The Impact of Default Risk on the Basu Measure of Accounting Conservatism

In this paper, we analytically and empirically examine the impact of default risk on the Basu (1997) measure of accounting conservatism. Using the classic Merton (1974) call-option model of equity, we show that the Basu asymmetric timeliness coefficient is biased upward by the existence of the default risk in a firm, and that bias tends to increase with the level of default risk. Furthermore, we propose a new measure of conservatism, the Default-Adjusted-Basu (ldquo;DABrdquo;) measure, by modifying the original Basu measure. The DAB measure is likely more robust to the influences of default risk than is the original Basu measure. Our empirical evidence is consistent with our theoretical arguments with regards to both the impact of default risk on original Basu measure and the advantage of our DAB measure of conservatism