The Effect of Indemnification on Earnings Guidance
54 Pages Posted: 22 Jul 2005
Date Written: July 2005
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: Suggested Citation