Director Liability Protection, Earnings Management, and Audit Pricing

• DOI: http://doi.org/10.1111/jels.12092
• Date: 01 December 2015
• Published date: 01 December 2015
• Author: John K. Wald,Sarfraz Khan

Director Liability Protection, Earnings

Management, and Audit Pricing

Sarfraz Khan and John K. Wald*

We examine how a firm’s director liability protection is related to earnings management

and audit pricing. Firms whose directors are protected from litigation either by state laws or

through clauses in the firm’s charter have significantly more accruals management. This

relation is significant after the passage of the Sarbanes-Oxley Act but not before. We also

find evidence of a positive association between director protection and auditor fees. The

results are robust to a number of alternative specifications, including one that instruments

for director liability protection.

I. Introduction

An existing literature shows that directors are important in monitoring earnings man-

agement activities. For instance, Klein (2002) shows that independent directors do a bet-

ter job of monitoring to reduce earnings management, and Xie et al. (2003) find that

boards with more financial sophistication and boards that meet more often are associ-

ated with lower levels of earnings management.

1

We extend the literature by examining

whether greater director liability implies more careful monitoring of management’s

earnings management activity.

2

We find that differences between how state laws and

firm charters protect directors have a significant effect on earnings management and

audit fees, even though almost all directors are protected by liability insurance.

3

*Address correspondence to skhan@louisiana.edu or john.wald@utsa.edu. Khan is at the University of Louisiana,

Lafayette; Wald is at the University of Texas at San Antonio.

We thank Roberta Romano for providing details on state-level director liability laws. We thank three anony-

mous referees, Sharad Asthana, Michal Barzuza, Bernard Black, Jeff Boone, Dhammika Dharmapala, Michael

Klausner, Ling Lisic, Kate Litvak, Juan Manuel Sanchez, and seminar participants at the 2014 ALEA meetings

and at the 2014 CELS meetings for comments on earlier drafts.

1

More generally, Larcker et al. (2007) find mixed relations between a number of governance measures and

accrual quality. Larcker et al. do not consider director liability provisions among their governance indices.

2

Schipper (1989) defines earnings management as “the purposeful intervention in the external financial report-

ing process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral

operation of the process).”

3

See figure 21 of Tillinghast Towers Perrin (2006) survey that shows that 100 percent of U.S. firms purchase

director liability insurance for their directors.

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Journal of Empirical Legal Studies

Volume 12, Issue 4, 781–814, December 2015

Thus our results show how director liability laws matter even though insurance contracts

effectively remove most directors’ personal financial risks. That is, even though almost

all directors have liability insurance, they may want to avoid the time, expense, and neg-

ative publicity of litigation. By reducing the probability that a successful suit can be filed,

and increasing the probability that a suit can be dismissed at an early stage, liability pro-

tection may significantly change directors’ personal incentives, and this can affect how

carefully directors monitor earnings management.

Director liability is related to earnings management because aggressive earnings

management can spawn litigation, and this litigation is often targeted at directors. Sev-

eral prior studies provide a strong link between greater earnings management and the

probability of litigation (see DuCharme et al. 2004; Palmrose & Scholz 2004; Gong et al.

2008; McTier & Wald 2011), and recent lawsuits targeting directors in cases of earnings

management illustrate the continuing importance of liability protection.

4

Director liability varies from firm to firm depending on where the firm is incorpo-

rated and what language the firm adopts in its charter. Following the 1980s’ rise in the

cost of D&O liability insurance prices, some states changed the liability for directors of

firms incorporated within the state from negligence to recklessness or misconduct (as in

the case of Indiana). Other states allowed firms to change the standard of director liabil-

ity within their charters (most notably Delaware), and Virginia added a cap on D&O

liability (for details, see Romano 2006). In 2001, Nevada added a more extreme set of

director liability provisions (for details, see Barzuza 2012). An existing literature has

addressed the importance of director and officer (D&O) liability for firm policy (Bhagat

et al. 1987; Brook & Rao 1994; Netter & Poulsen 1989; Aguir et al. 2014). In this article,

we consider the accounting implications of differences in director liability.

Our study is related to Chung and Wynn’s (2008) findings that, for Canadian

firms, more D&O insurance coverage is associated with less accounting conservatism.

Lin et al. (2013) also use Canadian data to show that D&O insurance is related to loan

spreads and restatement probabilities, while Cao and Narayanamoorthy (2014) find that

D&O premiums are related to ongoing issues with financial reporting for U.S. firms. In

contrast to this literature, our study considers the accounting implications of differences

in director liability protection, rather than the effects of private insurance, for U.S.

firms. As these differences in director liability protection are due either to differences in

state laws or firms’ charters, the effects that we measure are on top of director insur-

ance.

5

We test whether these differences in liability are related to firms’ accounting

choices even if, as Black et al. (2006a) show, the likelihood of directors suffering perso-

nal losses are minimal. Thus our first hypothesis is that directors with greater liability

protection allow more earnings management than those without such protection.

4

See, for instance, details on the WorldCom suit against directors in Lublin et al. (2005). See also the description

of director liability at AIG by Scannell (2005), and more recent director liability issues following restatements at

Groupon Inc. as detailed by Aubin (2012).

5

Our tests also show that another form of director protection, director indemnification clauses, have little effect

on earnings management or audit fees.

782 Khan and Wald

Cohen et al. (2008) and Bartov and Cohen (2009) show that there was a decline

in accrual-based earnings management following the passage of the Sarbanes-Oxley Act

(SOX). However, Cohen et al. (2008) suggest that firms increase the use of real activ-

ities in earnings management in the post-SOX period. In terms of liability, SOX

increased the focus on corporate responsibility and accountability and potentially

increased director liability (see Bormann 2014). Linck et al. (2009) and Cao and Naraya-

namoorthy (2014) find that D&O insurance premiums increased substantially following

SOX. Given this greater focus on director liability post-SOX, we hypothesize that direc-

tor liability protection is more closely related to accounting choices after the introduc-

tion of SOX than before.

6

We further consider the relation between director liability protection and audit

fees. The existing literature shows that audit fees are positively related to the litigation

risks resulting from earnings management (see, e.g., Heninger 2001). If auditors per-

ceive that protected directors are less careful in monitoring management to avoid earn-

ings management, then auditors may require a higher fee when auditing protected

firms as compensation for the greater auditing effort or litigation risk required. We

therefore hypothesize that audit fees are positively associated with director protection.

We use a panel of U.S. firms to test our hypotheses. To examine earnings manage-

ment, we primarily focus on the relation between discretionary accruals and director

liability protection. Discretionary accruals are a result of manipulation in accounting

policies related to accruals. For example, a firm may increase depreciation charges, it

may increase inventory writedowns, or record generous provisions for doubtful

accounts.

7

We find a positive association between discretionary accruals and firms with a

higher threshold for director liability. Additionally, director liability protection is not

associated with accruals management before SOX, but has a statistically significant rela-

tion with accruals management after the passage of SOX.

8

Moreover, using firm-level

fixed effects regressions, increases (decreases) in liability protection are also associated

with greater (lower) accruals after SOX. Further, discretionary accruals are higher for a

subsample of Delaware-incorporated firms with protected directors, where the differen-

ces in liability protection are only due to differences in how the firms’ charters are writ-

ten. Thus our results are not driven by other legal differences between states. In further

tests, we use state laws from where the firm is headquartered as instruments for director

6

Note that while SOX is a federal statute, litigation for a breach of fiduciary duty associated with SOX require-

ments could still be brought under state laws, and thus this litigation would be subject to the director protection

provisions we consider (see the discussion in Skinner 2006).

7

Firm earnings have two components: cash flows and total accruals. Total accruals are further classified into non-

discretionary accruals, which refers to accruals that result from normal business operations, and discretionary

accruals (our measure of accruals management), which are a function of management choices.

8

Consistent with existing research (see Cohen et al. 2008), we also find that accruals management decreases in

the post-SOX period for both protected and unprotected firms. Our results indicate that this reduction in

accruals management is more pronounced in firms with unprotected directors.

783Director Liability Protection, Earnings Management, and Audit Pricing