ahmed duellman
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Journal of Accounting and Economics 43 (2007) 411437
Accounting conservatism and board of director
characteristics: An empirical analysis$
Anwer S. Ahmeda, Scott Duellmanb,
aTexas A & M University, Texas, USAb
Department of Accounting, School of Management, State University of New York at Binghamton,Binghamton, NY 13902, USA
Available online 6 February 2007
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, andunobservable firm characteristics that are stable over time. Overall, the evidence is consistent with
accounting conservatism assisting directors in reducing agency costs of firms.
r 2007 Elsevier B.V. All rights reserved.
JEL classification: G3; M41
Keywords: Accounting conservatism; Board independence; Outside directors; Corporate governance; Agency
costs
1. Introduction
We investigate the relation between accounting conservatism and board of director
characteristics that proxy for board independence and the strength of outside directors
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www.elsevier.com/locate/jae
0165-4101/$ - see front matterr 2007 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2007.01.005
$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.
Corresponding author. Tel.: +1 607 777 2544; fax: +1 607 777 4422E-mail address: duellman@binghamton.edu (S. Duellman).
http://www.elsevier.com/locate/jaehttp://localhost/var/www/apps/conversion/tmp/scratch_4/dx.doi.org/10.1016/j.jacceco.2007.01.005mailto:duellman@binghamton.edumailto:duellman@binghamton.eduhttp://localhost/var/www/apps/conversion/tmp/scratch_4/dx.doi.org/10.1016/j.jacceco.2007.01.005http://www.elsevier.com/locate/jae -
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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 firms 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 organizations
monitoring and control system. Watts (2003, 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 followingBeaver 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 firms 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 thatare 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 fromagency 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 oneprior 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.
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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 (Pricewater-
houseCoopers, 2001). For example, it permits upward revaluations of assets and
capitalization of certain internally generated intangibles (e.g. development costs) whereasUS 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 inBeekes et al. (2004) need not hold for US firms.
Second, Beekes et al. (2004) use only one measure of conservatismBasus (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 followingRoychowdhury 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 theBasu 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, whileBeekes 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,
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1SeeAguilera et al. (2006)for a full discussion of the institutional differences between US and UK firms and
Seetharaman et al. (2002) for a full discussion on the difference in litigation risk.2When we use the single-period Basu measure we find that theBeekes et al. (2004)results do not hold for the US
sample.
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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 5presents the conclusion.
2. Hypothesis development
2.1. 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 equitystake 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 mechanisms arise to mitigate these
conflicts.3 Governance mechanisms (such as board of directors, institutional shareholders,
managerial ownership, labor and corporate control markets, etc) differ in terms of their
costs and benefits. The optimal combination of governance mechanisms is chosen to
maximize firm value and is likely to vary systematically across firms because these costs
and benefits likely vary with firm characteristics such as the investment opportunity set,
leverage, and the relative importance of external financing (Leftwich et al., 1981;Agrawal
and Knoeber, 1996;Boone et al., 2006; Watts, 2006).
Ideally, an empirical study of governance mechanisms would conduct a joint
examination of the entire set of internal and external governance mechanisms that
collectively maximize value. However, the identification and estimation of structural
equations that jointly explain the choice of governance mechanisms is a very difficult task.
We focus on the relation between board of director characteristics and accounting
conservatism for two reasons.
First,Fama and Jensen (1983, p. 311) argue that boards are the common apex of the
decision control systems of organizations in which decision agents do not bear a majorshare of the wealth effects of their decisions. Boards ratify and monitor top managers
decisions because it is efficient to separate decision initiation and implementation from
decision ratification and monitoring. Directors are given the power to hire and fire
managers, determine managers compensation, and approve key decisions such as
acceptance of major investment projects (Grinstein and Tolkowsky, 2004). Directors also
advise managers on proposed strategies and provide outside expertise.4
Second, directors need verifiable information in order to effectively monitor and advise
managers. The accounting and financial reporting system is a critical source of verifiable
information that is useful in monitoring and evaluating managers as well their decisions
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3Zingales (1998, p. 499)defines corporate governance as the complex set of constraints that shape the ex post
bargaining over quasi-rents generated by a firm.4Recent theoretical work on boards includesGillette et al. (2003),Harris and Raviv (2005),Raheja (2005), and
Adams and Ferreira (2007).
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and strategies (Watts and Zimmerman, 1986; Bushman and Smith, 2001). Furthermore,
conservatism is an important characteristic of a firms accounting system that can help
directors in reducing deadweight losses and disciplining other sources of information
thereby increasing firm and equity values (Watts, 2003, 2006). Therefore, examining the
relation between board characteristics and conservatism is potentially interesting. Therelation between board strength and accounting conservatism is discussed in greater detail
below.
2.2. Complementary relation between board strength and conservatism
In this sub-section, we argue that strong boards will demand greater conservatism
because conservatism can help directors in reducing agency costs (such as deadweight
losses) arising from asymmetric information between managers and other parties to the
firm as well as asymmetric payoff functions and limited liability (Watts, 1977, 2003, 2006).
Managers have better information than outsiders as well as incentives to favorably bias
the information they supply to outsiders and take actions that result in deadweight losses
and thus reduce firm and equity values (Jensen and Meckling, 1976; Watts and
Zimmerman, 1986). For example, managers can reduce firm value through extracting
excessive compensation or consumption of perquisites. The excessive compensation
reduces the resources that are available for investment in positive NPV projects. Thus,
such behavior generates deadweight losses due to forgone positive NPV projects. Similarly,
other value reducing actions include investing in pet projects that have a negative NPV or
for empire-building purposes, and/or manipulating stock price through accounting
manipulations.Watts (2003) argues that conservatism reduces managers ability and incentives to
overstate earnings and net assets by requiring higher verification standards for gain
recognition and reduces managers ability to withhold information on expected losses.
Thus, it prevents overcompensation of managers that is costly to recover ex postbecause of
managers limited liability and tenure. Similarly, in a debt contracting setting,
conservatism reduces managers ability to loosen or avoid dividend restrictions and
transfer wealth from bondholders to shareholders thereby mitigating deadweight losses
and increasing firm value (seeAhmed et al., 2002 for evidence).
Another argument for conservatism facilitating governance, noted byBall (2001), is that
conservatism plays a role in monitoring of firms investment policies. By requiring moretimely recognition of economic (or expected) losses conservatism helps in identifying
negative NPV projects or poorly performing investments. The timely identification of these
negative NPV projects provides the board of directors with a signal to investigate both the
project and the managers. This also limits deadweight losses from poor investment
decisions and thus increases firm and equity values.
The above arguments suggest that conservatism is a potentially useful tool for directors
(especially outside directors) in fulfilling their role of ratifying and monitoring key
decisions. Because stronger boards are likely to be more proficient at efficient contracting
and understand the benefits of conservatism they are likely to demand more conservative
accounting. On the other hand, boards dominated by insiders or boards with weakmonitoring incentives are likely to provide managers with greater opportunity to use
aggressive (less conservative) accounting. Under this view, the strength of board
governance will be positively associated with accounting conservatism.
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2.3. Factors mitigating the complementary relation between board strength and conservatism
There are a number of reasons that might weaken the positive relation between
conservatism and strength of board governance discussed above or even lead to a negative
relation.First, under conservative accounting growth options are not recorded and thus earnings
of firms with high growth options are not very informative about changes in the value of
these options (Ahmed, 1994;Roychowdhury and Watts, 2006). In such cases, boards and
contracting parties use alternative sources of information or even alternative financing
structures. For example, compensation plans for managers of firms with high growth
options exhibit a greater use of stock-based compensation than accounting-based
compensation (Smith and Watts, 1992). Similarly, firms with high growth options tend
to be financed more by equity financing than debt financing.
Second, the use of conservative accounting could possibly cause management to forgo
small positive NPV projects or to terminate positive NPV projects that have negative cash
flows in early periods. Furthermore, it could also result in a board initiating termination
prematurely. If these potentially adverse effects of conservatism exceed the benefits of
conservatism in monitoring investments, the association between board strength and
conservatism will be weakened.
Third, Bushman et al. (2004) suggest that in economies with strong legal protection,
transparency to outside investors disciplines managers to act in shareholders interests.
Thus, limited transparency can lead to increased demands on more costly governance
systems (e.g. the use of more outside directors) to alleviate moral hazard. Consistent with
this view,Bushman et al. (2004)find that when earnings are less timely in general, there is asubstitution towards more costly governance measures (e.g. greater incentives based
compensation). Although, their timeliness measure is not a direct measure of conservatism,
their results suggest the possibility that conservatism and the strength of board governance
could be substitutes.5 To allow for this possibility, our empirical analysis employs two-
tailed tests.
3. 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.
3.1. Proxies for board independence and monitoring incentives
We use five board of director characteristics that focus on the independence and
monitoring incentives of the board of directors: (i) Percentage of insiders on the board, (ii)
Separation of chairman and CEO positions, (iii) Board size, (iv) Number of additional
directorships held by board members, and (v) Outside director ownership.
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5Note that Bushman et al. (2004) report insignificant effects of their timeliness measure on outside director
ownership and percentage of inside directors in their Tables 4 and 5, respectively. Furthermore, the substitution
argument requires that some parties (e.g. shareholder groups or block-holders) other than the board of directors
are willing to act on the information generated by conservative accounting.
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Our first measure of board independence is the percentage of insiders on the board of
directors. Consistent with prior research, we define inside directors as directors who are
currently employed or have been employed by the firm for the past 3 years, are related to
current management, and/or are related to the firm-founder. Our definition of
independence is consistent with Klein (2002b), except that she classifies directors withsignificant business transactions with the firm as non-independent. However, the existence
of significant business transactions does not necessarily lower the monitoring incentive of
the director.6 Therefore, we do not classify directors involved in related party transactions
as non-independent. We obtain similar results (not reported) when directors with
significant business relations detailed in the proxy statements are considered non-
independent directors.
The separation of the position of CEO and chairman of the board proxies for the
strength of outside director monitoring incentives because if the CEO is also chairman
of the board, they are likely to have more influence on director nomination and election
than if these positions are separated. Jensen (1993) argues that separating the positions
of chairman of the board and chief executive officer results in greater independence
of the board from management. Previous research has linked the separation of the
positions of CEO and chairman of the board to higher debt ratings (Ashbaugh et al.,
2006), and to lower likelihood of an SEC enforcement action (Dechow et al., 1996).
We measure CEO/chair duality as a dichotomous variable set equal to one if the
positions of CEO and chairman of the board are occupied by different directors, zero
otherwise.
There are two competing views in the literature about the effects of board size. One view
is that large boards are less effective than small boards due to the difficulties ofcoordinating and engaging a large group (Jensen, 1993). Larger boards can also suffer
from the free-rider problem in the sense that each board member relies on the other
members to monitor management. Some evidence of these problems is discussed in
Hermalin and Weisbach (2003)who state that there is a negative relation between board
size and firm value. A competing view is that large boards allow directors to specialize. For
example, Klein (2002a) finds that audit committee independence is positively related to
board size. Thus, larger boards result in fewer committee assignments per director enabling
directors to specialize. Greater specialization can lead to more effective monitoring.
Consistent with prior literature, we measure board size as the natural log of the total
number of directors.There are competing views about the relation between additional directorships held by
directors and monitoring effectiveness. Fama and Jensen (1983) suggest that additional
outside directorships held by directors result in greater monitoring expertise, as directors
will learn and adapt monitoring techniques from other boards and look to establish a
reputation as an excellent director. Consistent with this theory, Ashbaugh et al. (2006)
document a positive link between the percentage of directors holding an additional
directorship and firm debt ratings. Conversely, a competing view is that additional
directorships distract the directors from their duty of monitoring the firm. Consistent with
this view, Beasley (1996) finds that the average number of outside directorships held is
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6For example, Warren Buffet has significant business transactions at Coca-Cola due to services performed
between Berkshire Hathaway and Coca-Cola. However, due to the significant investment of Berkshire Hathaway
in Coca-Cola it would likely be in Buffets best interest to effectively monitor the firm.
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positively related to the likelihood of financial statement fraud. We measure monitoring
expertise/overextension as the average number of outside directorships held by the board
that are available on Compustat during the sample period.
Finally, we use the percentage of shares held by outside directors as a proxy for the
strength of outside directors monitoring incentives. Although outside directors areimportant in ensuring the independence of the board, they will not have sufficiently strong
incentives to monitor (and if necessary confront) managers if they do not have significant
equity stakes in the firm (Jensen, 1993). Previous research documents that greater director
ownership is related to a lower likelihood of financial statement fraud (Beasley, 1996), and
positively related to firm debt ratings (Ashbaugh et al., 2007), suggesting that outside
director ownership enhances monitoring incentives.
3.2. Proxies for accounting conservatism
Our first set of tests focus require firm-specific conservatism measures at the end of each
year of our sample period that can be used as dependent variables. We use two firm-
specific proxies for conservatism in these tests: a market-value based proxy following
Beaver and Ryan (2000) and an accrual-based proxy following Givoly and Hayn (2000).
Our second set of tests are based on Basus (1997) asymmetric timeliness of earnings
measure estimated cumulatively over several prior years as suggested by Roychowdhury
and Watts (2006). We discuss below the respective measures and their strengths and
weaknesses.
The market-value based measure of conservatism, CON-MKT, is the book-to-market
ratio multiplied by negative one so positive values indicate greater conservatism. Asconservatism results in understating book value of equity relative to market value of
equity, firms using conservative accounting should have lower book-to-market ratios.
Following Beaver and Ryan (2000), we also use the current and 6-years lagged security
returns as additional explanatory variables in the estimation of regressions using CON-
MKT as the dependent variable.7 The strength of this measure is that it reflects the
cumulative effects of conservatism since the inception of the firm. However, it also reflects
economic rents expected to be generated by firms assets-in-place as well as future growth
opportunities (Lindenberg and Ross, 1981). Thus, it is important to control for economic
rents and growth opportunities. We discuss these controls in Section 3.3.
The accrual-based measure of conservatism,CON-ACC, is income before extra-ordinaryitems less cash flows from operations plus depreciation expense deflated by average total
assets, and averaged over a 3-year period centered on year t, multiplied by negative one.
Positive values ofCON-ACC indicate greater conservatism. The intuition underlying this
measure is that conservative accounting results in persistently negative accruals (Givoly
and Hayn, 2000). The more negative the average accruals over the respective periods, the
more conservative the accounting. Averaging over a number of periods also ensures that
the effects of any temporary large accruals are mitigated, as accruals tend to reverse within
a one to 2-year period (Richardson et al., 2005). This measure is not affected by future
economic rents or growth opportunities. However, it does not reflect total or cumulative
conservatism because it ignores the effects of conservatism in prior periods.
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7Using theBeaver and Ryan (2000) bias component instead of the simple book-to-market ratio yields very
similar results. Thus, we report the results based on book-to-market ratio only.
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Following Basu (1997), we use the coefficient that captures the difference in effects of
negative returns and positive returns on earnings, AT (a measure of asymmetric timeliness
in earnings), as a third conservatism measure. Intuitively, this measure captures
asymmetric verification standards for recognition of good and bad news. However, with
3 years of data, it is difficult to obtain firm-specific AT measures. Moreover, Givoly et al.(2007) show that the AT measure can contain significant amounts of measurement error
depending upon the characteristics of the information environment. For example, they
document that for large firms the AT measure is roughly one-third the size of the measure
for small firms.8 Another limitation of the AT measure noted by Roychowdhury and
Watts (2006)is that it ignores the effects of conservatism prior to the estimation period and
thus also does not reflect total conservatism.Roychowdhury and Watts (2006)suggest that
estimating the AT measure cumulatively over multiple periods preceding a given year
generates a better measure of conservatism than AT measures estimated over that year.
Therefore, we use their suggested backward-cumulation approach and discuss the results
in Section 4.4.
3.3. Empirical model for tests using firm-specific conservatism proxies
We estimate the following empirical model containing the five board characteristics
discussed above and seven control variables using OLS regression:
CONi;t b0 b1 Inside Director%i;t b2Avg:# of Directorshipsi;t
b3CEO=Chair Separationi;t b4Outside Director Ownershipi;t
b5Board Sizei;t b6GScorei;t b7 Institutional Ownershipi;t
b8Inside Director Ownershipi;t b9Firm Sizei;tb10Sales Growthi;t
b11R&DADVi;t b12CFO=TAi;t b13Leveragei;t
b14Litigation Riski;t e, 1
where G-Score i,t is the governance index of 24 governance provisions as calculated in
Gompers et al. (2003), Institutional Ownership i,t is the total common shares held by
institutional investors divided by total common shares outstanding, Inside Director
Ownership i,tis the common shares held by inside directors divided by total common shares
outstanding, Firm Size i,t is the natural log of average total assets, Sales Growth i,t is thepercentage of annual growth in total sales, R&D+ADVi,t is research and development
expenditures plus advertising expense divided by sales, CFO/TAi,t is cash flows from
operations divided by average total assets, and Leveragei,t is total long-term liabilities
divided by total assets, Litigation Riski,t is a dichotomous variable set equal to one if the
firm is in a technology industry, zero otherwise.
We control for the strength of shareholder rights, G-Score, because it is an alternative
governance mechanism. Firms with strong shareholder rights are likely to have stronger
governance. We measure shareholder rights following Gompers et al. (2003), who
construct a Governance Index (G-Score) of 24 governance provisions. They find that firms
with strong shareholder rights (low G-Score) have larger future stock returns than firms
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8Additionally,Dietrich et al. (2007)claim that the observed differences between good and bad news timeliness is
due to the sample truncation bias and sample variance ratio.
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with weak shareholder rights (high G-Score). However, this measure has a number of
limitations. First, Gompers et al. (2003) do not document significant difference in
operating performance. Furthermore,Core et al. (2006) document that firms with a high
G-Scorehave low operating performance but this underperformance does not surprise the
market, as indicated by analyst forecasts.Core et al. (2006)conclude that weak governanceis not related to stock returns as the negative stock returns reverse after the initial sample
period. Second, Brown and Caylor (2004) criticize the G-Score as primarily an index of
anti-takeover protection.
We use Institutional Ownership as a control variable because institutional investors are
viewed as an alternative governance mechanism. The large stockholdings of institutional
investors induce them to perform monitoring activities as their voting power allows them
to significantly influence management (Schleifer and Vishny, 1986).Bhojraj and Sengupta
(2003) find results consistent with the monitoring effect of institutional shareholders;
where firms with greater institutional ownership have lower bond yields and higher debt
ratings. Thus, monitoring by institutions can substitute for monitoring by the board.
However, high institutional ownership also allows institutions to influence managers and
secure private benefits at the expense of other shareholders. We use the percentage of
shares outstanding owned by institutional investors as an explanatory variable but because
of the competing effects, we do not have an a priori prediction on the coefficient of this
variable.
We control for the amount of ownership held by inside directors, Inside Director
Ownership, as under classical agency theory, larger amounts of ownership by management
will lead to greater goal congruence between management and shareholders. Consistent
with this theory, Warfield et al. (1995) find a negative relation between managerialownership and abnormal accruals. Conversely, inside directors could utilize their voting
power to expropriate rents from the firm. Additionally, in the extreme case that managers
own 100% of equity, there is no governance problem or a role for conservatism in firm
governance. Due to the competing effects, we do not have an a priori prediction on the
coefficient of this variable.
We control for firm size,Firm Size, by including the natural log of average total assets as
an explanatory variable. Large firms likely face large political costs that induces them to
use more conservative accounting (Watts and Zimmerman, 1978). However, these political
costs could be dominated by the information asymmetry effect and aggregation effect.
LaFond and Watts (2006) argue that information asymmetry is often smaller for largefirms because they produce more public information which in turn reduces the demand for
conservative accounting. Furthermore,Givoly et al. (2007)contend that the aggregation of
projects in large firms can lead to incorrect inferences regarding the level of conservatism.
Givoly et al. (2007) and LaFond and Watts (2006) document that the asymmetric
timeliness of earnings for large firms is significantly smaller than for small firms consistent
with the information asymmetry and aggregation effect dominating the political cost
effect.
We control for sales growth, Sales Growth, as proxied by the annual percentage growth
in total sales becauseAhmed et al. (2002)argue that sales growth is likely to affect CON-
ACCandCON-MKTfor three reasons. First, growth in sales will affect accruals such asinventory and receivables, which in turn affects CON-ACC. Second, for firms with
declining sales CON-ACC is likely a poor measure of accounting conservatism. Third,
large growth in sales often inflates the markets expectations of future cash flows, which
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could affectCON-MKT. Consistent withAhmed et al. (2002), we predict a negative effect
ofSales Growth on CON-ACCand a positive effect on CON-MKT.
We control for research and development and advertising expenditures, R&D+ADV,
as they are likely to capture economic rents generated by assets-in-place, growth
opportunities, and GAAP mandated conservatism (Ahmed, 1994). We control forprofitability as proxied by the cash flow from operations divided by average total assets,
CFO/TA, asAhmed et al. (2002)argue that profitable firms tend to use more conservative
accounting.
We include total long-term debt divided by average total assets, Leverage, as a control
variable. Firms with high levels ofLeverage tend to have greater bond-holder and share-
holder conflicts which in turn have been shown to affect the contractual demand for
conservative accounting. Ahmed et al. (2002) find accounting conservatism mitigates
bond-holder and share-holder conflict over dividend policy and reduces firms cost of debt.
Similarly,Zhang (2006) documents that lenders benefit from conservative accounting via
the accelerated violations of debt covenants while borrowers benefit from conservative
accounting via lower initial interest rates. Frankel and Roychowdhury (2005) find that
the asymmetric timeliness of GAAP earnings is greater than the asymmetric timeliness of
I/B/E/S earnings particularly in the presence of high leverage which they argue is con-
sistent with accounting conservatism reducing contracting costs. Additionally, Beatty
et al. (2006)find that contract modifications alone are unlikely to satisfy lenders demand
for information thus financial reporting conservatism is also required to reduce agency
costs.
We include a dummy variable to control for firms with high litigation risk (Litigation
Risk). As the expected cost of litigation is higher for firms that overstate their earningsand/or asset base than firms that understate their earnings and/or asset base firms can use
conservative accounting to decrease their expected litigation costs (Watts, 2003).
Furthermore, Field et al. (2005) find that technology firms have higher litigation risk
than non-technology firms. Thus, we control for litigation risk by including a dummy
variable indicating whether firms are in a technology industry, as defined by Field et al.
(2005), that is equal to one if the firm is an a technology industry and zero otherwise.
Finally, we control for industry, using industry definitions in Barth et al. (1999), by
deducting the industry median values of the dependent and independent variables used in
our tests. This is an additional control for economic rents and growth opportunities as
rents and growth opportunities likely vary across industries. We also include the currentand six years lagged returns buy and hold returns in the CON-MKTregressions following
Beaver and Ryan (2000).
3.4. Empirical model for tests using the asymmetric timeliness measure
In addition to the general problems with the asymmetric timeliness measure discussed in
Section 3.2, there are particular problems with this measure for our sample of firms, which
are among the top two size deciles of firms in the US. Specifically, these firms have smaller
asymmetric timeliness measures than smaller firms (Givoly et al., 2007). Smaller
magnitudes of the coefficient imply lower power to detect conservatism and thus testsbased on this measure for our sample are likely to have low power.
We follow the approach suggested by Roychowdhury and Watts (2006) and cumulate
returns and earnings over the past 3 years in estimating this measure. Roychowdhury and
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Watts (2006) demonstrate that the asymmetric timeliness measure is better at capturing
conservatism when estimated over several years. To test for the effects of firm governance
on asymmetric timeliness we employ the following model:
Et;tj=Pt;tj1 a0 b1Dt;tj b2Rt;tj b3Dt;tj Rt;tj
b4In%t b5In%t Rt;tjb6In%t Dt;tj b7In%t
Dt;tj Rt;tj b8Out ownt b9Out ownt
Rt;tj b10Out owntDt;tjb11Out ownt
Dt;tj Rt;tj Other Governance & Control Variablest, 2
where Et,tj is income before extraordinary items cumulative from year tj to year t, Pt,
tj1is the market value of equity at the end of the year t,Dt,tjis an indicator variable set
equal to one ifRett,
t
j
is less than one, zero otherwise, Rett, t
j
is the buy and hold return
starting 4 months after the end of the fiscal year tj1 and ending 4 months after the end
of year t, In %t is the percentage of directors who are currently employed or have been
employed by the firm for the past 3 years, are related to current management, and/or are
related to the firm-founder, Out ownt is the common shares held by outside directors
divided by total common shares outstanding. The other governance & control variables are
Avg. # of Directorships, CEO/Chair Separation, Board Size, G-Score, Institutional
Ownership, Inside Director Ownership, Firm Size, Sales Growth, R&D+ADV, CFO/TA,
Leverage,Litigation Risk, and Industry and Year Controls as defined in Section 3.3. All of
the other governance and control variables in the regression are also interacted with Rett,
t
j, Dt,tj, and Rett, tj* Dt,tj. We do not report the coefficients on the control variablesfor the sake of brevity. The results remain qualitatively unchanged when we remove the
control variables.
AsIn %is the percentage of directors directly affiliated with management, we expect that
firms with greater managerial representation on the board will result in a lower asymmetric
timeliness coefficient. AsOut own measures the incentive of directors to monitor the firm,
we expect that firms with higher levels of ownership by independent directors will result in
a higher asymmetric timeliness coefficient.
4. Evidence
4.1. Sample and descriptive statistics
The sample consists of 306 firms out of the S&P 500 over the fiscal years 19992001. We
collect Governance data from 1999 and 2000 from proxy statements in the LexisNexis
database.9 We obtain governance data for the year 2001 from the Corporate Library
historical governance database. The Corporate Library database contains governance data
from 2001 to 2003. We do not include 20022003 in the sample period because during this
period the legal and regulatory environment changed drastically due to new legislation and
high profile accounting scandals.
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9The G-score was obtained from Andrew Metricks website. As the G-score is only available in 1998, 2000, and
2002, the G-score for 1999 is the average G-score for 1998 and 2000, while the G-score for 2001 is the average G-
score for 2000 and 2002.
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We reconcile differences between the classifications of the independence of directors in
the hand-collected data and the Corporate Library database by referencing the proxy
statements in question.10 We winsorize the top and bottom 1% of the market-based
conservatism and accrual-based conservatism measures to mitigate the effects of extreme
observations.11
Table 1Panel A presents a summary of how the final sample was obtained. Of the 1500
S&P 500 firmyears that are in the sample we eliminate 264 firmyears in the financial
services and insurance (SIC codes 60006999) industries. We eliminate 151 firmyears due
to missing observations in Compustat and 71 firmyears due to missing observations in
Thompson Financial. Twenty-three firmyears are eliminated due to missing data in the
proxy statement. Eighty-five firmyears were eliminated due to missing G-Score values.
We also eliminate 18 firmyears that underwent significant mergers, as these mergers
temporarily inflated the board of directors and skewed the governance measures.
Additionally, 55 firmyears are eliminated, because their proxy statements are not
available in the LexisNexis database leaving a final sample of 833 firmyears (for 306
distinct firms).
Table 1 Panel B presents the industry breakdown of the sample firms. Industries are
defined as inBarth et al. (1999). The industry breakdown of the S&P 500 is proportionally
quite similar to the market as a whole. Each industry contains enough observations to
allow for median differencing by industry to control for industry effects in the regressions.
Table 2Panel A presents the descriptive statistics. The mean value of the accrual-based
conservatism measure (CON-ACC) is 0.010. This is higher than the mean value of accrual-
based conservatism (0.003) reported in Ahmed et al. (2002). However, the difference is
most likely due to the time periods of the studies, as Ahmed et al. (2002)use a sample ofS&P 500 firms from 1993 to 1998 and our sample encompasses accrual data from 1998 to
2002. During our sample period profitability was lower and thus we can expect more
negative accruals. Additionally,Givoly and Hayn (2000) find that conservatism has been
increasing over time. The mean value of the book-to-market ratio multiplied by negative
one (CON-MKT) is 0.363.
The average percentage of inside directors on the board is 22.5%, which is consistent
with the findings ofLarcker et al. (2005),Bushman et al. (2004), andBhojraj and Sengupta
(2003).12 The average director holds 1.4 outside directorships. The most outside
directorships held by any one director in the sample is 14. Approximately 31% of the
sample has a chairman of the board who is not the current CEO. Consistent withLarckeret al. (2005), outside directors typically hold a small percentage of stock with a median
value of 0.1% and a mean value of 1.4%. The board as a whole (not reported) on average
holds approximately 5% of all stock. Institutional investors own approximately 65% of
the stock for S&P 500 firms. The means of Leverage, Firm Size, and Sales Growth are
ARTICLE IN PRESS
10The corporate library database in 2001 classified directors as independent only if they were not current
employees of the firm. In 2002 and beyond the corporate library expanded the definition of outside directors to
outside related. Most of the discrepancies between the hand-collected and Corporate Library data was due to
the differential classification of family members.11
Results remain unchanged when the regressions are run on the unwinsorized data. Additionally, winsorizationat the 2% and 5% levels do not significantly affect the results. Furthermore, winsorization of the top and bottom
1% of independence and outside director ownership do not significantly affect the results.12Although the sample periods and sample sizes are different in Bhojraj and Sengupta (2003),Bushman et al.
(2004), andLarcker et al. (2005)we use these studies as a point of reference in regards to our hand-collected data.
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consistent with the findings ofAhmed et al. (2002). The level ofR&D+ADVare higher in
our sample than inAhmed et al. (2002). The median differenced descriptive statistics arepresented inTable 2Panel B.
Table 3Panel A presents the correlations between the conservatism measures and the
governance and control variables. The accrual-based measure of conservatism (CON-
ACC) and the market-based measure of conservatism (CON-MKT) are positively
correlated at the five percent level of significance using Pearson correlations. Several of
the governance variables (Board Size,CEO/Chair Separation, andAvg. # of Directorships)
are correlated with the accrual and market-based measures of conservatism. For the
control variables,Firm SizeandLeverageare negatively correlated to both the accrual and
market-based measure of conservatism; while R&D+ADV and CFO/TA are positively
related to accounting conservatism. The industry-adjusted correlations are presented inTable 3Panel B. The univariate correlations should be interpreted with caution, as they do
not indicate how the variables jointly affect accounting conservatism and are subject to
omitted variables bias.
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Table 1
(A)Sample selection of S&P 500 firms from 1999 to 2001
Number of firm years in the S&P 500 19992001 1500
Financial services and insurance firms (264)
Missing Compustat data (151)
Missing G-Score data (85)
Missing Thompson financial data (71)
Missing data in the proxy sheet (23)
Significant merger inflating board size (18)
Proxy statements not listed in Lexis-Nexis (55)
Final sample 833
SIC codes Firmyears Distinct firms
(B)Sample firm breakdown by industry
Mining and construction 10001199,
14001499
14 6
Food 20002111 38 13
Textiles, printing, and publishing 22002780 61 22
Chemicals 28002824,
28402899
47 16
Pharmaceuticals 28302836 44 16
Extractive industries 29002999,
13001399
39 16
Durable manufacturers 30003569,
35803669,
36803999
211 77
Computers 73707379,
35703579,36703679
123 45
Transportation 40004899 40 16
Utilities 49004999 75 28
Retail 50005999 101 37
Service 70007369,
73808999
40 14
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Table 2
Descriptive statistics on conservatism proxies, board characteristics, and control variables (without/with industry
adjustment) for the sample of 306 firms over the period 19992001
Mean Std. dev. Min 25% Median 75% Max
(A) Descriptive statistics without industry adjustment
CON-ACC 0.010 0.035 0.084 0.009 0.007 0.024 0.140
CON-MKT 0.363 0.278 2.087 0.503 0.306 0.156 0.253
Inside Director % 0.225 0.117 0.000 0.143 0.200 0.286 0.714
Avg # of Directorships 1.442 0.671 0.000 1.000 1.417 1.889 4.333
CEO/Chair Separation 0.313 0.464 0.000 0.000 0.000 1.000 1.000
Outside Director Ownership 0.014 0.046 0.000 0.000 0.001 0.004 0.479
Board Size 2.351 0.244 1.609 2.197 2.398 2.485 3.135
G-Score 9.739 2.526 3.000 8.000 10.000 11.500 16.000
Institutional Ownership 0.649 0.148 0.000 0.551 0.666 0.754 0.994
Inside Director Ownership 0.031 0.067 0.000 0.001 0.006 0.022 0.566
Firm Size 8.759 1.108 5.835 7.883 8.751 9.581 12.688
Sales Growth 0.144 0.385 0.526 0.002 0.086 0.190 7.110
R&D+ADV/Total Sales 0.055 0.073 0.000 0.000 0.026 0.075 0.386
CFO/TA 0.127 0.079 0.264 0.073 0.119 0.173 0.477
Leverage 0.219 0.155 0.000 0.099 0.220 0.318 0.922
Litigation Risk 0.213 0.411 0.000 0.000 0.000 0.000 1.000
(B) Descriptive statistics with industry adjustment
CON-ACC 0.002 0.034 0.098 0.016 0.000 0.018 0.132
CON-MKT 0.048 0.254 1.758 0.148 0.000 0.096 0.705
Inside Director % 0.015 0.114 0.220 0.067 0.000 0.073 0.532
Avg # of Directorships 0.042 0.657 1.698 0.423 0.000 0.455 2.917
CEO/Chair Separation 0.038 0.491 0.000 0.000 0.000 0.000 1.000
Outside Director Ownership 0.012 0.046 0.012 0.001 0.000 0.003 0.479
Board Size 0.004 0.223 0.875 0.133 0.000 0.143 0.629
G-Score 0.044 2.400 7.500 1.500 0.000 1.500 6.000
Institutional Ownership 0.012 0.136 0.652 0.087 0.000 0.076 0.342
Inside Director Ownership 0.023 0.067 0.033 0.003 0.000 0.011 0.564
Firm Size 0.040 1.020 2.448 0.681 0.000 0.672 4.279
Sales Growth 0.051 0.356 0.726 0.072 0.000 0.091 6.582
R&D+ADV/Total Sales 0.008 0.054 0.159 0.008 0.000 0.026 0.248
CFO/TA 0.004 0.072 0.398 0.039 0.000 0.040 0.326
Leverage 0.016 0.133 0.413 0.061 0.000 0.089 0.632
Litigation Risk 0.015 0.250 0.000 0.000 0.000 0.000 1.000
CON-ACCi,t (net income before extraordinary items plus depreciation expense less cash flows from operations,
where all variables are scaled by average total assets and averaged over 3 years centered around year t) multiplied
by1.CON-MKTi,t book-to-market ratio multiplied by1.Inside Director %i,t percentage of directors who
are currently employed or have been employed by the firm for the past 3 years, are related to current management,
and/or are related to the firm-founder. G-Scorei,t governance index of 24 governance provisions as calculated in
Gompers et al. (2003), the G-score increases as shareholder rights decrease. Avg. # of Directorshipsi,t total
directorships held by the board of directors divided by the total number of directors. CEO/Chair
Separationi,t dummy variable equal to one if the CEO is not chairman of the board, zero otherwise. Board
Sizei,t natural log of the number of directors. Institutional Ownershipi,t total common shares held by
institutional investors divided by total common shares outstanding. Outside Director Ownershipi,t the common
shares held by outside directors divided by total common shares outstanding. Firm Sizei,t natural log of averagetotal assets. Sales Growthi,t percentage of annual growth in total sales. R&D+ADVi,t research and
development costs plus advertising expense divided by sales. CFO/TAi,t cash flows from operations divided
by average total assets. Leveragei,t total long-term liabilities divided by average total assets. Litigation
Riski,t dummy variable equal to one if the firm is classified as a technology firm.
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4.2. Accrual-based conservatism and board characteristics
We estimate Eq. (1) using both an OLS regression and a fixed effects regression with firm
and year-specific intercepts. The fixed effects regression has two advantages over OLS.
First, using panel data in an OLS regression can potentially generate biased estimates, asthe observations are not completely independent. Second, the fixed firm effects pick up the
effect of unobservable firm characteristics that are stable over time and correlated with the
independent variables (Greene, 2000).13 However, because fixed effects regressions control
for unobservable firm characteristics that are constant over time, to the extent that the
relation between conservatism and board characteristics varies cross-sectionally with these
characteristics, there is a potential danger that we are controlling for the effect we are
looking for. Further, the number of observations drops in the fixed effects regressions
because we estimate the fixed effects model on balanced panel data requiring each firm to
have 3 years of data available.14 Table 4presents the results of the regression of the 3-year
industry-adjusted accrual-based conservatism measure on board characteristics. Column
(i) presents the OLS regression results without control variables. Column (ii) presents the
regression in column (i) augmented by the control variables. Column (iii) presents the
results of the regression without control variables including firm and year fixed effects.
Column (iv) presents the regression in column (iii) augmented by the control variables
including firm and year fixed effects. The t-statistics reported in columns (i) and (ii) are
corrected for heteroscedasticity and first-order autocorrelation using the NeweyWest
procedure.15
The coefficient onInside Director %is negative and significant at the 5% level in all four
columns, consistent with conservatism complementing board governance. The coefficienton Outside Director Ownership is positive, consistent with conservatism complementing
board governance. The coefficient is significant at the 1% level in column (i), at the 5%
level in column (ii), and at the 10% level in columns (iii) and (iv) in two tailed tests.
The coefficient on Avg. # of Directorships is significantly negative in columns (i) and
(ii) indicating that each additional directorship weakens the monitoring for the central
firm. However, it is not significant in columns (iii) and (iv). The coefficients onCEO/Chair
Separation andBoard Size are not significant in all four columns.
With respect to control variables, the coefficient on G-Score is negative and marginally
significant in column (ii) suggesting that firms with weaker shareholder rights have less
conservative accounting. However, the coefficient is no longer significant in column (iv).The coefficient on Institutional Ownership, an alternative monitoring mechanism, is
negative significant at the 10% level in column (iv) but insignificant in column (ii). The
coefficient on Firm Size, although insignificant in column (ii), is similar to the size of the
coefficient found inAhmed et al. (2002). However, in column (iv) the coefficient on Firm
Sizeis positive and significant. The signs and significance in column (ii) ofR&D+ADVand
Leverage are consistent with the findings reported in Ahmed et al. (2002). However, these
ARTICLE IN PRESS
13Due to our small sample period, one caveat of our study is the inability to control for cross-sectional
correlation using FamaMacBeth regressions. However, the firm-specific intercept, along with the industry
differencing, should control for a large portion of possible cross-sectional correlation.14We omit theLitigation Riskproxy from the fixed effect models because the firm-specific intercept picks up the
litigation risk as none of the observations change their industry classification during the sample period.15Results do not significantly change by assuming second-order autocorrelation using the NeweyWest
procedure.
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ARTICLE IN PRESS
Table3
Correlations
betweenconservatismproxies,boardcharacteristics,
andcontrolva
riables(without/withindustryadjustment)forthesamplefirmsover1999
2001
1
2
3
4
5
6
7
8
9
10
11
12
13
14
1
5
16
(A)Correlationswithoutindustryadjustment
1
CON-AC
C
1
0.0
6
0.0
4
0.
07
0.
09
0.05
0.
08
0.0
1
0.0
4
0.0
1
0.
07
0.
14
0.
14
0.
30
0.
07
0.
09
2
CON-MKT
0.
08
1
0.0
2
0.0
5
0.
08
0.
07
0.
09
0.
17
0.0
4
0.
10
0.
23
0.
14
0.
43
0.
53
0.
32
0.
31
3
InsideDirector%
0.0
4
0.0
3
1
0.
29
0.
26
0.00
0.
18
0.
18
0.0
1
0.
54
0.
27
0.
16
0.
11
0.
15
0.
21
0.
16
4
Avg#ofDirectorships
0.
07
0.0
5
0.
29
1
0.
11
0.
19
0.
25
0.
13
0.0
2
0.
24
0.
37
0.
15
0.0
4
0.
09
0.0
6
0.
13
5
CEO/Ch
airSeparation
0.
10
0.0
4
0.
26
0.
11
1
0.01
0.
07
0.0
3
0.0
1
0.
07
0.
07
0.
08
0.0
5
0.0
5
0.0
4
0.0
0
6
OutsideDirectorOwnership
0.0
6
0.0
7
0.0
3
0.0
6
0.0
3
1
0.0
0
0.0
1
0.0
2
0.
37
0.
32
0.
11
0.0
5
0.0
0
0.
09
0.0
6
7
BoardSize
0.
07
0.0
8
0.
23
0.
25
0.0
5
0.
13
1
0.
21
0.
15
0.
21
0.
47
0.0
5
0.
20
0.
09
0.
23
0.
29
8
G-Score
0.0
5
0.1
1
0.
17
0.
09
0.0
2
0.02
0.
23
1
0.
16
0.
12
0.0
2
0.
10
0.
07
0.0
1
0.
19
0.
19
9
Institutio
nalOwnership
0.0
0
0.0
4
0.0
2
0.0
3
0.0
1
0.
08
0.
14
0.
16
1
0.0
2
0.
21
0.0
3
0.0
0
0.0
1
0.0
3
0.0
2
10
InsideDirectorOwnership
0.0
0
0.0
8
0.
40
0.
16
0.
09
0.06
0.
15
0.
16
0.
26
1
0.
36
0.
16
0.0
1
0.
07
0.
21
0.0
6
11
FirmSiz
e
0.
07
0.2
2
0.
26
0.
33
0.0
5
0.06
0.
48
0.0
1
0.
21
0.
13
1
0.0
0
0.
25
0.
26
0.
34
0.
18
12
SalesGrowth
0.0
2
0.0
6
0.0
5
0.
10
0.0
6
0.02
0.0
1
0.
09
0.0
4
0.0
1
0.0
6
1
0.
13
0.
11
0.0
3
0.
08
13
R&D+ADV/TotalSales
0.
23
0.3
3
0.
13
0.0
4
0.0
5
0.05
0.
24
0.
13
0.0
4
0.0
2
0.
21
0.0
5
1
0.
29
0.
46
0.
53
14
CFO/TA
0.
34
0.4
6
0.
13
0.
08
0.0
4
0.04
0.
13
0.0
4
0.0
1
0.0
3
0.
25
0.
08
0.
27
1
0.
34
0.
18
15
Leverage
0.
10
0.2
4
0.
16
0.0
5
0.0
1
0.01
0.
23
0.
17
0.0
4
0.
09
0.
31
0.
10
0.
42
0.
32
1
0.
43
16
LitigationRisk
0.
12
0.2
7
0.
19
0.
12
0.0
0
0.
09
0.
33
0.
18
0.0
0
0.0
1
0.
18
0.0
2
0.
62
0.
20
0.
41
1
(B)Correlationswithindustryadjustment
1
CON-AC
C
1
0.0
2
0.0
1
0.0
6
0.0
0
0.01
0.0
1
0.0
0
0.0
2
0.0
1
0.0
4
0.
08
0.
13
0.
29
0.0
1
0.0
2
2
CON-MKT
0.0
6
1
0.0
3
0.
09
0.
07
0.06
0.0
3
0.
13
0.
09
0.
08
0.
13
0.
22
0.
21
0.
48
0.
17
0.
08
3
InsideDirector%
0.0
0
0.0
4
1
0.
30
0.
26
0.01
0.
10
0.
16
0.
09
0.
50
0.
19
0.
17
0.
07
0.
10
0.
13
0.
09
4
Avg#ofDirectorships
0.
07
0.0
7
0.
31
1
0.
11
0.
22
0.
24
0.
11
0.0
4
0.
30
0.
41
0.
11
0.0
1
0.
11
0.0
5
0.
11
5
CEO/Ch
airSeparation
0.0
1
0.0
4
0.
25
0.
11
1
0.05
0.0
4
0.0
3
0.0
2
0.
13
0.
10
0.0
5
0.0
6
0.
07
0.0
3
0.0
2
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variables are insignificant after the inclusion of the firm and year specific fixed effects.Additionally, the coefficient on CFO/TA is positive and significant in column (ii) and
insignificant in column (iv). The coefficients on the other control variables are not
significant at conventional levels.
ARTICLE IN PRESS
Table 4
Results for the regression of industry-adjusted accrual-based conservatism measure on industry-adjusted board
characteristics and control variables. Dependent variable: CON-ACC
(i) (ii) (iii) (iv)
Intercept ? 0.001 (0.77) 0.000 (0.36) 0.008 (0.79) 0.020 (1.98)**
Board characteristics
Inside Director % 0.027 (1.98)** 0.033 (2.50)** 0.030 (2.10)** 0.034 (2.32)**
Avg. # of Directorships ? 0.005 (2.28)** 0.005 (2.31)** 0.004 (1.41) 0.003 (1.19)
CEO/Chair Separation + 0.005 (1.52) 0.003 (1.35) 0.001 (0.55) 0.001 (0.28)
Outside Director Ownership + 0.021(2.41)*** 0.013 (2.01)** 0.067 (1.71)* 0.067 (1.70)*
Board Size ? 0.008 (1.35) 0.010 (1.54) 0.012 (1.54) 0.010 (1.28)
Control variables
G-Score 0.001 (1.68)* 0.001 (0.63)
Institutional Ownership ? 0.000 (0.02) 0.023 (1.76)*Inside Director Ownership ? 0.012 (0.57) 0.011 (0.38)
Firm Size + 0.002 (1.29) 0.012 (2.74)***
Sales Growth 0.008 (1.71)* 0.005 (2.12)**
R&D+ADV + 0.055 (2.24)** 0.051 (1.36)
CFO/TA + 0.165 (7.00)*** 0.009 (0.53)
Leverage + 0.020 (2.20)** 0.014 (0.86)
Litigation Risk ? 0.006 (1.51)
Year & firm fixed effects No No Yes Yes
Sample period 19992001 19992001 19992001 19992001
N 833 833 744 744
Adjusted R-square 0.0130 0.1296 0.7809 0.7885
Thet-statistics reported in columns (i) and (ii) are corrected for heteroscedasticity and first-order autocorrelation
using the NeweyWest procedure. Significance is based on two-tailed tests. */**/*** represents significance at the
10/5/1% level.
CON-ACCi,t (net income before extraordinary items plus depreciation expense less cash flows from operations,
where all variables are scaled by average total assets and averaged over 3 years centered around year t) multiplied
by1.Inside Director %i,t percentage of directors who are currently employed or have been employed by the
firm for the past 3 years, are related to current management, and/or are related to the firm-founder. Avg. # of
Directorshipsi,t total directorships held by the board of directors divided by the total number of directors. CEO/
Chair Separationi,t dummy variable equal to one if the CEO is not chairman of the board, zero otherwise.
Outside Director Ownershipi,t the common shares held by outside directors divided by total common shares
outstanding. G-Scorei,t governance index of 24 governance provisions as calculated in Gompers et al. (2003),
the G-score increases as shareholder rights decrease. Institutional Ownershipi,t total common shares held by
institutional investors divided by total common shares outstanding. Inside Director Ownershipi,t the common
shares held by inside directors divided by total common shares outstanding. Board Sizei,t natural log of the
number of directors. Firm Sizei,t natural log of average total assets. Sales Growthi,t percentage of annual
growth in total sales. R&D+ADVi,t research and development costs plus advertising expense divided by sales.
CFO/TAi,t cash flows from operations divided by average total assets. Leveragei,t total long-term liabilities
divided by average total assets. Litigation Riski,t dummy variable equal to one if the firm is classified as a
technology firm.
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4.3. Market-based conservatism and board characteristics
Table 5 presents the results of regressions similar to those in Table 4 except that we
use the industry-adjusted market-based measure of conservatism as the dependent
variable. FollowingBeaver and Ryan (2000), we include the current and past 6 years buy
ARTICLE IN PRESS
Table 5
Results for the regression of industry-adjusted market-based conservatism measure on industry-adjusted board
characteristics and control variables. Dependent variable: CON-MKT
(i) (ii) (iii) (iv)
Intercept ? 0.085 (8.82)*** 0.079 (7.97)*** 0.222 (3.64)*** 0.263 (4.62)***
Board characteristics
Inside Director % 0.245 (2.80)*** 0.213 (2.63)*** 0.146 (1.40) 0.239 (1.40)
Avg. # of Directorships ? 0.019 (1.31) 0.010 (0.65) 0.003 (0.13) 0.004 (0.24)
CEO/Chair Separation + 0.006 (0.38) 0.005 (0.34) 0.006 (0.46) 0.003 (0.27)
Outside Director Ownership + 0.364 (2.35)** 0.216 (2.06)** 0.331 (1.87)* 0.193 (1.75)*
Board Size ? 0.028 (0.78) 0.046 (1.09) 0.129 (2.13)** 0.065 (1.26)
Control variables
G-Score 0.001 (0.18) 0.019 (1.09)
Institutional Ownership ? 0.118 (1.96)** 0.026 (1.43)
Inside Director Ownership ? 0.029 (0.28) 0.078 (0.43)
Firm Size + 0.006 (0.67) 0.057 (1.95)*
Sales Growth 0.003 (0.19) 0.007 (0.43)
R&D+ADV + 0.208 (1.62) 0.241 (0.96)
CFO/TA + 0.962 (8.29)*** 0.232 (2.29)**
Leverage + 0.017 (0.24) 0.073 (0.86)
Litigation Risk ? 0.029 (1.80)*
Year and firm fixed effects No No Yes Yes
Included lagged returns Yes Yes Yes Yes
Sample period 19992001 19992001 19992001 19992001
N 786 786 705 705
Adjusted R-square 0.2413 0.3224 0.8506 0.8991
Thet-statistics reported in columns (i) and (ii) are corrected for heteroscedasticity and 1st order autocorrelationusing the NeweyWest procedure. Significance is based on two-tailed tests. */**/*** represents significance at the
10/5/1% level.
CON-MKTi,t book-to-market ratio multiplied by 1. Inside Director %i,t percentage of directors who are
currently employed or have been employed by the firm for the past 3 years, are related to current management,
and/or are related to the firm-founder. Avg. # of Directorshipsi,t total directorships held by the board of
directors divided by the total number of directors.CEO/Chair Separationi,t dummy variable equal to one if the
CEO is not chairman of the board, zero otherwise. Outside Director Ownershipi,t the common shares held by
outside directors divided by total common shares outstanding. G-Scorei,t governance index of 24 governance
provisions as calculated in Gompers et al. (2003), the G-score increases as shareholder rights decrease.
Institutional Ownershipi,t total common shares held by institutional investors divided by total common shares
outstanding. Inside Director Ownershipi,t the common shares held by inside directors divided by total common
shares outstanding. Board Sizei,t natural log of the number of directors. Firm Sizei,t natural log of averagetotal assets. Sales Growthi,t percentage of annual growth in total sales. R&D+ADVi,t Research and
development costs plus advertising expense divided by sales.CFO/TAi,t cash flows from operations divided by
average total assets. Leveragei,t total long-term liabilities divided by average total assets. Litigation
Riski,t dummy variable equal to one if the firm is classified as a technology firm.
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and hold market return as additional independent variables to control for the delayed
recognition component of book-to-market ratio. We obtain similar results if we exclude
these returns.
The coefficients on Inside Director % and Outside Director Ownership are negative and
positive respectively consistent with the signs of the coefficients observed in Table 4.Furthermore, they are significant at the 5% level in columns (i) and (ii). However, based on
a two-tailed test, the coefficient on Inside Director % is not significant in the fixed effects
regressions. The lack of significance in this two-tailed test is potentially due to the firm-
specific effects controlling for firm characteristics that affect the relation between
conservatism and board characteristics as well as the smaller sample size. The coefficient
on Outside Director Ownership is significant at the 10% in columns (iii) and (iv). The
coefficients on CEO/Chair Separation, Avg. # of Directorships, and Board Size are
generally not significant.
The control variables in Table 5 have similar signs to those reported in Table 4.
Surprisingly, Institutional Ownership is negatively related to CON-MKT in column (ii).
Although the sign on R&D+ADV is positive, consistent with Ahmed et al. (2002), it is
statistically not significant. However, this is likely due to CFO/TA picking up the growth
opportunities effects.16 Consistent withAhmed et al. (2002), Sales Growth is unrelated to
the market-based measure of conservatism. The sign on Litigation Risk is negative and
significant at the 10% level, which is contrary to the findings of previous literature where
firms with higher litigation risk are more conservative. However, this result is likely
confounded due to the industry differencing. Additionally, Firm Size is negative and
significant in column (iv) but insignificant in column (ii). The negative sign on Firm Sizein
column (ii) is consistent with the findings ofGivoly et al. (2007)and LaFond and Watts(2006)where large firms have less conservative accounting. All other control variables are
insignificant at conventional levels.
To summarize, using the firm-specific measures of conservatism (CON-ACCandCON-
MKT), 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 firms shares owned by outside directors and conservatism.
4.4. Tests based on the asymmetric timeliness of earnings
Table 6 presents the results of pooled regressions used to estimate the asymmetrictimeliness coefficient and test for the effects of the board of director characteristics on
asymmetric timeliness. We first present the Basu regression without backward cumulation
(column i) and with backward cumulation (column ii). Consistent with the size decile
results of Givoly et al. (2007), we find that the asymmetric timeliness coefficient for
our sample is 0.064, which is much smaller than the asymmetric timeliness coefficient
based on large samples. When we use the backward cumulation approach suggested
by Roychowdhury and Watts (2006), the coefficient increases to 0.187, consistent with
results in Roychowdhury and Watts (2006), but it is still considerably smaller than the
magnitude found inRoychowdhury and Watts (2006)due to the large firm bias discussed
in Section 3.2.
ARTICLE IN PRESS
16WhenCFO/TAis removed from the model the coefficient onR&D+ADVbecomes positive and significant at
conventional levels.
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ARTICLE IN PRESS
Table 6
Relation between asymmetric timeliness and board characteristics. Dependent Variable: income before
extraordinary items divided by the market value of equity at the beginning of the year
(i) (ii) (iii) (iv)
Predicted sign j 0 j 3 j 0 j 3
Intercept ? 0.047
(11.22)***
0.240
(25.23)***
0.020 (0.34) 0.006 (0.05)
D 0.002 (0.27) 0.074
(3.76)***
0.070 (0.74) 0.199 (0.54)
R + 0.010 (1.08) 0.030 (5.18)*** 0.100 (0.75) 0.057 (0.68)
D*R + 0.064 (3.15)*** 0.187 (2.92)*** 0.187 (0.63) 0.087 (0.08)
In % ? 0.009 (0.19) 0.058 (0.67)
In % *R ? 0.051 (0.53) 0.049 (0.99)
In % *D ? 0.069 (1.02) 0.473
(1.97)**
In % *D*R 0.079 (0.43) 1.569
(2.08)**
Out own ? 0.060 (0.58) 0.331 (1.38)
Out own *R ? 0.040 (0.19) 0.865
(4.71)***
Out own *D ? 0.135 (0.93) 0.387 (0.94)
Out own *D*R + 0.269 (0.83) 1.684 (1.79)*
Other
governance &
control variables
No No Yes Yes
Sample period 19992001 19992001 19992001 19992001N 747 747 747 747
Adj. R-square 0.0496 0.1978 0.1678 0.3911
Significance is based on two-tailed tests. */**/*** represents significance at the 10/5/1% level.
The regression being estimated is
Et;tj=Pt;tj1 a0 b1Dt;tj b2Rt;tjb3Dt;tj Rt;tj
b4In%t b5In%t Rt;tj b6In%t
Dt;tj b7In%t Dt;tj Rt;tjb8Out ownt
b9Out ownt Rt;tj b10Out ownt Dt;tjb11Out ownt
Dt;tj Rt;tj Other Governance& Control Variablest,
whereEt,,tjis the cumulative income before extraordinary items, Pt, tj1the market value of equity at the end of
the year,Dt,tjthe indicator variable set equal to one ifRt, tjis less than one, zero otherwise,Rt, tjthe buy and
hold return starting 4 months after the end of the fiscal year tj1 and ending 4 months after the end of yeart, In
%tthe percentage of directors who are currently employed or have been employed by the firm for the past 3 years,
are related to current management, and/or are related to the firm-founder. Out owntthe common shares held by
outside directors divided by total common shares outstanding. The other governance and control variables are
Avg. # of Directorships, CEO/Chair Separation, Board Size, G-Score, Institutional Ownership, Inside Director
Ownership, Firm Size, Sales Growth, R&D+ADV, CFO/TA, Leverage, Litigation Risk, and Industry and Year
dummies. All of the other governance and control variables in the regression are also interacted with Rett, tj,
Dt,tj, and Rett, tj*Dt,tj.
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In columns (iii) and (iv), we allow the asymmetric timeliness coefficient to vary with
board characteristics and control variables mentioned in Section 3.2. For brevity, we only
report the coefficients on the two key board characteristics in the table and discuss the
other coefficients in the text. Contrary to the results inBeekes et al. (2004), we do not find a
significant effect of inside director percentage on asymmetric timeliness when we estimatethe asymmetric timeliness coefficient without backward cumulation (column iii). This is
not surprising given the differences in their sample firms and our sample firms mentioned
in Section 1. When we use cumulative earnings and returns to include the current and prior
3 year lags (column iv), we find that firms with greater levels of insiders on the board
appear to have smaller asymmetric timeliness coefficients than firms with lower levels of
insiders on the board.
We do not find a significant effect of outside director ownership on asymmetric
timeliness when we estimate the asymmetric timeliness coefficient without backward
cumulation (column iii). When earnings and returns are cumulated over several years
(column iv), outside director share ownership is positively associated with asymmetric
timeliness. These results are consistent with our findings about outside director share
ownership and conservatism inTables 4 and 5.
The effects of the other governance variables (Avg. # of Directorships, CEO/Chair
Separation, andBoard Size) are all unrelated to the asymmetric timeliness of earnings in all
regressions. For the control variables Inside Director Ownership is positively related to
asymmetric timeliness when earnings and returns are cumulated over several years.
Additionally,R&D+ADVis negatively related to asymmetric timeliness when earnings and
returns are cumulated over several years. However, both Inside Director Ownership and
R&D+ADV are unrelated to asymmetric timeliness when asymmetric timeliness ismeasured contemporaneously. All other control variables are unrelated to asymmetric
timeliness at conventional levels using both the contemporaneous and backward
cumulation estimation of the Basu model.
4.5. Robustness tests
We perform a number of additional robustness tests. First, we conduct tests utilizing a 5-
year measure ofCON-ACC, where CON-ACC, is income before extraordinary items less
cash flows from operations plus depreciation expense deflated by average total assets, and
averaged over a 5-year period centered on year t, multiplied by negative one. Results aregenerally consistent with the findings reported in Table 4, however, the percentage of
independent directors and percentage shares owned by outside directors are significant at
the 10% level in some specifications.
Second, we repeat our tests using year-by-year annual data. We obtain results similar to
those reported except that in 2001 the coefficient on percentage of inside directors is
negative but insignificant. The lack of significance on board independence is possibly due
to the changing legal and regulatory environment in 2001 and 2002. During this time
period executive directors may have adapted their financial accounting policies to avoid
regulation.
Third, we proxy for the wealth effects of ownership rather (price multiplied by sharesowned) than the control aspect of ownership (percentage of shares owned) and find the
amount outside directors have invested in the firm is positively related to accounting
conservatism.
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Fourth, we test for the possible endogenous selection of the percentage of inside
directors and accounting conservatism. We assume that the percentage of outside directors
is a function of CEO tenure, inside director ownership, staggered elections, the existence of
a nominating committee, the independence of the nominating committee, and board size.
Using a DurbinWuHausman test to test the efficiency of OLS we find that our results arenot biased to the simultaneous selection of board independence and accounting
conservatism.
Fifth, as an additional test to ensure our results are not caused due to litigation risk we
drop high litigation risk firms from our sample in unreported testing. Despite the smaller
sample size, the results are qualitatively similar to those reported in the tables. Thus, our
results are unlikely to be driven by high litigation risk firms.
4.6. Earnings management as an alternative explanation
Our tests discussed above control for a number of observable firm characteristics,
unobservable firm characteristics that are constant over time, and industry. Another
potential explanation of our results is earnings management. Previous studies, such
as Klein (2002b), Xie et al. (2003), and Bowen et al. (2005), find that the percentage
of inside directors on the board is related to income increasing earnings manage-
ment. However, our results are not likely due to the relation between earnings manage-
ment and conservatism for two reasons. First, the studies examining earnings management
and board characteristics use accruals or discretionary accruals for a single period
as a proxy for earnings management in that period. To the extent that accruals or
discretionary accruals reflect earnings management, they are likely to reverse in the nextperiod. Because we use operating accruals averaged over a 3-year period to measure
conservatism, the managed portion of accruals will very likely reverse within the 3-year
window. Second, we obtain similar results when we use a market-based measure
of conservatism or the asymmetric timeliness measure (based on backward cumulation).
Both of these measures are unlikely to be affected significantly by earnings manage-
ment reducing the likelihood of our results reflecting earning
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