Legal Expertise in Top Management: Does it Lead to Conservatism in Accounting?

Wednesday, November 10, 2021

Shareholders of a San Diego-based pharmaceutical company filed a federal class action lawsuit accusing the company of overstating its assets and exaggerating its financial health.

An investor sued a Chinese vaping company, claiming that it had overstated its financials when it filed its IPO paperwork.

A shareholder of a Chicago-based cybersecurity technology company filed a securities fraud class action complaint, alleging that the company overstated its revenue from software licenses.

These lawsuits, filed in the last few years, illustrate a well-founded belief in accounting circles: overstatements in financial reporting are more likely to trigger lawsuits than understatements because it's easier to show investor harm.

"If a company understates, people are surprised in a good way," says Jonathan Black, assistant professor of accounting in Krannert School of Management. "The economic reality is better than the picture that was painted in the financial statements, so they are less likely to initiate a lawsuit."

Reporting conservatively on financial statements — whether recognizing bad news sooner or good news later — can help deter lawsuits. Because managers with legal expertise are more likely to recognize the benefits of conservatism, Black and his collaborators were interested to see whether legal expertise in the senior management team leads to greater conservatism. They also sought to determine if changes in the legal environment that alter the legal costs of overstated earnings or net assets result in an adjustment of conservatism levels among firms with such legal expertise.

Black and his co-authors, Charles Ham of Washington University in St. Louis, Michael D. Kimbrough of University of Maryland, and Ha Yoon Yee of Krannert, used the presence of a general counsel (GC) in senior management as evidence of legal expertise. While a growing number of firms are appointing GCs to senior management, the researchers note that it isn't obvious that GCs will seek to minimize legal risks through conservative reporting because this may conflict with other incentives to report favorably. A rosier financial picture may increase a GC's compensation or improve their career prospects.

But the researchers' findings, revealed in a paper entitled "Legal Expertise and the Role of Litigation Risk in Firms' Conservatism Choices," indicate that a GC in senior management does lead to greater conservatism.

Analyzing almost 30,000 annual observations of firms from 1992 to 2017, the researchers found that firms with a GC in senior management, relative to non-GC firms, are faster to recognize bad news on their financial reports and do so more asymmetrically — more uniformly with how they recognize good news.

"If you have inventory that is going obsolete and you need to write-down the inventory, how quickly do you do that?" Black says, citing an example of "bad news" that a GC firm may recognize sooner than a non-GC firm.

Exploring the responsiveness of GC and non-GC firms to changes in the legal environment, the researchers found that GC firms report more conservatively when their industry peers have faced recent litigation. In contrast, non-GC firms show no significant change in their conservatism when their peers experience legal action.

The researchers also looked at the impact of two court decisions that affected litigation risk for firms in the Ninth Circuit Court of Appeals. Litigation risk decreased for firms in the Ninth Circuit following the 1999 Silicon Graphics International (SGI) case, but returned to the same level as other Circuits after the 2007 Tellabs case.

The researchers found that during the period of lower litigation risk (2000 to 2006) GC firms in the Ninth Circuit were significantly less conservative than GC firms outside the Ninth Circuit. But outside this period (before 2000 and after 2006), GC firms in the Ninth Circuit were no more or less conservative than GC firms in other Circuits. Just as telling, the GC firms outside the Ninth Circuit and the non-GC firms inside the Ninth Circuit did not alter their level of conservatism in response to the cases.

These findings suggest that firms with legal expertise in top management adjust their level of conservatism to changes in the legal environment that alter the legal risks associated with overstated earnings or net assets.

As more lawyers occupy senior positions in companies, making decisions alongside CEOs and CFOs, the research helps reveal the implications of this trend.

"Our study suggests that companies with influential GCs report their earnings differently, and specifically, they're going to report more conservatively, which is a good thing for investors that are worried about unexpected bad news," Black says. "The alternative possibility would be that if you pay a lawyer a lot of money, they may try to maximize their own wealth at the expense of the shareholder and the company. So, we find some evidence that influential GCs benefit investors rather than harm them."

The study also substantiates one of the factors for conservative reporting.

"There's been some evidence that litigation risk drives conservative reporting, but our study confirms that," Black says. "We have these shocks to litigation risk and we have variation in who would be responsive to it."

By Melvin Durai