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Litigation risk, information asymmetry and conditional conservatism

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Abstract

This study examines whether a change in litigiousness explains variations in the relationship between information asymmetry and conditional conservatism. Prior literature documents a positive association between information asymmetry and conservatism. Prior literature also demonstrates that shareholder litigation concerns motivate managers and auditors to be conservative in preparing financial statements. In a more litigious environment, both managers and auditors have incentives to be more sensitive to expected litigation costs which increase with the level of information asymmetry. We hypothesize and find that higher levels of litigiousness enhance the association between information asymmetry and conservatism. This topic is important given the role of conservatism in accounting practice and the recent tendency for standard setters to view conservatism in a negative light. Prior research argues that conservatism is a favorable characteristic in equity markets because of its information role. This study attempts to gain a further understanding of what affects that role.

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Notes

  1. The legal regime change was a result of a 1994 major US Supreme Court decision in Central Bank of Denver, N.A.V. First Interstate Bank of Denver case and the Private Securities Litigation Reform Act of 1995.

  2. The increase in conditional conservatism is immediate in response to increases in the probability of litigation but delayed with a lag in response to increases in information asymmetry. C-score rises by 0.233 over a two-year period in response to increases in the probability of litigation compared with 0.056 in response to increases in information asymmetry.

  3. Under Joint and Several Liability, auditors could be named to lawsuits because of their deep pockets rather than culpability.

  4. http://en.wikipedia.org/wiki/Central_Bank_v._First_Interstate_Bank.

  5. Shortly after the enactment of the Act, shareholders managed to circumvent the Act and shift their cases to the state courts from the federal courts. As a result, litigiousness bounced back moderately (Grundfest and Perino 1997) until the US congress passed the Securities Litigation Uniform Standards Act in October 1998. This somewhat works against supporting our hypothesis. Note, though, that the vast majority of the literature still concludes a decrease in ex-ante litigation risk after the legal regime change. The judicial and legislative events will affect the ex-ante litigation risk at least over a short period of time.

  6. Some studies (e.g., Givoly et al. 2007) have identified measurement error issues with the Basu model. But asymmetric timeliness is the most direct implication of conservatism (Ryan 2006). The Basu measure is conceptually superior and remains a premier, widely-used measure of earnings conservatism (Ball et al. 2010; Ryan 2006). We also follow Khan and Watts (2009) and use C_score as an alternative measure of conditional conservatism.

  7. The purpose of using the annual returns ending three months after the fiscal year end is to ensure that the market response to the previous year’s earnings is excluded. We use net income (Compustat #172) instead of net income before extraordinary items (Compustat #18) because the latter may not capture all the conservative accounting choices made by the firm (Pope and Walker 1999).

  8. See Easley et al. (1997, 2002) for more details.

  9. We use dummy variables instead of continuous PIN or bid-ask spread variables to facilitate interpretation and allow for non-linearity as well as alleviate measurement error concerns. Results using continuous variables are qualitatively similar.

  10. Compared with the Kim and Skinner (2012) sample, our sample of 44,519 (vs. 32,906) over 1996–2008 has a greater portion of firms in high-risk industries (0.357 vs. 0.263), a greater percentage of smaller firms (lagged assets 5.608 vs. 6.368), higher sales growth (0.156 vs. 0.113), lower return (0.076 vs. 0.123), less return skewness (0.319 vs. 0.334), much higher standard deviation (0.152 vs. 0.031) as well as greater turnover (1.88 vs. 1.21).

  11. We thank Professor Soeren Hvidkjaer for making the PIN scores available on his website.

  12. All the t-statistics in this paper are based on robust standard errors with cluster analysis at the firm-year level to control for cross-sectional and time-series correlation.

  13. Incidentally, untabulated basic Basu (1997) model results show greater conditional conservatism for firms exposed to higher levels of ex-ante litigation risk (t = 1.83; p = 0.034 one-tailed), consistent with the litigation explanation for conservatism.

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Acknowledgments

The authors would like to thank Cheng-Few Lee (the editor) and the anonymous referees for helpful comments. We appreciate the insightful comments and suggestions from Dan Thornton, Mike Welker and Lynette Purda at Queen’s university as well as comments from Mozaffar Khan, Hollis Ashbaugh-Skaife, Jinhan Pae, Steven Salterio, Pamela Murphy, Fayez Elayan, Pascale Lapointe-Antunes, Feng Chen, Leona Lai, Songlan Peng, Sung Kwon, Samir Trabelsi, Hussein Warsame and other participants at Queen’s University, York University, UBC Okanagan, University of Saskatchewan, University of Lethbridge, Brock University, Ryerson University as well as Hanmei Chen and Shelley Lukasewich (the discussants) at the 2010 AAA Mid-Atlantic Region meeting and 2010 AAA and 2010 CAAA Annual Meetings.

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  1. Goodman School of Business, Brock University, St Catharines, ON, Canada

    Zhefeng Liu & Fayez A. Elayan

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  1. Zhefeng Liu
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Correspondence to Zhefeng Liu.

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Liu, Z., Elayan, F.A. Litigation risk, information asymmetry and conditional conservatism. Rev Quant Finan Acc 44, 581–608 (2015). https://doi.org/10.1007/s11156-013-0428-y

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