Litigation Cost, Market-to-Book, and Asymmetric Timeliness of Earnings

Abstract

Recent studies have questioned the validity of the Basu asymmetric timeliness of earnings (AT) as the proxy for accounting conservatism. An important basis for the criticism is the negative association observed between AT and market-to-book ratio (MB), another proxy for conservatism. Drawing upon prior research, we hypothesize and find that the negative relationship is stronger in a more litigious environment, indicating that low MB is a proxy for elevated expected litigation cost. Therefore the negative association reflects the rational response of managers and auditors in applying greater conservatism to mitigate expected litigation cost that increases as MB dips below a threshold. The negative association is not a valid basis for questioning the validity of the Basu model. This study demonstrates that MB is a proxy for risk, contributing to the debate on whether book-to-market ratio is a proxy for risk or the product of mispricing in the finance literature.