Universal Demand Laws and the Monitoring Device Role of Accounting Conservatism

Abstract

While prior research holds the consensus that accounting conservatism can serve as an effective monitoring device, it is not clear whether shareholders can successfully enforce managers’ adherence to accounting conservatism when directors fail to fulfill their fiduciary duties. We attempt to answer the question by exploiting staggered enactments of the universal demand (UD) laws in 23 U.S. states. UD laws raise procedural hurdles for shareholders to file derivative lawsuits against managers and directors who allegedly breach their fiduciary duties. For firms incorporated in states that adopt UD laws, restrictions on shareholder litigation rights shift power to managers, thereby weakening directors’ incentives to monitor managers. We predict and find a decrease in conditional conservatism following the enactment of UD laws. The main result is attributable to both the direct channel (through restriction of shareholder litigation rights) and the indirect channel (through the deployment of management-friendly governance provisions). The decline in conditional conservatism exists only for firms with low institutional ownership, low external equity dependence, or high ex-ante derivative lawsuit risk. Our findings suggest that shareholders cannot successfully demand accounting conservatism when managers possess extensive power and directors lack the incentives to monitor managers.

Keywords: Derivative Lawsuits; Universal Demand Laws; Conditional Conservatism; Monitoring Demand

JEL Classification: M41; D22; G34; K22