Debtholders’ Demand for Conservatism: Evidence from Changes in Directors’ Fiduciary Duties

• Author: MIKHAIL PEVZNER,JAGADISON K. AIER,LONG CHEN
• Published date: 01 December 2014
• DOI: http://doi.org/10.1111/1475-679X.12062
• Date: 01 December 2014

DOI: 10.1111/1475-679X.12062

Journal of Accounting Research

Vol. 52 No. 5 December 2014

Printed in U.S.A.

Debtholders’ Demand for

Conservatism: Evidence from

Changes in Directors’ Fiduciary

Duties

JAGADISON K. AIER,

∗LONG CHEN,

∗

AND MIKHAIL PEVZNER

†

Received 24 May 2012; accepted 31 August 2014

ABSTRACT

Debtholders’ demand has been widely discussed as a key determinant of con-

servatism but clear causal evidence is not yet established. Using a natural ex-

periment setting, wherein a Delaware court ruled that the fiduciary duties

of directors in near insolvent Delaware companies extend to creditors, we

predict and find that firms subject to the ruling significantly increased their

accounting conservatism. In addition, our results suggest that the increase

in conservatism is more pronounced in near insolvent Delaware firms with

stronger boards, confirming that the court ruling takes effect through the

channel of the board of directors. Our results are robust to using alternative

∗School of Business, George Mason University †Merrick School of Business, University of

Baltimore.

Accepted by Christian Leuz. We appreciate helpful comments from an anonymous ref-

eree, Ron Allen, Bill Baber, Augustine Duru, Keith Jones, Gopal Krishnan, Tao Ma, Xiu-

min Martin, Sarah Nutter, Sugata Roychowdhury, Partha Sengupta, Phil Shane, Min Shen,

Anup Srivastava, Gnanakumar Visvanathan, Regina Wittenberg-Moerman, Fei Xie, and work-

shop participants at American University, George Mason University, University of Illinois at

Chicago, Suffolk University, and 2012 Virginia Accounting Research Conference. Long Chen

acknowledges the summer research grants from George Mason University’s Provost Office

and School of Business. Mikhail Pevzner acknowledges the assistance of Ernst and Young

Chair in Accounting at the University of Baltimore. We thank Larry Friedman and Hui Zhang

for their insights on corporate law. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

993

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

994 J.K.AIER,L.CHEN,AND M.PEVZNER

measures of conservatism and near insolvency status, and controlling for

potential confounding factors and other stakeholders’ demand for conser-

vatism. Overall, our study provides empirical evidence to support the causal

relation between debtholders’ demand and accounting conservatism previ-

ously suggested in the literature, and offers some insights into the role of the

board of directors in financial reporting.

JEL codes: M41; G34; K20

Keywords: Conservatism; fiduciary duties; near insolvency; board

governance

1. Introduction

Research on accounting conservatism posits that demand from lenders is

the main reason why firms adopt conservative accounting policies (Watts

[2003]). Supporting evidence for this conjecture is primarily based on doc-

umented associations between conservatism and various characteristics of

debt contracting (e.g., Ahmed et al. [2002], Ball and Shivakumar [2005],

Beatty, Weber, and Yu [2008], Zhang [2008]), but most of them are not

of a causal nature, raising the question of whether conservatism is indeed

demanded by debtholders. Moreover, conservatism could also be excessive

and thus inefficient for firms and even detrimental to debtholders, which

appears to conflict with the presumption that debtholders would always

demand conservatism. For instance, too much conservatism may result in

tighter debt covenants leading to premature transfer of decision rights to

debtholders, which might unduly constrain a firm’s investment and financ-

ing policies (Leuz [2001]). Also, excessive conservatism may allow man-

agers to create hidden reserves, which may be reversed in the future at the

discretion of shareholders (Leuz [1998]). To help resolve this ambiguity

on debtholder preferences, we exploit an important legal event to identify

a causal link between debtholders’ demand and accounting conservatism.

A 1991 Delaware court in the ruling of Credit Lyonnais Bank v. Pathe

Communications (hereafter “the court ruling”) expanded the scope of direc-

tors’ fiduciary duties to include creditors when a Delaware incorporated

firm is in the “vicinity of insolvency.” The fact that the court ruling had

no judgment on financial reporting per se, combined with the natural

event setting, which helps mitigate the issue of confounding factors, makes

it possible to attribute any post-ruling change in conservatism by near

insolvent Delaware companies to debtholders’ demand for conservatism.1

1The idea is that the court ruling provides an exogenous change in fiduciary duties, which

in turn should affect firms’ supply of conservative accounting. This exogenous variation allows

us to identify debtholders’ demand for conservatism. If the shift in supply leads to no change

in conservatism, this suggests that the demand for conservatism is either fully inelastic (which

is implausible) or absent, which is the null for our tests.

DEBTHOLDERS’DEMAND FOR CONSERVATISM 995

We use a difference-in-differences research design to capture the dif-

ferential post-ruling changes in financial reporting conservatism between

firms near insolvency and away from insolvency and between firms incorpo-

rated in and outside the State of Delaware. We employ a firm-year specific

composite score as our main measure of conservatism and supplement it

with the asymmetric timeliness models of Basu [1997] and Ball and Shiv-

akumar [2006]. Overall, we find that, in the immediate period following

the court ruling in 1991, financial reporting conservatism significantly in-

creased for near insolvent Delaware firms. The results indicate that, in re-

sponse to their increased fiduciary obligations to creditors, directors of

firms subject to the court ruling influence managers to adopt more con-

servative financial reporting.

We further examine the role of board characteristics on the effect of the

court ruling since this legal event increased the fiduciary duties of individ-

ual directors, thereby establishing a firm’s board as the primary channel

through which any response to the ruling should occur. Our finding of

a more pronounced increase in conservatism for near insolvent Delaware

firms with stronger boards provides additional support to our argument

that the observed changes in conservatism are driven by the court ruling.

We conduct a number of additional analyses to test the robustness of our

findings. Our results hold after controlling for confounding factors like

real actions that firms can take as they become distressed, large negative

write-offs, covenant violations and bankruptcies, and other stakeholders’

demand for conservatism. To account for the effect of fluctuating firm per-

formance, we rerun our main test on a performance-matched sample, a

subsample that holds a firm’s near insolvency status constant, and a short-

ened sample period during which firms are less likely to change their near

insolvency status. We also address possible selection biases on account of

state of incorporation choice and the level of default risk. Our main results

remain significant and consistent across all supplemental tests.

Our study makes a number of contributions. First, it establishes a clear

causal link between debtholders’ demand and accounting conservatism.

Prior studies have struggled to provide causal evidence on debtholders’ de-

mand for conservatism due to potential confounding factors that may also

contribute to a firm’s decision to adopt more accounting conservatism.2

We use an exogenous shock of a legal event, which expanded fiduciary du-

ties of directors to include creditors, as a mechanism to examine whether

debtholders indeed demand conservatism. This natural setting significantly

mitigates endogeneity concerns and makes it easier to attribute changes in

conservatism around the event to debtholders’ demand. Second, our find-

ings of a more pronounced increase in conservatism for firms with stronger

2Gormley, Kim, and Martin [2012] exploit an exogenous regulatory change in the Indian

banking industry. They document that foreign bank entry is associated with more timely loss

recognition, and this change appears to be driven by a shift in firms’ incentives to supply

additional information to lenders.