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

ARTICLE IN PRESS

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: [email protected] (S. Duellman).
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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,

ARTICLE IN PRESS

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

ARTICLE IN PRESS

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.

ARTICLE IN PRESS

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

ARTICLE IN PRESS

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



12/27

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.

ARTICLE IN PRESS

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.



13/27

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.



14/27

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.

ARTICLE IN PRESS

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



15/27

ARTICLE IN PRESS

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.



16/27

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.



17/27

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



18/27


19/27

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

Ahmed Duellman

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