Universal Demand Laws and the Monitoring Device Role of Accounting Conservatism
59 Pages Posted: 4 May 2017 Last revised: 18 Jan 2018
Date Written: January 17, 2018
Existing literature offers mixed empirical findings on the relationship between corporate governance strength and accounting conservatism. Since shareholder litigation rights are positively associated with corporate governance strength, we examine how an exogenous shock to shareholder litigation rights can affect conditional accounting conservatism by exploiting staggered enactments of the universal demand (UD) laws in 23 states over 16 years. The UD laws raise procedural hurdles for shareholders to file derivative lawsuits against executives and directors who allegedly breach their fiduciary duties. When derivative suits cannot serve as an enforcement mechanism for directors and managers to fulfill their fiduciary duties, we predict that directors will possess weaker monitoring incentives, thereby reducing the monitoring device role of accounting conservatism. Moreover, deteriorating corporate governance following UD law adoptions provides managers with greater opportunities to engage in aggressive accounting. Consistent with our prediction, we find a significant decrease in conditional conservatism following the enactment of UD laws. The decline in conditional conservatism is exacerbated for firms in which institutional investors hold smaller stakes or for firms that operate in non-litigious industries. Our findings are robust to potentially confounding legal changes, the exogeneity assumption, the assumptions for the difference-in-difference research design, alternative samples, alternative conditional conservatism measures, and alternative explanations.
Keywords: Derivative Lawsuits; Universal Demand Laws; Conditional Conservatism; Monitoring Demand
JEL Classification: M41; D22; G34; K22
Suggested Citation: Suggested Citation