The Effect of Accounting Conservatism on Measures of Distress Risk*

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Abstract
This paper investigates how the trend in accounting conservatism effects measures of financial distress. We find that existing accounting-based measures of financial distress become less accurate as accounting conservatism increases across time. We document that (1) higher levels of accounting conservatism increase the likelihood of misclassification of solvent firms (2) adjusting for conservatism increases the number of correctly identified distressed firms by an average of 13% per year (3) adjusted measures of distress eliminate the previously documented anomalously low returns of large high distress risk firms with low book-to-market and (4) adjusted O-score measures provide important information on distress risk for large firms with average book to market classification. Our results suggest that extant literature relying on accounting measures of distress incorrectly predicts or controls for distress risk.

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