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Journal of Accounting and Economics 43 (2007) 411437


www.elsevier.com/locate/jae

Accounting conservatism and board of director


characteristics: An empirical analysis$
Anwer S. Ahmeda, Scott Duellmanb,
a
Texas A & M University, Texas, USA
b
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,
rm size, leverage, growth opportunities, institutional ownership, inside director ownership, and
unobservable rm characteristics that are stable over time. Overall, the evidence is consistent with
accounting conservatism assisting directors in reducing agency costs of rms.
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

$
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 4422
E-mail address: duellman@binghamton.edu (S. Duellman).

0165-4101/$ - see front matter r 2007 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2007.01.005
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monitoring incentives. We nd 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 rms shares owned by outside directors and
conservatism. These ndings are consistent with accounting conservatism assisting
directors in reducing agency costs of rms.
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 efcient contracting technology that helps in reducing
deadweight losses resulting from agency problems. Given that directors require veriable
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 following Beaver and Ryan (2000), and
a measure of asymmetric timeliness of earnings following Roychowdhury and Watts
(2006). We study ve 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 rms 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, rm 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 rm characteristics that
are constant over time by using the xed effects regression model with rm and time-
specic intercepts.
We nd 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 specications. The average number of outside directorships is
negatively related to conservatism using the accrual-based measure of conservatism.
Board size is generally not signicantly 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 from
agency conicts.
A number of prior studies examine the relation between board characteristics
and nancial 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 nancial reporting quality. However, only one
prior study, Beekes et al. (2004), examines board independence and conservatism and
documents a positive relation for a sample of UK rms 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 rms (Pricewater-
houseCoopers, 2001). For example, it permits upward revaluations of assets and
capitalization of certain internally generated intangibles (e.g. development costs) whereas
US GAAP prohibits such upward revaluations or capitalization of intangibles.
Furthermore, US rms are subject to considerably higher litigation risk than UK rms
(Fulbright and Jaworski, 2005; Seetharaman et al., 2002). Finally, UK rms have greater
institutional ownership than US rms and UK institutional investors more actively
monitor rms as they regularly meet with the board and top management to discuss
strategy, governance issues, and nancial 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 signicant differences in
accounting and institutional environments between the US and the UK suggest that the
results in Beekes et al. (2004) need not hold for US rms.
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 following Roychowdhury 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 the
Basu 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, protability, R&D, litigation risk, and the strength
of shareholder rights.
Third, while Beekes et al. (2004) focus on examining board independence, we examine a
broader set of board characteristics that reect the strength of directors monitoring
incentives as well as board independence.
In summary, we employ more rigorous testing on a sample of rms 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 benets and the optimal combination of mechanisms is chosen to
maximize rm 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 nancing 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,

1
See Aguilera et al. (2006) for a full discussion of the institutional differences between US and UK rms and
Seetharaman et al. (2002) for a full discussion on the difference in litigation risk.
2
When we use the single-period Basu measure we nd that the Beekes 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 5
presents the conclusion.

2. Hypothesis development

2.1. Motivation for examination of the relation between board characteristics and
conservatism

Conicts of interest between managers and other parties to the rm arise because
managers effectively control rms assets but generally do not have a signicant equity
stake in their rms (Berle and Means, 1932; Jensen and Meckling, 1976). These conicts
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
conicts.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 benets. The optimal combination of governance mechanisms is chosen to
maximize rm value and is likely to vary systematically across rms because these costs
and benets likely vary with rm characteristics such as the investment opportunity set,
leverage, and the relative importance of external nancing (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 identication and estimation of structural
equations that jointly explain the choice of governance mechanisms is a very difcult 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 major
share of the wealth effects of their decisions. Boards ratify and monitor top managers
decisions because it is efcient to separate decision initiation and implementation from
decision ratication and monitoring. Directors are given the power to hire and re
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 veriable information in order to effectively monitor and advise
managers. The accounting and nancial reporting system is a critical source of veriable
information that is useful in monitoring and evaluating managers as well their decisions
3
Zingales (1998, p. 499) denes corporate governance as the complex set of constraints that shape the ex post
bargaining over quasi-rents generated by a firm.
4
Recent theoretical work on boards includes Gillette 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 rms accounting system that can help
directors in reducing deadweight losses and disciplining other sources of information
thereby increasing rm and equity values (Watts, 2003, 2006). Therefore, examining the
relation between board characteristics and conservatism is potentially interesting. The
relation 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
rm 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 rm and equity values (Jensen and Meckling, 1976; Watts and
Zimmerman, 1986). For example, managers can reduce rm 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 verication 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 post because 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 rm value (see Ahmed et al., 2002 for evidence).
Another argument for conservatism facilitating governance, noted by Ball (2001), is that
conservatism plays a role in monitoring of rms investment policies. By requiring more
timely recognition of economic (or expected) losses conservatism helps in identifying
negative NPV projects or poorly performing investments. The timely identication 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 rm and equity values.
The above arguments suggest that conservatism is a potentially useful tool for directors
(especially outside directors) in fullling their role of ratifying and monitoring key
decisions. Because stronger boards are likely to be more procient at efcient contracting
and understand the benets of conservatism they are likely to demand more conservative
accounting. On the other hand, boards dominated by insiders or boards with weak
monitoring 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 rms 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 nancing
structures. For example, compensation plans for managers of rms with high growth
options exhibit a greater use of stock-based compensation than accounting-based
compensation (Smith and Watts, 1992). Similarly, rms with high growth options tend
to be nanced more by equity nancing than debt nancing.
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
ows in early periods. Furthermore, it could also result in a board initiating termination
prematurely. If these potentially adverse effects of conservatism exceed the benets 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) nd that when earnings are less timely in general, there is a
substitution 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 ve 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.
5
Note 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 rst measure of board independence is the percentage of insiders on the board of
directors. Consistent with prior research, we dene inside directors as directors who are
currently employed or have been employed by the rm for the past 3 years, are related to
current management, and/or are related to the rm-founder. Our denition of
independence is consistent with Klein (2002b), except that she classies directors with
signicant business transactions with the rm as non-independent. However, the existence
of signicant 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
signicant 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 inuence 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 ofcer 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 difculties of
coordinating 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 rm value. A competing view is that large boards allow directors to specialize. For
example, Klein (2002a) nds 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 rm debt ratings. Conversely, a competing view is that additional
directorships distract the directors from their duty of monitoring the rm. Consistent with
this view, Beasley (1996) nds that the average number of outside directorships held is

6
For example, Warren Buffet has signicant business transactions at Coca-Cola due to services performed
between Berkshire Hathaway and Coca-Cola. However, due to the signicant investment of Berkshire Hathaway
in Coca-Cola it would likely be in Buffets best interest to effectively monitor the rm.
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positively related to the likelihood of nancial 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 are
important in ensuring the independence of the board, they will not have sufciently strong
incentives to monitor (and if necessary confront) managers if they do not have signicant
equity stakes in the rm (Jensen, 1993). Previous research documents that greater director
ownership is related to a lower likelihood of nancial statement fraud (Beasley, 1996), and
positively related to rm debt ratings (Ashbaugh et al., 2007), suggesting that outside
director ownership enhances monitoring incentives.

3.2. Proxies for accounting conservatism

Our rst set of tests focus require rm-specic conservatism measures at the end of each
year of our sample period that can be used as dependent variables. We use two rm-
specic 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. As
conservatism results in understating book value of equity relative to market value of
equity, rms 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 reects the
cumulative effects of conservatism since the inception of the rm. However, it also reects
economic rents expected to be generated by rms 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-ordinary
items less cash ows from operations plus depreciation expense deated by average total
assets, and averaged over a 3-year period centered on year t, multiplied by negative one.
Positive values of CON-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 reect total or cumulative
conservatism because it ignores the effects of conservatism in prior periods.
7
Using the Beaver 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 coefcient 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 verication standards for recognition of good and bad news. However, with
3 years of data, it is difcult to obtain rm-specic AT measures. Moreover, Givoly et al.
(2007) show that the AT measure can contain signicant amounts of measurement error
depending upon the characteristics of the information environment. For example, they
document that for large rms the AT measure is roughly one-third the size of the measure
for small rms.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 reect 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 ve board characteristics


discussed above and seven control variables using OLS regression:
CON i;t b0 b1 Inside Director %i;t b2 Avg:# of Directorshipsi;t
b3 CEO=Chair Separationi;t b4 Outside Director Ownershipi;t
b5 Board Sizei;t b6 G  Scorei;t b7 Institutional Ownershipi;t
b8 Inside Director Ownershipi;t b9 Firm Sizei;t b10 Sales Growthi;t
b11 R&D ADV i;t b12 CFO=TAi;t b13 Leveragei;t
b14 Litigation 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,t is 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 the
percentage 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 ows 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
rm 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 nd that rms
with strong shareholder rights (low G-Score) have larger future stock returns than rms
8
Additionally, 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 signicant difference in
operating performance. Furthermore, Core et al. (2006) document that rms with a high
G-Score have low operating performance but this underperformance does not surprise the
market, as indicated by analyst forecasts. Core et al. (2006) conclude that weak governance
is 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 signicantly inuence management (Schleifer and Vishny, 1986). Bhojraj and Sengupta
(2003) nd results consistent with the monitoring effect of institutional shareholders;
where rms 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 inuence managers and
secure private benets 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 coefcient 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, Wareld et al. (1995) nd a negative relation between managerial
ownership and abnormal accruals. Conversely, inside directors could utilize their voting
power to expropriate rents from the rm. Additionally, in the extreme case that managers
own 100% of equity, there is no governance problem or a role for conservatism in rm
governance. Due to the competing effects, we do not have an a priori prediction on the
coefcient of this variable.
We control for rm size, Firm Size, by including the natural log of average total assets as
an explanatory variable. Large rms 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 large
rms 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 rms 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 rms is signicantly smaller than for small rms 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 because Ahmed et al. (2002) argue that sales growth is likely to affect CON-
ACC and CON-MKT for three reasons. First, growth in sales will affect accruals such as
inventory and receivables, which in turn affects CON-ACC. Second, for rms with
declining sales CON-ACC is likely a poor measure of accounting conservatism. Third,
large growth in sales often inates the markets expectations of future cash ows, which
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could affect CON-MKT. Consistent with Ahmed et al. (2002), we predict a negative effect
of Sales Growth on CON-ACC and 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 for
protability as proxied by the cash ow from operations divided by average total assets,
CFO/TA, as Ahmed et al. (2002) argue that protable rms 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 of Leverage tend to have greater bond-holder and share-
holder conicts which in turn have been shown to affect the contractual demand for
conservative accounting. Ahmed et al. (2002) nd accounting conservatism mitigates
bond-holder and share-holder conict over dividend policy and reduces rms cost of debt.
Similarly, Zhang (2006) documents that lenders benet from conservative accounting via
the accelerated violations of debt covenants while borrowers benet from conservative
accounting via lower initial interest rates. Frankel and Roychowdhury (2005) nd 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) nd that contract modications alone are unlikely to satisfy lenders demand
for information thus nancial reporting conservatism is also required to reduce agency
costs.
We include a dummy variable to control for rms with high litigation risk (Litigation
Risk). As the expected cost of litigation is higher for rms that overstate their earnings
and/or asset base than rms that understate their earnings and/or asset base rms can use
conservative accounting to decrease their expected litigation costs (Watts, 2003).
Furthermore, Field et al. (2005) nd that technology rms have higher litigation risk
than non-technology rms. Thus, we control for litigation risk by including a dummy
variable indicating whether rms are in a technology industry, as dened by Field et al.
(2005), that is equal to one if the rm is an a technology industry and zero otherwise.
Finally, we control for industry, using industry denitions 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 current
and six years lagged returns buy and hold returns in the CON-MKT regressions 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 rms, which
are among the top two size deciles of rms in the US. Specically, these rms have smaller
asymmetric timeliness measures than smaller rms (Givoly et al., 2007). Smaller
magnitudes of the coefcient imply lower power to detect conservatism and thus tests
based 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 rm governance
on asymmetric timeliness we employ the following model:

E t;tj =Pt;tj1 a0 b1 Dt;tj b2 Rt;tj b3 Dt;tj  Rt;tj


b4 In%t b5 In%t  Rt;tj b6 In%t  Dt;tj b7 In%t
 Dt;tj  Rt;tj b8 Out ownt b9 Out ownt
 Rt;tj b10 Out ownt  Dt;tj b11 Out 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,
tj1 is the market value of equity at the end of the year t, Dt,tj is an indicator variable set
equal to one if Rett, tj is less than one, zero otherwise, Rett, tj is the buy and hold return
starting 4 months after the end of the scal 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 rm for the past 3 years, are related to current management, and/or are
related to the rm-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 dened in Section 3.3. All of
the other governance and control variables in the regression are also interacted with Rett,
tj, Dt,tj, and Rett, tj * Dt,tj. We do not report the coefcients on the control variables
for the sake of brevity. The results remain qualitatively unchanged when we remove the
control variables.
As In % is the percentage of directors directly afliated with management, we expect that
rms with greater managerial representation on the board will result in a lower asymmetric
timeliness coefcient. As Out own measures the incentive of directors to monitor the rm,
we expect that rms with higher levels of ownership by independent directors will result in
a higher asymmetric timeliness coefcient.

4. Evidence

4.1. Sample and descriptive statistics

The sample consists of 306 rms out of the S&P 500 over the scal 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 prole accounting scandals.
9
The 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 classications 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 1 Panel A presents a summary of how the nal sample was obtained. Of the 1500
S&P 500 rmyears that are in the sample we eliminate 264 rmyears in the nancial
services and insurance (SIC codes 60006999) industries. We eliminate 151 rmyears due
to missing observations in Compustat and 71 rmyears due to missing observations in
Thompson Financial. Twenty-three rmyears are eliminated due to missing data in the
proxy statement. Eighty-ve rmyears were eliminated due to missing G-Score values.
We also eliminate 18 rmyears that underwent signicant mergers, as these mergers
temporarily inated the board of directors and skewed the governance measures.
Additionally, 55 rmyears are eliminated, because their proxy statements are not
available in the LexisNexis database leaving a nal sample of 833 rmyears (for 306
distinct rms).
Table 1 Panel B presents the industry breakdown of the sample rms. Industries are
dened as in Barth 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 2 Panel 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 of
S&P 500 rms from 1993 to 1998 and our sample encompasses accrual data from 1998 to
2002. During our sample period protability was lower and thus we can expect more
negative accruals. Additionally, Givoly and Hayn (2000) nd 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 ndings of Larcker et al. (2005), Bushman et al. (2004), and Bhojraj 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 with Larcker
et 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 rms. The means of Leverage, Firm Size, and Sales Growth are

10
The corporate library database in 2001 classied directors as independent only if they were not current
employees of the rm. In 2002 and beyond the corporate library expanded the denition of outside directors to
outside related. Most of the discrepancies between the hand-collected and Corporate Library data was due to
the differential classication of family members.
11
Results remain unchanged when the regressions are run on the unwinsorized data. Additionally, winsorization
at the 2% and 5% levels do not signicantly affect the results. Furthermore, winsorization of the top and bottom
1% of independence and outside director ownership do not signicantly affect the results.
12
Although the sample periods and sample sizes are different in Bhojraj and Sengupta (2003), Bushman et al.
(2004), and Larcker et al. (2005) we use these studies as a point of reference in regards to our hand-collected data.
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Table 1

(A) Sample selection of S&P 500 firms from 1999 to 2001


Number of rm years in the S&P 500 19992001 1500
Financial services and insurance rms (264)
Missing Compustat data (151)
Missing G-Score data (85)
Missing Thompson nancial data (71)
Missing data in the proxy sheet (23)
Signicant merger inating board size (18)
Proxy statements not listed in Lexis-Nexis (55)
Final sample 833
SIC codes Firmyears Distinct rms
(B) Sample firm breakdown by industry
Mining and construction 10001199, 14 6
14001499
Food 20002111 38 13
Textiles, printing, and publishing 22002780 61 22
Chemicals 28002824, 47 16
28402899
Pharmaceuticals 28302836 44 16
Extractive industries 29002999, 39 16
13001399
Durable manufacturers 30003569, 211 77
35803669,
36803999
Computers 73707379, 123 45
35703579,
36703679
Transportation 40004899 40 16
Utilities 49004999 75 28
Retail 50005999 101 37
Service 70007369, 40 14
73808999

consistent with the ndings of Ahmed et al. (2002). The level of R&D+ADV are higher in
our sample than in Ahmed et al. (2002). The median differenced descriptive statistics are
presented in Table 2 Panel B.
Table 3 Panel 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 ve percent level of signicance using Pearson correlations. Several of
the governance variables (Board Size, CEO/Chair Separation, and Avg. # of Directorships)
are correlated with the accrual and market-based measures of conservatism. For the
control variables, Firm Size and Leverage are 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 in
Table 3 Panel 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 2
Descriptive statistics on conservatism proxies, board characteristics, and control variables (without/with industry
adjustment) for the sample of 306 rms 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 ows from operations,
where all variables are scaled by average total assets and averaged over 3 years centered around year t) multiplied
by 1. 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 rm for the past 3 years, are related to current management,
and/or are related to the rm-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 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 ows 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 rm is classied as a technology rm.
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4.2. Accrual-based conservatism and board characteristics

We estimate Eq. (1) using both an OLS regression and a xed effects regression with rm
and year-specic intercepts. The xed effects regression has two advantages over OLS.
First, using panel data in an OLS regression can potentially generate biased estimates, as
the observations are not completely independent. Second, the xed rm effects pick up the
effect of unobservable rm characteristics that are stable over time and correlated with the
independent variables (Greene, 2000).13 However, because xed effects regressions control
for unobservable rm 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 xed effects regressions
because we estimate the xed effects model on balanced panel data requiring each rm to
have 3 years of data available.14 Table 4 presents 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 rm and year xed effects.
Column (iv) presents the regression in column (iii) augmented by the control variables
including rm and year xed effects. The t-statistics reported in columns (i) and (ii) are
corrected for heteroscedasticity and rst-order autocorrelation using the NeweyWest
procedure.15
The coefcient on Inside Director % is negative and signicant at the 5% level in all four
columns, consistent with conservatism complementing board governance. The coefcient
on Outside Director Ownership is positive, consistent with conservatism complementing
board governance. The coefcient is signicant 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 coefcient on Avg. # of Directorships is signicantly negative in columns (i) and
(ii) indicating that each additional directorship weakens the monitoring for the central
rm. However, it is not signicant in columns (iii) and (iv). The coefcients on CEO/Chair
Separation and Board Size are not signicant in all four columns.
With respect to control variables, the coefcient on G-Score is negative and marginally
signicant in column (ii) suggesting that rms with weaker shareholder rights have less
conservative accounting. However, the coefcient is no longer signicant in column (iv).
The coefcient on Institutional Ownership, an alternative monitoring mechanism, is
negative signicant at the 10% level in column (iv) but insignicant in column (ii). The
coefcient on Firm Size, although insignicant in column (ii), is similar to the size of the
coefcient found in Ahmed et al. (2002). However, in column (iv) the coefcient on Firm
Size is positive and signicant. The signs and signicance in column (ii) of R&D+ADV and
Leverage are consistent with the ndings reported in Ahmed et al. (2002). However, these

13
Due to our small sample period, one caveat of our study is the inability to control for cross-sectional
correlation using FamaMacBeth regressions. However, the rm-specic intercept, along with the industry
differencing, should control for a large portion of possible cross-sectional correlation.
14
We omit the Litigation Risk proxy from the xed effect models because the rm-specic intercept picks up the
litigation risk as none of the observations change their industry classication during the sample period.
15
Results do not signicantly change by assuming second-order autocorrelation using the NeweyWest
procedure.
Table 3
Correlations between conservatism proxies, board characteristics, and control variables (without/with industry adjustment) for the sample rms over 19992001

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

(A) Correlations without industry adjustment


1 CON-ACC 1 0.06 0.04 0.07 0.09 0.05 0.08 0.01 0.04 0.01 0.07 0.14 0.14 0.30 0.07 0.09
2 CON-MKT 0.08 1 0.02 0.05 0.08 0.07 0.09 0.17 0.04 0.10 0.23 0.14 0.43 0.53 0.32 0.31
3 Inside Director % 0.04 0.03 1 0.29 0.26 0.00 0.18 0.18 0.01 0.54 0.27 0.16 0.11 0.15 0.21 0.16
4 Avg # of Directorships 0.07 0.05 0.29 1 0.11 0.19 0.25 0.13 0.02 0.24 0.37 0.15 0.04 0.09 0.06 0.13
5 CEO/Chair Separation 0.10 0.04 0.26 0.11 1 0.01 0.07 0.03 0.01 0.07 0.07 0.08 0.05 0.05 0.04 0.00
6 Outside Director Ownership 0.06 0.07 0.03 0.06 0.03 1 0.00 0.01 0.02 0.37 0.32 0.11 0.05 0.00 0.09 0.06
7 Board Size 0.07 0.08 0.23 0.25 0.05 0.13 1 0.21 0.15 0.21 0.47 0.05 0.20 0.09 0.23 0.29
8 G-Score 0.05 0.11 0.17 0.09 0.02 0.02 0.23 1 0.16 0.12 0.02 0.10 0.07 0.01 0.19 0.19
9 Institutional Ownership 0.00 0.04 0.02 0.03 0.01 0.08 0.14 0.16 1 0.02 0.21 0.03 0.00 0.01 0.03 0.02
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10 Inside Director Ownership 0.00 0.08 0.40 0.16 0.09 0.06 0.15 0.16 0.26 1 0.36 0.16 0.01 0.07 0.21 0.06
11 Firm Size 0.07 0.22 0.26 0.33 0.05 0.06 0.48 0.01 0.21 0.13 1 0.00 0.25 0.26 0.34 0.18
12 Sales Growth 0.02 0.06 0.05 0.10 0.06 0.02 0.01 0.09 0.04 0.01 0.06 1 0.13 0.11 0.03 0.08
13 R&D+ADV/Total Sales 0.23 0.33 0.13 0.04 0.05 0.05 0.24 0.13 0.04 0.02 0.21 0.05 1 0.29 0.46 0.53
14 CFO/TA 0.34 0.46 0.13 0.08 0.04 0.04 0.13 0.04 0.01 0.03 0.25 0.08 0.27 1 0.34 0.18
15 Leverage 0.10 0.24 0.16 0.05 0.01 0.01 0.23 0.17 0.04 0.09 0.31 0.10 0.42 0.32 1 0.43
16 Litigation Risk 0.12 0.27 0.19 0.12 0.00 0.09 0.33 0.18 0.00 0.01 0.18 0.02 0.62 0.20 0.41 1

(B) Correlationswith industry adjustment


A.S. Ahmed, S. Duellman / Journal of Accounting and Economics 43 (2007) 411437

1 CON-ACC 1 0.02 0.01 0.06 0.00 0.01 0.01 0.00 0.02 0.01 0.04 0.08 0.13 0.29 0.01 0.02
2 CON-MKT 0.06 1 0.03 0.09 0.07 0.06 0.03 0.13 0.09 0.08 0.13 0.22 0.21 0.48 0.17 0.08
3 Inside Director % 0.00 0.04 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 # of Directorships 0.07 0.07 0.31 1 0.11 0.22 0.24 0.11 0.04 0.30 0.41 0.11 0.01 0.11 0.05 0.11
427

5 CEO/Chair Separation 0.01 0.04 0.25 0.11 1 0.05 0.04 0.03 0.02 0.13 0.10 0.05 0.06 0.07 0.03 0.02
Table 3 (continued ) 428

6 Outside Director Ownership 0.08 0.06 0.02 0.09 0.05 1 0.03 0.06 0.06 0.29 0.25 0.12 0.00 0.01 0.09 0.03
7 Board Size 0.04 0.01 0.17 0.23 0.03 0.07 1 0.20 0.11 0.20 0.43 0.08 0.09 0.04 0.09 0.12
8 G-Score 0.03 0.08 0.16 0.08 0.03 0.07 0.22 1 0.09 0.16 0.06 0.07 0.03 0.00 0.17 0.06
9 Institutional Ownership 0.04 0.07 0.11 0.04 0.02 0.09 0.10 0.10 1 0.17 0.10 0.07 0.05 0.10 0.11 0.00
10 Inside Director Ownership 0.00 0.06 0.38 0.17 0.09 0.06 0.11 0.16 0.35 1 0.30 0.14 0.01 0.04 0.16 0.08
11 Firm Size 0.06 0.12 0.19 0.37 0.07 0.06 0.44 0.01 0.12 0.08 1 0.05 0.11 0.22 0.22 0.08
12 Sales Growth 0.00 0.10 0.08 0.06 0.02 0.01 0.02 0.05 0.06 0.01 0.01 1 0.03 0.16 0.02 0.04
13 R&D+ADV/Total Sales 0.16 0.14 0.06 0.05 0.04 0.01 0.06 0.06 0.06 0.03 0.11 0.01 1 0.19 0.18 0.19
14 CFO/TA 0.34 0.40 0.10 0.09 0.05 0.04 0.05 0.02 0.07 0.03 0.21 0.06 0.16 1 0.27 0.01
15 Leverage 0.03 0.11 0.06 0.06 0.01 0.07 0.09 0.16 0.12 0.05 0.21 0.08 0.17 0.24 1 0.14
16 Litigation Risk 0.03 0.06 0.14 0.10 0.02 0.01 0.14 0.09 0.03 0.01 0.08 0.02 0.25 0.00 0.14 1

Spearman (Pearson) correlations are above (below) the diagonal.


Correlations in bold represent signicance at the 5% using a two-tailed test.
CON-ACCi,t (net income before extraordinary items plus depreciation expense less cash ows from operations, where all variables are scaled by average total assets
and averaged over 3 years centered around year t) multiplied by 1. 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 rm for the past 3 years, are related to current management, and/or are related to the rm-
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. Board Sizei,t natural log of the number of directors. 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. Firm
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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 ows 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 rm is classied as a technology rm.
A.S. Ahmed, S. Duellman / Journal of Accounting and Economics 43 (2007) 411437
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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 & rm xed 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

The t-statistics reported in columns (i) and (ii) are corrected for heteroscedasticity and rst-order autocorrelation
using the NeweyWest procedure. Signicance is based on two-tailed tests. */**/*** represents signicance at the
10/5/1% level.
CON-ACCi,t (net income before extraordinary items plus depreciation expense less cash ows from operations,
where all variables are scaled by average total assets and averaged over 3 years centered around year t) multiplied
by 1. Inside Director %i,t percentage of directors who are currently employed or have been employed by the
rm for the past 3 years, are related to current management, and/or are related to the rm-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 ows 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 rm is classied as a
technology rm.

variables are insignicant after the inclusion of the rm and year specic xed effects.
Additionally, the coefcient on CFO/TA is positive and signicant in column (ii) and
insignicant in column (iv). The coefcients on the other control variables are not
signicant at conventional levels.
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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. Following Beaver and Ryan (2000), we include the current and past 6 years buy

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 rm xed 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

The t-statistics reported in columns (i) and (ii) are corrected for heteroscedasticity and 1st order autocorrelation
using the NeweyWest procedure. Signicance is based on two-tailed tests. */**/*** represents signicance 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 rm for the past 3 years, are related to current management,
and/or are related to the rm-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 ows 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 rm is classied as a technology rm.
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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 coefcients on Inside Director % and Outside Director Ownership are negative and
positive respectively consistent with the signs of the coefcients observed in Table 4.
Furthermore, they are signicant at the 5% level in columns (i) and (ii). However, based on
a two-tailed test, the coefcient on Inside Director % is not signicant in the xed effects
regressions. The lack of signicance in this two-tailed test is potentially due to the rm-
specic effects controlling for rm characteristics that affect the relation between
conservatism and board characteristics as well as the smaller sample size. The coefcient
on Outside Director Ownership is signicant at the 10% in columns (iii) and (iv). The
coefcients on CEO/Chair Separation, Avg. # of Directorships, and Board Size are
generally not signicant.
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 signicant. However, this is likely due to CFO/TA picking up the growth
opportunities effects.16 Consistent with Ahmed et al. (2002), Sales Growth is unrelated to
the market-based measure of conservatism. The sign on Litigation Risk is negative and
signicant at the 10% level, which is contrary to the ndings of previous literature where
rms with higher litigation risk are more conservative. However, this result is likely
confounded due to the industry differencing. Additionally, Firm Size is negative and
signicant in column (iv) but insignicant in column (ii). The negative sign on Firm Size in
column (ii) is consistent with the ndings of Givoly et al. (2007) and LaFond and Watts
(2006) where large rms have less conservative accounting. All other control variables are
insignicant at conventional levels.
To summarize, using the rm-specic measures of conservatism (CON-ACC and CON-
MKT), we nd 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 rms 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 asymmetric
timeliness coefcient and test for the effects of the board of director characteristics on
asymmetric timeliness. We rst 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 nd that the asymmetric timeliness coefcient for
our sample is 0.064, which is much smaller than the asymmetric timeliness coefcient
based on large samples. When we use the backward cumulation approach suggested
by Roychowdhury and Watts (2006), the coefcient increases to 0.187, consistent with
results in Roychowdhury and Watts (2006), but it is still considerably smaller than the
magnitude found in Roychowdhury and Watts (2006) due to the large rm bias discussed
in Section 3.2.
16
When CFO/TA is removed from the model the coefcient on R&D+ADV becomes positive and signicant at
conventional levels.
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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 j0 j3 j0 j3

Intercept ? 0.047 0.240 0.020 (0.34) 0.006 (0.05)


(11.22)*** (25.23)***
D  0.002 (0.27) 0.074 0.070 (0.74) 0.199 (0.54)
(3.76)***
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 No No Yes Yes
governance &
control variables
Sample period 19992001 19992001 19992001 19992001
N 747 747 747 747
Adj. R-square 0.0496 0.1978 0.1678 0.3911

Signicance is based on two-tailed tests. */**/*** represents signicance at the 10/5/1% level.
The regression being estimated is

E t;tj =Pt;tj1 a0 b1 Dt;tj b2 Rt;tj b3 Dt;tj  Rt;tj


b4 In%t b5 In%t  Rt;tj b6 In%t
 Dt;tj b7 In%t  Dt;tj  Rt;tj b8 Out ownt
b9 Out ownt  Rt;tj b10 Out ownt  Dt;tj b11 Out ownt
 Dt;tj  Rt;tj Other Governance & Control Variablest ,

where Et,,tj is the cumulative income before extraordinary items, Pt, tj1 the market value of equity at the end of
the year, Dt,tj the indicator variable set equal to one if Rt, tj is less than one, zero otherwise, Rt, tj the buy and
hold return starting 4 months after the end of the scal year tj1 and ending 4 months after the end of year t, In
%t the percentage of directors who are currently employed or have been employed by the rm for the past 3 years,
are related to current management, and/or are related to the rm-founder. Out ownt the 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 coefcient to vary with
board characteristics and control variables mentioned in Section 3.2. For brevity, we only
report the coefcients on the two key board characteristics in the table and discuss the
other coefcients in the text. Contrary to the results in Beekes et al. (2004), we do not nd a
signicant effect of inside director percentage on asymmetric timeliness when we estimate
the asymmetric timeliness coefcient without backward cumulation (column iii). This is
not surprising given the differences in their sample rms and our sample rms mentioned
in Section 1. When we use cumulative earnings and returns to include the current and prior
3 year lags (column iv), we nd that rms with greater levels of insiders on the board
appear to have smaller asymmetric timeliness coefcients than rms with lower levels of
insiders on the board.
We do not nd a signicant effect of outside director ownership on asymmetric
timeliness when we estimate the asymmetric timeliness coefcient 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 ndings about outside director share
ownership and conservatism in Tables 4 and 5.
The effects of the other governance variables (Avg. # of Directorships, CEO/Chair
Separation, and Board 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+ADV is 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 is
measured 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 of CON-ACC, where CON-ACC, is income before extraordinary items less
cash ows from operations plus depreciation expense deated by average total assets, and
averaged over a 5-year period centered on year t, multiplied by negative one. Results are
generally consistent with the ndings reported in Table 4, however, the percentage of
independent directors and percentage shares owned by outside directors are signicant at
the 10% level in some specications.
Second, we repeat our tests using year-by-year annual data. We obtain results similar to
those reported except that in 2001 the coefcient on percentage of inside directors is
negative but insignicant. The lack of signicance 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 nancial accounting policies to avoid
regulation.
Third, we proxy for the wealth effects of ownership rather (price multiplied by shares
owned) than the control aspect of ownership (percentage of shares owned) and nd the
amount outside directors have invested in the rm 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 efciency of OLS we nd that our results are
not 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 rms 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 rms.

4.6. Earnings management as an alternative explanation

Our tests discussed above control for a number of observable rm characteristics,


unobservable rm 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), nd 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 reect earnings management, they are likely to reverse in the next
period. 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 signicantly by earnings manage-
ment reducing the likelihood of our results reecting earnings management rather than
conservatism.

5. Conclusion

Using three different proxies for conservatism, we nd 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 rms shares
owned by outside directors and conservatism. Our results hold after controlling for
industry, rm size, leverage, growth opportunities, institutional ownership, inside director
ownership, strength of shareholder rights, and unobservable rm characteristics that
are stable over time. As there are multiple ways to reduce agency problems, rms likely
select the combination of governance mechanisms that maximize rm value. Although
we control for many of these mechanisms, a limitation of our study is that we are
unable to completely control for endogeneity, which prevents us from drawing strong
conclusions about the direction of causality. Overall, our ndings are consistent with
the notion that accounting conservatism assists directors in reducing the agency costs of
rms.
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