With a Legal Expert in Leadership, Firms Are Less Likely to Overstate Earnings

Firms are more likely to face accounting-related lawsuits for overstating their earnings or assets than for understating them because it’s easier to demonstrate investor harm with overstatements. So erring on the conservative side can reduce a firm’s legal costs. Whether firms recognize this benefit of conservatism has a lot to do with who sits on a firm’s senior management team, finds new research from Maryland Smith’s Michael Kimbrough.

In the research forthcoming in The Accounting Review, Kimbrough and his co-authors, Charles Ham of Washington University (a 2015 Maryland Smith PhD graduate) and Jonathan Black and Ha Yoon Yee of Purdue University, examined how firms reported their earnings when they did or did not have general counsels in senior management positions. They focus on a general counsel in senior management as an indicator of legal expertise in a company’s top ranks because general counsels have a much more intricate understanding than other managers of applicable laws and regulations and how they are enforced. The thinking, then, is that if being part of the senior management team gives general counsels sufficient influence, they will lead their firms to be more conservative when reporting earnings.

They find that firms with a general counsel in senior management do, in fact, report more conservatively. Specifically, the earnings of firms with a general counsel in senior management map more closely to negative returns than to positive returns, indicating that these firms recognize relatively more bad news than good news in earnings. This tendency is more pronounced than for firms without a general counsel in senior management. This is true even though conservative reporting is at odds with the typical incentive and compensation structures of senior management teams – which often reward emphasizing good news. These findings indicate that firms with legal expertise in the top ranks pay more attention to legal risks and are more likely than those without it to recognize the benefits of being conservative.

“Overall, our findings suggest that populating senior management with legal experts affects the extent to which a firm’s level of conservatism incorporates legal risks,” write the researchers.

Kimbrough and his co-authors also looked at what was going on in industries to provide further evidence on general counsels’ responsiveness to the external legal environment. They find the general counsel firms report more conservatively when their industry peers face recent litigation. But firms without general counsel in leadership roles don’t do the same.

The researchers also looked at two court decisions that affected the litigation risk for firms located in the Ninth Circuit, which includes most of the Western United States, Alaska, Hawaii and several U.S. territories. A 1999 court ruling decreased the litigation risk for firms in the Ninth Circuit, but then that ruling was effectively reversed with a 2007 ruling. But during the years with the decreased risk of lawsuits, the researchers find that even firms with general counsels in leadership positions in the Ninth Circuit were far less conservative than firms in other districts. Outside of those years, neither general counsel-led firms located outside the Ninth Circuit nor non-general counsel firms located in the Ninth Circuit altered their level of conservatism in response to the legal shocks.

“Collectively, the results of these tests suggest that firms with legal expertise in top management adjust their level of conservatism in response to changes in the legal environment that alter the legal risks associated with overstated earnings or net assets,” write the researchers.

Having legal experts in top management may also influence how timely firms are about revealing bad news to investors, find the researchers. In another analysis, they examine whether having a general counsel in top management affects how promptly a company reveals good and bad news and how the stock price reacts.

The researchers classify management earnings forecasts that are higher (lower) than prevailing market expectations as good (bad) news. They interpret larger market reactions as news having been withheld longer. They find that firms with an influential general counsel reveal bad news more promptly, which minimizes precipitous stock price declines and the associated legal risks.

The research adds to the understanding of a general counsel’s role in a firm’s accounting choices. Their evidence shows general counsels in leadership roles help firms act more conservatively with their accounting choices to minimize litigation risks. More broadly, the findings show how individual leaders – beyond the CEO and CFO – can affect observed financial reporting practices.

The research also shows the important role general counsels play in translating legal outcomes to firms, which has important implications for lawmakers and policymakers since a key purpose of the legal system is not only to punish directly but to send an observable signal to others that influences their behavior, say the researchers. When it’s easier to litigate against firms for aggressive reporting, general counsels encourage their firms to report more conservatively, they say.

Read the research, “Legal Expertise and the Role of Litigation Risk in Firms’ Conservatism Choices,” in The Accounting Review.