In common law countries such as the U.S., corporate governance aims primarily to protect shareholders from managers’ self-dealing. Post-Enron reforms such as the Sarbanes-Oxley Act of 2002 and various Securities and Exchange Commission rules are examples of this shareholder-oriented approach. However, to the extent that the interests of shareholders and debtholders are not entirely aligned, governance reforms that beneﬁt shareholders may harm debtholders. Similarly, some public polices such as state anti-takeover laws (ATLs) may entrench management and harm shareholders but benefit debtholders by reducing both the variance of cash flow from operations and the firm’s risk of default.
In our recent paper, available here, we examine the effect of state ATLs on accounting conservatism. An important attribute of accounting conservatism is that it requires more stringent verification for good news recognized as gains than for bad news recognized as losses in financial statements. Prior literature suggests two competing views. The “shareholder demand” view is that conservatism facilitates efficient contracting between managers and shareholders in the presence of agency problems. Because ATLs generally entrench corporate management, the severity of manager-shareholder conflicts increases with the strength of ATLs. As such, in the presence of stronger ATLs, shareholders would demand more conservatism as a governance mechanism to constrain opportunistic management behavior such as excess compensation payments and inefficient investments. This view expects firms’ choice of accounting conservatism to increase with the strength of ATLs.
According to the “debtholder demand” view, debtholders, who also demand conservatism, are likely to play a more important role than shareholders in shaping conservatism. Conservatism benefits debtholders by curtailing excessive payments of dividends to shareholders and more quickly transferring decision rights to debtholders. As stronger ATLs provide better protection for the interests of debtholders, debtholders would reduce their demand for conservatism. This view predicts a negative association between the strength of ATLs and accounting conservatism.
To examine our research question, we use a sample of 32,246 observations during the period 1987-2011. We measure the state-level strength of ATLs by the number of ATLs adopted in the state in which the firm is incorporated, and this measure varies over years in many states. We first analyze whether firms incorporated in states with more ATLs choose higher or lower levels of conservatism. With this full sample, we find no significant association between ATLs and accounting conservatism. After dividing our sample according to whether firms are incorporated in the states where their headquarters are located (hereafter, home states) and correcting for potential bias resulting from endogenous incorporation decisions, we find that conservatism decreases with ATLs in firms that are incorporated in states other than their home state (hereafter, out-of-state incorporated firms), suggesting that ATLs indeed reduce conservatism. We do not find such results in firms that are incorporated in their home state.
Our results are robust to a number of alternative specifications including an alternative sample period, additional control variables, and alternative measures of conservatism and antitakeover laws. Our results are also contrary to the findings of Jayaraman and Shivakumar (2013). They document an increase in accounting conservatism after the passage of state ATLs. However, a potential drawback of their model is that it does not control for economy-wide trends in accounting conservatism. We replicate their study and show that after controlling for such changes in accounting conservatism, the post-passage increase in conservatism disappears.
In sum, our results based on out-of-state firms are consistent with the prediction of the debtholder demand view. A possible interpretation for the different results between the two regimes is that, unlike the incumbent managers of home-state incorporated firms who are more likely to benefit from local favoritism, those of out-of-state incorporated firms are less likely to receive such favorable treatment with respect to ATL-related issues. Accordingly, to the extent that managers of out-of-state firms are less entrenched by ATLs, they are thus less likely to engage in self-dealing (e.g., excess compensation) and harm shareholder value. In other words, the potential downside of ATLs is likely less harmful to shareholders of out-of-state firms. Therefore, shareholder demand for conservatism to address ATLs-associated agency problems is relatively weaker for out-of-state firms, relative to home-state firms. On the other hand, stronger ATLs serve as a potent safeguard for debtholder interests, suggesting that debtholder demand for conservatism would decrease in the presence of stronger ATLs. Given that accounting conservatism as a tool also imposes costs upon shareholders and managers, out-of-state firms, when subject to stronger ATLs, would tend to adopt less conservatism without facing significant resistance by shareholders. In comparison, in home-state incorporated firms where the potential downside of ATLs (e.g., exacerbating self-dealing) is relatively severe to shareholders, such switch to less conservatism is more likely to be resisted by shareholders.
Our study suggests that public policies that aim to increase takeover protection are likely to impact accounting conservatism, not through its effect on shareholder interests, but through its effect on debtholder interests. As such, policy makers should be aware of the impact of governance reforms on debtholder interests when they consider and design such policies.
This post comes to us from Professor Shijun Cheng at the University of Maryland’s Robert H. Smith School of Business and from Professor Augustine Duru and Professor Yijiang Zhao at American University’s Kogod School of Business. It is based on their recent paper, “Antitakeover Legislation and Accounting Conservatism: New Evidence,” available here.