Accounting conservatism and board of director characteristics: An empirical analysis

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Abstract

Using three different measures of conservatism, we document that (i) the percentage of inside directors is negatively related to conservatism, and (ii) the percentage of outside directors’ shareholdings is positively related to conservatism. Our results hold after controlling for industry, firm size, leverage, growth opportunities, institutional ownership, inside director ownership, and unobservable firm characteristics that are stable over time. Overall, the evidence is consistent with accounting conservatism assisting directors in reducing agency costs of firms.

Introduction

We investigate the relation between accounting conservatism and board of director characteristics that proxy for board independence and the strength of outside directors’ monitoring incentives. We find strong and robust evidence of (i) a negative relation between the percentage of inside directors on the board and conservatism, and (ii) a positive relation between the percentage of a firm's shares owned by outside directors and conservatism. These findings are consistent with accounting conservatism assisting directors in reducing agency costs of firms.

Fama and Jensen (1983) refer to the board of directors as the apex of an organization's monitoring and control system. Watts, 2003, Watts, 2006 argues that accounting conservatism has evolved as part of an efficient contracting technology that helps in reducing deadweight losses resulting from agency problems. Given that directors require verifiable information to monitor managers and conservatism can facilitate in reducing deadweight losses, examining the relation between conservatism and board characteristics is potentially interesting.

Our tests utilize three conservatism measures: an accrual-based measure, following Givoly and Hayn (2000), a market-based measure following Beaver and Ryan (2000), and a measure of asymmetric timeliness of earnings following Roychowdhury and Watts (2006). We study five board characteristics that proxy for board independence and the strength of the monitoring incentives: (i) percentage of inside directors, (ii) average number of additional directorships held by a firm's directors, (iii) CEO/chair separation, (iv) percentage of shares held by outside directors, and (v) board size.

Our tests control for institutional ownership, percentage of shares held by inside directors, strength of shareholder rights, firm size, sales growth, growth opportunities (R&D and advertising), cash-based performance, and leverage. Furthermore, we use industry-adjusted variables to ensure that our results are not driven by industry differences. In additional testing, we control for unobservable firm characteristics that are constant over time by using the fixed effects regression model with firm and time-specific intercepts.

We find strong and robust evidence of (i) a negative relation between the percentage of inside directors on the board and conservatism, and (ii) a positive relation between outside director ownership and conservatism. CEO/chair separation is unrelated to accounting conservatism in all specifications. The average number of outside directorships is negatively related to conservatism using the accrual-based measure of conservatism. Board size is generally not significantly related to conservatism after controlling for other characteristics and control variables. Overall, the evidence is consistent with the notion that accounting conservatism assists directors in reducing deadweight losses arising from agency conflicts.

A number of prior studies examine the relation between board characteristics and financial reporting quality. For example, Beasley (1996), Dechow et al. (1996), and Farber (2005) document that the percentage of outside directors is negatively related to the likelihood of fraud. Peasnell et al. (2000), Klein (2002b), Xie et al. (2003), and Bowen et al. (2005) document a negative relation between the percentage of outside directors and proxies for earnings management. Anderson et al. (2004) and Ashbaugh et al. (2006) investigate the relation between board characteristics and debt ratings. Wright (1997) documents a positive relation between outside director percentage and analyst ratings of financial reporting quality. However, only one prior study, Beekes et al. (2004), examines board independence and conservatism and documents a positive relation for a sample of UK firms using the Basu measure of conservatism.

Our study differs from Beekes et al. (2004) in three important ways. First, there are important differences in UK and US GAAP as well as other institutional characteristics.1 In general, UK GAAP allows more variation in conservatism across firms (PricewaterhouseCoopers, 2001). For example, it permits upward revaluations of assets and capitalization of certain internally generated intangibles (e.g. development costs) whereas US GAAP prohibits such upward revaluations or capitalization of intangibles. Furthermore, US firms are subject to considerably higher litigation risk than UK firms (Fulbright and Jaworski, 2005; Seetharaman et al., 2002). Finally, UK firms have greater institutional ownership than US firms and UK institutional investors more actively monitor firms as they regularly meet with the board and top management to discuss strategy, governance issues, and financial performance (Black and Coffee, 1994; Williams and Conley, 2005; Aguilera et al., 2006). Greater institutional ownership and more active institutional investor involvement could result in greater board independence as well as the use of more conservative accounting. Taken together, these significant differences in accounting and institutional environments between the US and the UK suggest that the results in Beekes et al. (2004) need not hold for US firms.

Second, Beekes et al. (2004) use only one measure of conservatism—Basu's (1997) contemporaneous or single-period asymmetric timeliness of earnings measure whereas we use an accrual-based measure, a market-based measure, and the Basu measure estimated cumulatively over multiple years following Roychowdhury and Watts (2006).2 The single-period Basu measure is dependent on the composition of equity at the beginning of the period and ignores conservatism effects prior to the estimation period. This is referred to as the ‘starting point problem’ (Pae et al., 2005). Roychowdhury and Watts (2006) show that measuring asymmetric timeliness over a longer horizon mitigates some of the bias in the Basu measure. Other methodological differences between Beekes et al. (2004) and our study are that we employ a more extensive set of control variables not included in their tests: industry, institutional ownership, profitability, R&D, litigation risk, and the strength of shareholder rights.

Third, while Beekes et al. (2004) focus on examining board independence, we examine a broader set of board characteristics that reflect the strength of directors’ monitoring incentives as well as board independence.

In summary, we employ more rigorous testing on a sample of firms that is potentially quite different than the sample studied in Beekes et al. (2004) and examine additional board characteristics not examined in their study.

An important limitation of our study is that we only focus on board of director characteristics and conservatism. In reality, there are many governance mechanisms with differing costs and benefits and the optimal combination of mechanisms is chosen to maximize firm value. In other words, conservatism and board characteristics are likely to be endogenously chosen along with other governance mechanisms such as incentive contracts, managerial and institutional ownership, and financing structure. While the positive association between our measures of board independence and conservatism is robust to various controls such as institutional ownership, inside director ownership, shareholder rights, and leverage as control variables, the endogeneity inherent in our tests prevents us from drawing strong conclusions about the direction of causality.

The remainder of this paper proceeds as follows. We develop the link between board characteristics and conservatism in Section 2. Section 3 presents the research design. Section 4 presents the evidence and a discussion of alternative explanations. Section 5 presents the conclusion.

Section snippets

Motivation for examination of the relation between board characteristics and conservatism

Conflicts of interest between managers and other parties to the firm arise because managers effectively control firms’ assets but generally do not have a significant equity stake in their firms (Berle and Means, 1932; Jensen and Meckling, 1976). These conflicts cannot be resolved completely through contracts because it is costly, if not impossible, to write and enforce complete contracts (Fama and Jensen, 1983; Hart, 1995). Thus, in a world with incomplete contracts, corporate governance

Research design

This section presents a discussion of (i) the proxies we use for board independence and the strength of monitoring incentives, (ii) measures of accounting conservatism, and (iii) the empirical models and estimation methods.

Sample and descriptive statistics

The sample consists of 306 firms out of the S&P 500 over the fiscal years 1999–2001. We collect Governance data from 1999 and 2000 from proxy statements in the Lexis–Nexis database.9 We obtain governance data for the year 2001 from the Corporate Library

Conclusion

Using three different proxies for conservatism, we find robust evidence of (i) a negative relation between the percentage of inside directors on the board and conservatism, and (ii) a positive relation between the percentage of a firm's shares owned by outside directors and conservatism. Our results hold after controlling for industry, firm size, leverage, growth opportunities, institutional ownership, inside director ownership, strength of shareholder rights, and unobservable firm

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  • Cited by (0)

    We thank Bill Baber, Bill Brown, Ravi Dharwadkar, Randy Elder, David Harris, Sok-Hyon Kang, Krishna Kumar, Gerry Lobo, P.K. Sen, Doug Stevens, Ross Watts (the editor), an anonymous referee, and workshop participants at the University of Cincinnati, University of New Hampshire, George Washington University, Syracuse University, and the 2006 AAA annual meeting for helpful comments.

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