Earnings Conservatism, Litigation, and Contracting: The Case of Cross-Listed Firms

Abstract

In this study we compare earnings conservatism of UK companies cross-listed in the US to that of UK companies without a US-listing. We expect that conservatism will be more pronounced for UK cross-listed firms because they i) face the threat of litigation from a wider audience of shareholders and a stricter enforcement system than companies with a domestic listing only, and ii) use a listing on a US exchange to signal high-quality reporting to investors. We conjecture that since the liability exposure of managers and auditors in the US is regarded to be more burdensome than in the UK, there seems to be a bonding explanation for the migration of cross-listed firms into capital markets with a harsher regime. The UK provides an attractive research environment to investigate this phenomenon due to the relatively large number of firms that cross-list in the US. The general similarities in the reporting and market environments of the UK and US make it easier to control for confounding factors.

Using a matched-pairs research design for the period from 1993 to 2002, we find that UK GAAP earnings of UK firms cross-listed in the US are significantly more conservative than earnings reported by UK firms without a US listing. Our results suggest that litigation is one force driving accounting conservatism. It is noteworthy that earnings conservatism is especially apparent for the cohort of firms that chose to cross-list in the US relatively recently. Our findings suggest that company managers adopt an integrated approach toward the communication of a perception of care for investors: by means of a cross-listing on US exchanges they bond themselves to highly demanding listing requirements and to increased levels of litigation exposure with respect to their accounting. Subsequently, they reinforce this perception of investor care by reporting conservative earnings.

Keywords: accounting conservatism, financial reporting, contracting, corporate governance, cross-listing

JEL Classification: G14, G15, G34, G38, M41, M43, M44, K22