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Agency-based demand for conservatism: evidence from state adoption of antitakeover laws

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Abstract

We use antitakeover laws passed by several states in the mid-1980s and early 1990s as an exogenous increase in agency conflicts and examine how these laws affect the demand for asymmetric timeliness of loss recognition (ATLR). Consistent with the debt-based contracting demand for ATLR, we find an increase in ATLR after the passage of antitakeover laws for firms with high contracting pressures. These increases are incremental to those found in control firms that face similar pressures but whose states did not pass antitakeover laws. We do not find comparable changes in ATLR for firms with higher agency costs of equity. In contrast to the observed increases in ATLR, we find no change in the short-window information content of earnings announcements. Overall, our results suggest that higher agency conflicts result in a heightened demand for ATLR in financial statements but not for more forward-looking new information. Further, these demands seem to emanate from debtholders and not from equityholders.

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Notes

  1. Consistent with prior studies, we define asymmetric timeliness of loss recognition (or conditional conservatism) as the incremental timeliness with which accounting earnings reflect economic losses relative to economic gains.

  2. We also compare changes in the information content of earnings to examine whether increases in agency conflicts result in more forward-looking information in earnings.

  3. While we focus on the agency costs of debt, we also examine, in subsequent tests, whether increases in agency conflicts between shareholders and managers contribute to our findings. We find that they do not.

  4. While Dietrich et al. (2007) and Patatoukas and Thomas (2011) argue that the Basu measure suffers from biased inferences, Ball et al. (2010) demonstrate that the Basu measure is well specified. Moreover, Ball et al. (2011b) note that including firm fixed effects (which we do) purges biases identified by Patatoukas and Thomas (2011). We do not rely on the firm-level measure of conservatism developed by Khan and Watts (2009), since it is based on leverage, and changes in leverage around the passage of antitakeover laws could mechanically cause an increase in ATLR in the post-antitakeover period. Callen et al. (2010) provide an alternative firm-specific measure of conservatism that is based on a particular VAR decomposition of returns and earnings. Chen and Zhao (2009), however, suggest that VAR decompositions of returns and earnings yield counterintuitive and non-robust results.

  5. We present only a brief overview of the passage of these laws and refer the reader to more detailed discussions in Hackl and Testani (1988), Karpoff and Malatesta (1989), and Bertrand and Mullainathan (1999, 2003).

  6. John and Litov (2010) attribute their findings partly to the greater presence and higher levels of credit ratings for firms with entrenched managers.

  7. Chava et al. (2009) note an indirect effect of increased managerial entrenchment on payout policy. Entrenched managers value internal cash and liquid assets for empire building, whereas shareholders prefer the use of cash for larger divided payments. While this managerial preference for cash might appear to benefit bondholders, its benefit is limited as managers can fritter away the cash in other ways.

  8. Other studies on the effects of antitakeover laws include Cheng et al. (2004), who document a decline in managerial ownership in the post-legislation period, and Francis et al. (2010), who study the effect of antitakeover laws on cost of debt.

  9. We find consistent results when we define returns from the period t − 9 to t + 3 relative to the fiscal year end (t).

  10. Bebchuk and Cohen (2003) find that adoption of antitakeover laws affects firms’ choice of state of incorporation. By requiring firms to be present in the pre- and the post-periods, our sample selection criterion helps assuage these endogeneity concerns. However, we find qualitatively similar results when we do not restrict our sample to only firms with both pre- and post-period data.

  11. Interacting the Basu coefficient with the year indicators does not alter our inferences.

  12. We examine the sensitivity of our results to using shorter windows around the event. These results are presented in Sect. 5.5.

  13. We find similar results to those reported when we measure SIZE using chained-dollars (based on the Chain-type GDP price index (http://research.stlouisfed.org/fred2/series/GDPCTPI/downloaddata?cid=21)).

  14. Our inferences are unaltered by changing the year around which debt increases are computed for control firms.

  15. POST is defined relative to the middle year of the sample (that is, 1986) for control firms.

  16. We find results consistent with those reported when we use data from the cash-flow statement for a smaller sample of firms with both pre- and post-adoption cash-flow statement data.

  17. The coefficient on RET*NEG is positive and significant when CFO is the dependent variable, suggesting that accruals are not the sole driver of ATLR in the pre-period. This finding is consistent with the evidence in Basu (1997), who reports a similar result for the sample period 1963–1990. However, increases in ATLR after adoption of antitakeover laws (the focus of our study) are driven by accruals and not by cash flows.

  18. We use the FTP (Legacy) version of the merged CRSP/Compustat database for these tests to maintain consistency with Richardson (2006).

  19. These inferences are robust to using debt issuances to capture debt-contracting pressures.

  20. Results are robust to using only firms with credit ratings.

  21. These results are also robust to using debt issuances to capture firms with greater debt-contracting pressures.

  22. Results based on the entire sample with an interaction term for good news provide similar inferences.

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Acknowledgments

We thank Russ Lundholm (editor), an anonymous referee, Sugata Roychowdhury, and workshop participants at London Business School for helpful comments.

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Authors and Affiliations

  1. Olin Business School, Washington University in St. Louis, Campus Box 1133, One Brookings Drive, St. Louis, MO, 63130, USA

    Sudarshan Jayaraman

  2. London Business School, Regent’s Park, London, NW1 4SA, UK

    Lakshmanan Shivakumar

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  1. Sudarshan Jayaraman
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  2. Lakshmanan Shivakumar
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Correspondence to Lakshmanan Shivakumar.

Appendix

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Table 17 Variable definitions
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Jayaraman, S., Shivakumar, L. Agency-based demand for conservatism: evidence from state adoption of antitakeover laws. Rev Account Stud 18, 95–134 (2013). https://doi.org/10.1007/s11142-012-9205-8

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