Universal Demand Laws and the Monitoring Device Role of Accounting Conservatism

63 Pages Posted: 4 May 2017 Last revised: 16 Mar 2019

See all articles by Feng Chen

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: March 9, 2019

Abstract

While prior research holds the consensus that accounting conservatism can serve as an effective monitoring device, it is not clear whether shareholders can successfully enforce managers’ adherence to accounting conservatism when directors fail to fulfill their fiduciary duties. We attempt to answer the question 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 managers and directors who allegedly breach their fiduciary duties. For firms incorporated in states that adopt UD laws, restrictions on shareholder litigation rights shift power to managers, thereby weakening directors’ incentives to monitor managers. We predict and find a decrease in conditional conservatism following the enactment of UD laws. The main result is attributable to both the direct channel (through restriction of shareholder litigation rights) and the indirect channel (through the deployment of management-friendly governance provisions). The decline in conditional conservatism exists only for firms with low institutional ownership, low external equity dependence, or high ex-ante derivative lawsuit risk. Our findings suggest that shareholders cannot successfully demand accounting conservatism when managers possess extensive power and directors lack the incentives to monitor managers.

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 Device Role of Accounting Conservatism (March 9, 2019). 2018 Canadian Academic Accounting Association (CAAA) Annual Conference. 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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