Managerial legal liability coverage and earnings conservatism☆
Introduction
This study examines whether managerial legal liability coverage and earnings conservatism are negatively associated. Recent high-profile financial scandals have heightened the concerns of the investing public, accounting and auditing regulators, and the accounting profession at large regarding the quality of corporate financial reporting, especially the practice of aggressive accounting. Managers have an incentive to report earnings aggressively to increase their compensation, avoid debt covenant violations, and/or decrease the firm's cost of capital. However, litigation concerns constrain aggressive reporting by managers. Prior studies identify litigation as one of the explanations for conservative financial reporting, arguing that managers have an incentive to report conservatively to reduce expected legal liability (Basu, 1997; Holthausen and Watts, 2001; Watts, 2003). This paper documents empirical evidence that managerial legal liability coverage reduces earnings conservatism.
Our measure of managerial legal liability coverage is the sum of directors’ and officers’ (D&O) liability insurance coverage and cash for indemnification. Since D&O insurance data is unavailable for U.S. firms, we use publicly available insurance data for Canadian firms. We measure earnings conservatism by examining asymmetric timeliness in earnings (i.e., a more timely recognition of bad news in earnings). Our analysis using Canadian firms indicates that the higher the D&O insurance coverage and cash for indemnification, reducing the expected legal liability of managers, the less conservative the firm's earnings. This association is more pronounced in a sub-sample of Canadian firms cross-listed in the U.S., compared to the sample firms with local listing only, which we attribute to greater legal liability exposure. Various measures of earnings conservatism provide similar results.
Our findings contribute to the conservatism literature by examining the association between managerial legal liability coverage and earnings conservatism. Thoman (1996) suggests that both managers’ and auditors’ legal liability exposure influences conservative reporting.1 Although extensive prior research examines whether variation in auditor legal liability exposure is associated with earnings conservatism (e.g., Kothari et al., 1989; Basu, 1997; Basu et al., 2001; Holthausen and Watts, 2001; Krishnan, 2005), empirical research of the association between managers’ legal liability exposure and conservatism is lacking. Our study provides the first empirical evidence that managerial legal liability coverage is a determinant of earnings conservatism.
The remainder of this paper is organized as follows. In Section 2, we provide institutional background, review the literature, and develop hypotheses. Section 3 contains the research design for the empirical tests, and Section 4 presents the sample selection and data description. In Section 5, we discuss the empirical findings, and Section 6 performs robustness checks. Section 7 offers some concluding remarks.
Section snippets
Institutional background, literature review, and hypothesis development
In Canada, two layers of protection are available to lift the risk of lawsuits away from directors and officers and enable the firm to retain and attract talented corporate leadership. In this section, we first present the details of indemnification, a legislative response to protect the wealth of directors and officers, and provide historical development as well as institutional arrangements of D&O insurance. We then review the literature on the effect of legal liability on earnings
Measures of earnings conservatism
We measure managers’ legal liability coverage by the sum of the D&O insurance coverage limit and cash for indemnification. Following Basu (1997), our first model is a reverse regression of annual earnings on contemporaneous stock returns, where the timeliness of earnings is measured as the responsiveness of accounting income to changes in market value. Conservatism is defined as accounting income asymmetrically reflecting economic news. Using negative stock returns as a proxy for bad news, and
Sample selection
We examine Canadian firms that were listed on the Toronto Stock Exchange (TSX) because their insurance data is publicly available.24 Table 1 presents the sample selection process. Using the Compustat Canadian Industrial Quarterly file from 1998 to 2004, we identify an initial sample of 438 firms (2,862 firm-years) that were listed at least once on the TSE 300 index (currently the S&P/TSX Composite Index).25
Earnings-return regressions
Table 4 reports results of testing the relation between annual earnings and contemporaneous stock returns for the full, the cross-listed and the local sample. To see whether there is a difference between conservatism of high coverage firms and low coverage firms, we focus on the coefficient on DR×RET×RANK, β22, which measures the incremental responsiveness of earnings to bad news when total coverage is high. If conservatism were reduced in those instances where total liability coverage is high,
Exclusion of firms that do not carry D&O insurance
In cases where proxy circulars do not mention D&O insurance, we assume that the firm does not carry D&O insurance. To check the robustness of this assumption, we conduct the ordinary least squares estimation of Eqs. (2), (3) and examine earnings and stock returns skewness using only the 783 firm-years for firms that carry D&O insurance. The ordinary least squares estimation (with Newey-West corrected t-statistics) of earnings–returns relation and the earnings skewness provide results consistent
Concluding remarks
Using Canadian firms whose D&O insurance data are publicly available, we find that managerial legal liability coverage is negatively associated with earnings conservatism. Specifically, firms with high managerial liability coverage, as measured by the sum of D&O insurance coverage and cash for indemnification, tend to recognize bad news in a less timely manner than those with low liability coverage. This association is more pronounced for the cross-listed sample that faces greater litigation
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We are grateful for the comments from Avinash Arya, Mark Bagnoli, Huajing Chen, Bill Duncan, Catherine Finger, Bun Lee, William Stammerjohan, Don Vickrey, Susan Watts, Han Yi, and participants at Louisiana State University, Louisiana Tech University, Purdue University, and the 2006 American Accounting Association annual conference. We are indebted to the editor, Ross Watts, and the referee, Sudipta Basu, for their valuable insights. We would also like to thank Karen Pierce for her research assistance.