Director-Liability-Reduction Laws and Conditional Conservatism

Abstract

We study non-officer directors’ causal influence on the conditional conservatism of firms’ financial statements. We treat director-liability-reduction laws enacted by the 50 U.S. states in different years since 1986 as exogenous shocks to non-officer directors’ litigation risk. We find decreases in conditional conservatism after the law enactments, which vary predictably with cross-sectional variation in the demand for conditional conservatism from shareholders and lenders. We show that these effects flow through current asset decreases and switches away from Big N auditors. The results are robust to controlling for state antitakeover laws, tests for endogenous law enactment and parallel trends, and other sensitivity checks. Our results are consistent with non-officer directors monitoring and influencing the financial reporting process and have implications for corporate governance and corporate law reforms.