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Universal Demand Laws and the Monitoring Demand for Accounting Conservatism

57 Pages Posted: 4 May 2017 Last revised: 27 Sep 2017

Feng Chen

University of Toronto - Rotman School of Management

Qingyuan Li

Wuhan University - School of Economics and Management

Li Xu

Washington State University, Vancouver

Date Written: September 25, 2017

Abstract

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

Chen, Feng and Li, Qingyuan and Xu, Li, Universal Demand Laws and the Monitoring Demand for Accounting Conservatism (September 25, 2017). Available at SSRN: https://ssrn.com/abstract=2963162 or http://dx.doi.org/10.2139/ssrn.2963162

Feng Chen (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Qingyuan Li

Wuhan University - School of Economics and Management ( email )

Wu Han, Hu-Bai 430072
China

Li Xu

Washington State University, Vancouver ( email )

14204 NE Salmon Creek Avenue
Vancouver, WA WA 98686-9600
United States

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