Auditor Conservatism and Quarterly Earnings

Abstract

Auditors’ legal liability incentives to be conservative cause fourth quarter earnings to differ systematically from interim quarter earnings. We show that the frequencies and average magnitudes of losses, negative extraordinary items, negative special items and negative discontinued operations are highest in the fourth quarter. We show that earnings is more timely in recognizing bad news in the fourth quarter than in earlier quarters, and this greater timeliness for bad news is largely accomplished through operating accruals. Our conservatism measures are higher in periods of high auditor liability exposure consistent with auditors being more conservative when exposed to greater legal liability.

Keywords: Quarterly earnings; Earnings-return relation; Negative returns

JEL Classification: M41, D21, D82, G14, G38, K41, N20