The Effect of Indemnification on Earnings Guidance

54 Pages Posted: 22 Jul 2005

See all articles by Jiangxia Liu

Jiangxia Liu

University of Texas at Dallas - Naveen Jindal School of Management

Suresh Radhakrishnan

JSOM, University of Texas at Dallas

Chandra Seethamraju

Franklin Templeton Investments

Date Written: July 2005

Abstract

We examine the relationship between earnings guidance and manger indemnification controlling for earnings surprise, size, book-to-market, whether the firm operates in the high technology or regulated industries, and the type of news. We find that indemnification decreases the likelihood of earnings guidance; and that manager indemnification affects both good news and bad news firms in the same fashion, i.e., decreases the likelihood of earnings guidance. This relationship is driven primarily by the earnings guidance in the fourth quarter when the earnings surprise is the highest. This suggests that increased litigation triggered by indemnification, i.e., the deep pocket theory leads to less earnings guidance. We also examine whether managers' opportunistically disclose information when they are indemnified by considering the interaction between indemnification and change in compensation (salary, bonus and options) from the previous to the current year. We find that managers who are indemnified are more likely to provide good news earnings guidance, which is consistent with the notion that indemnification is used in an opportunistic fashion to disclose good news information so as obtain higher compensation package. These findings highlight the importance of considering the insurance effects and its interactions especially when examining the relationship between disclosure and litigation. Noting that the direct litigation costs (legal expenses and penalties) can be insured but the indirect litigation costs (cost of lost reputation and productive activities) cannot, we find evidence consistent with the argument that indirect litigation costs are of greater concern for managers than direct litigation costs.

Keywords: Earnings Guidance, indemnification, litigation risk

JEL Classification: M41, M45, J33

Suggested Citation

Liu, Jiangxia and Radhakrishnan, Suresh and Seethamraju, Chandrakanth, The Effect of Indemnification on Earnings Guidance (July 2005). Available at SSRN: https://ssrn.com/abstract=757005 or http://dx.doi.org/10.2139/ssrn.757005

Jiangxia Liu

University of Texas at Dallas - Naveen Jindal School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States

Suresh Radhakrishnan (Contact Author)

JSOM, University of Texas at Dallas ( email )

Mail Stop SM 41
800 West Campbell Road
Richardson, TX 75080
United States
972-883-4438 (Phone)
972-883-6811 (Fax)

Chandrakanth Seethamraju

Franklin Templeton Investments ( email )

Multi Asset Strategies
P.O. Box 997152
San Mateo, CA 95899-7152
United States

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