SYNOPSIS

This paper investigates the association between investor sentiment and accounting conservatism. We find that managers recognize economic losses in earnings in a more timely manner during periods of high investor sentiment. Further, the sentiment-conservatism relation is stronger for firms with greater sentiment-price sensitivity. We also find that the sentiment-conservatism association is stronger for firms with higher litigation risk and financial expert CEOs, and is weaker for firms with retiring CEOs. Overall, our results suggest that firms report earnings more conservatively in response to higher investor sentiment in order to mitigate potential litigation costs. These findings have implications for regulators and standard setters who have deemphasized accounting conservatism in recent years.

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