Accounting Conservatism and Audit Quality
Timely loss recognition or conservatism is an essential element that defines the quality of financial statements, where auditors have incentives to investigate this subjective term. Several motivations have created the need for existence and pervasiveness of conservatism. Contractual obligation, shareholder litigation, taxation, and accounting regulation are the motivations for the existence and pervasiveness of conservatism. Moreover, lower corporate governance quality asks for conservative reporting due to accounting scandals that have occurred in the past and have eroded the investor confidence in the financial markets. Because of conservatism, investors gain more confidence about their investments as earnings are less manipulated in conservative financial reports. This empirical study highlights the association between accounting conservatism and audit quality of financial statements by regressing the book to market ratio, a measure used for conservatism, and audit fees, a measure used for audit quality, for 84 largest publicly and privately held companies in the United States for the years 2014 - 2017. Moreover, since audit quality is a subjective term, this paper also analyses various secondary sources to support the positive association between the two variables. It also focuses on the motivations of conservatism and conservative auditing and why it became crucial in increasing investor confidence in capital markets after accounting scandals.
Keywords - Audit Quality, Conservatism, Financial Statement, Misrepresentation, Information Asymmetry