Director–Liability–Reduction Laws and Conditional Conservatism

• Date: 01 September 2019
• Author: YI LIANG,SUDIPTA BASU
• DOI: http://doi.org/10.1111/1475-679X.12267
• Published date: 01 September 2019

DOI: 10.1111/1475-679X.12267

Journal of Accounting Research

Vol. 57 No. 4 September 2019

Printed in U.S.A.

Director–Liability–Reduction Laws

and Conditional Conservatism

SUDIPTA BASU

∗AND YI LIANG

∗

Received 9 April 2017; accepted 13 March 2019

ABSTRACT

We study nonofficer directors’ influence on the accounting conservatism of

U.S. public firms. Between 1986 and 2002, all 50 U.S. states enacted laws that

limited nonofficer directors’ litigation risk but often left officer directors’ liti-

gation risk unchanged. We find that conditional conservatism decreased after

the staggered enactments of the laws, which we attribute to less nonofficer di-

rector monitoring of financial reporting in affected firms. Conservatism fell

less when shareholder or debtholder power was high, consistent with major

stakeholders moderating the influence of nonofficer directors. We verify that

our results stem from reductions in the asymmetric timeliness of accruals and,

specifically, its current assets components. We also show that affected firms

∗Fox School of Business, Temple University.

Accepted by Douglas Skinner. We thank an anonymous reviewer, Steve Balsam, Larry

Brown, Dmitri Byzalov, Kai Wai Hui (discussant), Sudarshan Jayaraman, Jayanthi Krishnan,

Eric Press, Bryce Schonberger (discussant), Phillip Wang (discussant), Matthew Wieland

(discussant), and workshop participants at the 2016 Annual Conference on Empirical Le-

gal Studies, 2016 Conference on Convergence of Financial and Managerial Accounting Re-

search, 2017 American Accounting Association Annual Meeting, 2018 Conference on Fi-

nancial Economics and Accounting, 2019 Hawaii Accounting Research Conference, Stony

Brook University, University of Hawaii at Manoa, and Temple University brown bag semi-

nar for helpful comments and suggestions. We thank Martijn Cremers for providing G-index

data, Sudarshan Jayaraman and Francis Kim for providing historical state of incorporation

data, Roberta Romano for providing director–liability–law enactment data, and Xinjie Ma

for excellent research assistance. An online appendix to this paper can be downloaded at

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

889

CUniversity of Chicago on behalf of the Accounting Research Center,2019

890 S.BASU AND Y.LIANG

switched away from Big N auditors more often, which reduced these firms’

commitment to conservative financial reports.

JEL codes: G14; G34; G38; K22; M41

Keywords: litigation risk; corporate governance; D&O insurance; nonoffi-

cer directors; board monitoring

1. Introduction

Between 1986 and 2002, all 50 U.S. states enacted laws that limited nonof-

ficer directors’ litigation risk in a staggered manner (Romano [2006]).

We argue that these laws reduced nonofficer directors’ incentive to mon-

itor financial reporting. Because conditional conservatism causes poor

performance to be reported more quickly than good performance, man-

agers often prefer less conservatism (Watts [2003]). We predict that con-

ditional conservatism (measured as the asymmetric timeliness of earnings)

decreased after these laws affected firms. Our results are consistent with

this prediction. We also find that the decrease in conditional conservatism

was smaller when shareholder power and debt-contracting demand were

high, suggesting that these laws had less effect when major stakeholders

demanded conservatism.

Nonofficer directors are usually outsiders who are expected to over-

see the firm’s decision-making processes including financial reporting

(Larcker and Tayan [2015]).1Directors can be sued for breaching their

fiduciary duties. Crutchley, Minnick, and Schorno [2015] find that, be-

tween 1997 and 2009, 376 (out of 673) shareholder class-action lawsuits

alleging Federal Securities Laws frauds named nonofficer directors as de-

fendants. Such lawsuits can lead to directors paying large sums out of

their own pockets in major frauds (Black, Cheffins, and Klausner [2006])2

and can also harm directors’ reputations and labor-market prospects

(Srinivasan [2005], Fich and Shivdasani [2007]).

We validate our results by examining the asymmetric timeliness of accru-

als. We first follow Collins, Hribar, and Tian [2014] and separately model

1A nonofficer director is defined as a director who is not an officer (i.e., an executive) of

the firm. In the United States, nonofficer directors are almost always outside directors unless

they are founder family members. However, in other countries such as Germany, employee

representatives are also important nonofficer directors (Fauver and Fuerst [2006]). Because

our study examines U.S. data, our findings are most relevant to outside directors. Conversely,

officer directors are a subset of inside directors, who also include nonofficer employees and

direct stakeholders.

2Based on settlement agreements that were publicly available in 2005, Black, Cheffins and

Klausner ([2006], table 2) report that 12 outside directors at WorldCom paid a total of $24.75

million out of pocket, while 11 Enron outside directors paid out a total of $14.5 million. Most

shareholder lawsuits are settled privately,and even when the settlement amounts are disclosed,

the ultimate payers are often not specified (Black, Cheffins, and Klausner [2006], p. 1062),

making it impossible to compile comprehensive data on outside director payments out of

pocket.