Universal Demand Laws and the Monitoring Device Role of Accounting Conservatism
65 Pages Posted: 4 May 2017 Last revised: 15 May 2018
Date Written: May 10, 2018
While the consensus holds that accounting conservatism can serve as an effective monitoring device, existing literature offers mixed empirical findings on the relationship between corporate governance strength and accounting conservatism. We examine how exogenous shocks to corporate governance strength affect conditional accounting conservatism by exploiting staggered enactments of the universal demand (UD) laws in 23 U.S. states. UD laws raise procedural hurdles for shareholders to file derivative lawsuits against executives and directors who allegedly breach their fiduciary duties. For firms incorporated in states that adopt UD laws, their corporate governance will deteriorate due to restricting shareholder litigation rights and instituting management-friendly governance provisions. As a result, directors are expected to possess weaker monitoring incentives and managers will have greater opportunities to engage in aggressive accounting. We thus predict a decrease in conditional conservatism following the enactment of UD laws. The results are consistent with our prediction, which we further reveal is attributable to both the direct channel (through restriction of shareholder litigation rights) and the indirect channel (through management-friendly governance provisions). We find a decline in conditional conservatism only for firms with low institutional ownership, low external equity dependence, or high ex-ante derivative lawsuit risk. Our findings are robust to potentially confounding legal changes, the assumptions for the difference-in-difference research design, alternative samples, alternative financial reporting measures, and alternative explanations.
Keywords: Derivative Lawsuits; Universal Demand Laws; Conditional Conservatism; Monitoring Demand
JEL Classification: M41; D22; G34; K22
Suggested Citation: Suggested Citation