AbstractWe use state‐level increases in unemployment insurance (UI) benefits as exogenous shocks to unemployment risk to examine its effect on accounting conservatism. Employing difference‐in‐differences analyses, we find an increase in accounting conservatism after UI benefit increases. Our findings support the employee perception management hypothesis, which argues that in order to mitigate labor costs associated with worker turnover, firms have incentives to manage employees’ perceived job security through less conservative accounting. When UI laws reduce workers’ separation costs, employer firms have less incentives to manage employees’ perception, attributing to the positive relation between UI benefits and accounting conservatism. Subsample tests show that this effect is driven by labor‐intensive firms as well as firms with higher risk. Overall, our paper suggests that labor market frictions have a significant impact on firm's accounting reporting policies.
