some profitable firms may appear less profitable and riskier than they really are due to
conservative accounting, making bankruptcy seem more likely than warranted. Conservatism
also fails to recognize gains that could be used to defray future losses, limiting loss-absorbing
capacity. Overall, while theoretical justifications exist for why conservatism might
reduce bankruptcy probability, the empirical evidence on this link is mixed and there are also
reasonable arguments against this relationship.

In summary, this framework discusses the theoretical rationale for how accounting conservatism
could lower bankruptcy risks by avoiding overstated profits, providing loss-absorbing capacity
buffers, and enhancing stakeholder trust. However, counterarguments against this link also
highlight how conservatism may sometimes obscure a firm's underlying economic strength and
profitability or limit its ability to defray losses, making bankruptcy seem more likely even for
fairly healthy firms. More research is needed to draw definitive conclusions on the complex
relationship between conservatism and bankruptcy risk.

Hypotheses

Relations Between Accounting Conservatism and Bankruptcy Risk

Figure 1 depicts the financial accounting continuum by which firms transition from relative
financial health (C=0) through financial distress accounting conservatism of technical default
(C=1) and actual default (C=2) to bankruptcy liquidation (C=3).
Our focus is on the relationship between accounting conservatism and bankruptcy risk versus
bankruptcy, so we examine the entire financial accounting conservatism continuum (C=0 to
C=3). To provide for firm transitions into and out of stress accounting conservatism, we examine
bankruptcy risk measures that are accounting conservatism on financial distress.

Figure I. Financial condition continuum.

over C=0 to C=2 and the C=3 bankruptcy accounting conservatism as a corroborative robustness
test. Our focus on bankruptcy risk versus bankruptcy reflects its relevance to ongoing firms as
informed by its realized accounting conservatism being one of cash versus profit insufficiency.
In total, examine four scenarios of financial distress that we discuss concerning related studies in
the following section.

Several prior studies examine accounting conservatism in accounting conservatism s of financial

distress and bankruptcy (Figure 1, C=1 to C=3). Zhang (2008) finds that borrowers with more
conservative accounting violate debt covenants following negative share price shocks sooner,
thus providing for more timely workouts and an ex-ante benefit of lower borrowing costs.
Carrizosa and Ryan (2013) find that conservative accounting and complementary accounting-
based debt covenants increase expected default recovery rates with stronger results for
accounting conservatism. Donovan et al. (20depend5) find that creditors of firms with more
conservative accounting before default have higher recovery rates, especially firms that violated
covenants before default.
Accelerated technical defaults due to conservatism also have been found to facilitate the transfer
of control rights from shareholders to debtholders and promote debtholder monitoring (Nikolaev,
2010; Roberts & Sufi, 2009; Zhang,2008). This helps mitigate underinvestment and improves
operating cash flows in covenant-violating firms (Tan, 2013).

Improved operating cash flows in turn enhance firms' abilities to service and renegotiate debts
(Chatterjee et al., 1995). Whereas analytical results show that the effects of accounting
conservatism on debt contracting efficiency depend on debt contract features (Gigler et al, 2009;
Li,2013),
these findings indicate overall that in accounting conservatism of financial distress (C=1 and
C=2), accounting conservatism helps avoid bankruptcy liquidation (C=3) by facilitating debt
renegotiations, re-financings, and workouts. However, these studies do not address how
accounting conservatism and bankruptcy risk relate to relatively more healthy firms (C=0).

For relatively healthy firms (C=0), it is well-documented that accounting conservatism is

prevalent and that its prevalence has increased over time (Givoly & Hayn, 2000; Ruch & Taylor,
2015; Watts, 2003).
Specifically, prior studies reveal that accounting conservatism is associated with reduced
bondholder-shareholder conflicts and lower debt costs (Ahmed et al., 2002; Beatty et al.,
2012;Brockman et al., 2012), mitigated agency costs (Ahmed & Duellman, 2007;Beatty et al.,
2012; Lobo et al., 2020), reduced information asymmetry (Duffie & Lando, 2001;Goh et al.,
2017; Khan & Watts, 2009), enhanced investment efficiency (Garcia Lara et al., 2016), and
reduced stock price crash risk (J.-B. Kim & Zhang, 2016). These findings suggest associations of
accounting conservatism with bankruptcy risk. These findings, when combined with results for
distress Accounting, lead to the notion that accounting conservatism may help to lower
bankruptcy risk.

Extensive prior research on accounting conservatism (see Basu, 2009;Ewert &

Wagenhofer,2012; Mora & Walker, 2015; Penalva & Wagenhofer,2019;Ruch & Taylor,
2015;Zhong & Li, 2017) has evolved into considerations of Accounting conservatism (Ball &
Shivakumar, 2005;Beaver & Ryan, 2005). Accounting conservatism characterizes a
predetermined underreporting of net assets and net income, and accounting conservatism is a
more timely reporting of arising bad versus good financial news. Despite these subtle
differences,
both types of accounting conservatism support a negative relationship between both accounting
conservatism and bankruptcy risk, as we hypothesize below:
Hypothesis 1 (H1):Accounting conservatism is negatively associated with subsequent
bankruptcy risk, ceteris paribus.
To provide corroborative evidence for H1 and new insights into how accounting conservatism
relates to bankruptcy risk, we then separately examine cash enhancement and earnings
management mitigation as two channels by which accounting conservatism could reduce
bankruptcy risk, as suggested by prior studies. Our examinations of these effects of accounting
conservatism are motivated by their associations with the defining characteristic of realized 4
bankruptcy risk, cash insufficiency. We argue that accounting conservatism helps enhance cash
availability via cash retention and cash accessibility facilitated by earnings management
mitigation. In the following discussion, we first consider the cash enhancement channel followed
by a consideration of the earnings management channel.
Cash Enhancement Channel
Prior studies reveal positive associations between accounting conservatism and cash holdings.
Specifically, Kirschenheiter and Ramakrishnan (2010)show analytically that accounting
conservatism promotes precautionary cash savings, especially when future cash flows are riskier.
Watts (2003)argues that conservatism reduces or defers cash expenditures for performance-based
compensation, dividends, and taxation. Hui et al. (2012) propose and find that conservatism
reduces cash payouts by eliciting more lenient contracting terms from suppliers and customers.
Louis and Urcan (2015) posit and find that conservatism lowers dividend payouts.

This cash-enhancing effect of accounting conservatism mitigates bankruptcy risk by facilitating a

firm's debt servicing and renegotiation capability. Because bankruptcy is ultimately cash
insufficiency, and cash enhancement facilitates debt servicing, firms can operate indefinitely
without entering real default or bankruptcy ifnet cash flows are sufficient to debt service
obligations, irrespective of contemporaneous earnings. Correspondingly, J. Kim, et al. (1993)
and Uhrig-Homburg (2005) model bankruptcy as a real default triggered when cash flow falls
below the required debt service payments. Campbell et al. (2008) document that cash holdings
reduce failure risk over various prediction horizons.
Enhanced 6 cash holdings also alleviate underinvestment, particularly when firms face
difficulties in rolling over debts (Harford et al., 2014). This in turn increases future operating
cash flow and elevates debtholders' beliefs in the firms' abilities to service their debts, thus
facilitating debt renegotiation and restructuring that preclude bankruptcy filings (Berkovitch &
Israel, 1998; Perotti & Spier, 1993).

Whereas agency problems associated with increased cash holdings (e.g., Jensen, 1986) could be
argued to increase bankruptcy risk, Louis et al. (2012) show that Accounting conservatism helps
to mitigate negative net present value investments. In addition, Bates et al. (2009) report that
increased cash holdings is associated with lower cash flow risk to a greater extent than with
agency problems.Anderson and Carverhill (2012) further argue that holding cash to guard
against real default serves shareholders' interests even if doing so aggravates cash-related agency
problems. Drawing on this evidence, we predict that accounting conservatism will reduce
subsequent bankruptcy risk by enhancing cash holdings, expressed as follows:

Hypothesis 2 (H2): Accounting conservatism helps lower subsequent bankruptcy risk by

enhancing cash holdings , ceteris paribus.

Earnings Management Mitigation Channel

 Beyond cash holdings, cash obtained from outside sources also can be used to meet arising
obligations to mitigate bankruptcy risk. Prior findings regarding conservatism and cash
accessibility support the notion that accounting conservatism mitigates bankruptcy risk by
facilitating debt contracting and enhancing external cash accessibility (e.g., Ball et al., 2008;
Kothari et al., 2010;Watts,2003). Specifically,prior studies report that conservatism helps to set
lower net asset bounds in capital grantingdecisions (Sunder et al., 2018;Watts,2003),signal
financial distress sooner to facilitate capital access (Ball et al., 2008;Ball & Shivakumar, 2005;
Christensen & Nikolaev, 2012; Nikolaev, 2010;Smith & Warner, 1979;Zhang, 2008), and
disciplines investment project selection (Francis & Martin, 2010; Kravet, 2014) and numbers
contained in debt contracts (Ball, 2001; Chen et al., 2007;Gao,2013; Watts, 2003).

Importantly, these benefits of accounting conservatism on debt contracting and cash accessibility
are realized through its effect on mitigating earnings management. Although managers have
incentives to manage earnings upward to avoid debt covenant violations (Jha, 2013;Rosner,
2003),Chen et al. (2007) and Gao(2013)show analytically that conservative accounting helps
constrain earnings management ex-ante to counteract the misstatement of earnings and assets ex-
post. This effect of accounting conservatism on earnings management is especially important
after firms commit technical defaults because at that time firms are likely to be involved in
earnings management to improve their bargaining power and reduce renegotiation costs in the
subsequent debt renegotiation process (Jha,2013).

Nikolaev (2010) correspondingly finds that firms with debt covenants are more accounting
conservative in their reporting and Tan (2013) finds firms to report more conservatively
following bond covenant violations.
Thus, prior findings considered altogether lend support to an earnings management mitigation
channel for a negative association between accounting conservatism and bankruptcy risk. A less
conclusive prediction follows for accounting conservatism from findings by Jackson and Liu
(2010) that managers use bad debt accounting to meet earnings targets and by Penman and
Zhang (2002) that Accounting conservatism can facilitate real earnings management via R&D ,
marketing, and LIFO reserves.
. Given these findings and previously documented interrelationships between accounting
conservatism (Qiang, 2007; Roychowdhury & Watts, 2007), we treat this as an empirical
question hypothesized as follows:

Hypothesis 3 (H3): Accounting conservatism helps lower subsequent bankruptcy risk by

mitigating earnings management, ceteris paribus.