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E-MailSuresh Radhakrishnan is a Professor of Accounting at The University of Texas at Dallas, Ke Wang is an Associate Professor of Accounting at University of Alberta, and Zheng Wang is a Professor of Accounting at City University of Hong Kong. This post is based on their recent article forthcoming in the Journal of Accounting and Public Policy.
Key takeaways
- Adopting state-level constituency statutes is related to a significant decrease in accounting conservatism, especially for firms with greater agency conflicts between shareholders (represented by directors and managers) and nonfinancial stakeholders such as employees, customers, and suppliers.
- The state-level constituency statutes allow directors and managers to adopt direct mechanisms to protect stakeholder interests in business decisions without breaching the fiduciary duty owed to shareholders. The direct protection mechanisms reduce nonfinancial stakeholders’ demand for the indirect protection mechanism of accounting conservatism. The evidence in this study is consistent with the view that nonfinancial stakeholders demand conservative accounting policy as protection for their relationship-specific investments.
- The findings suggest that stakeholder-oriented legislative changes effectively increase corporate attention to stakeholder interests.
In the debate over the role of modern corporations in society, a central question is whether corporations should serve the interests of shareholders only or a broader group of stakeholders, especially nonfinancial stakeholders such as employees, customers, and suppliers. The former is the shareholder primacy view, while the latter is the stakeholder view. It is essential to understand the legal perspective of these two views, given that the Environmental, Social, and Governance (ESG) issues are close related to the stakeholder view and have drawn considerable attention and debate from regulators and the public.
Historically, the shareholder primacy view prevailed in courts. For example, in the seminal case of Dodge v. Ford Motor Co. (204 Mich. 459, 170 N.W. 668; Mich. 1919), the Michigan Supreme Court rejected the decision of Ford’s board of directors to withhold dividends and instead use the funds to support employee benefits and product price cuts. To counter the regulatory regime of shareholder primacy, starting from the mid-1980s, 35 U.S. states adopted constituency statutes in a staggered manner. These constituency statutes explicitly allow directors and managers to consider firms’ long-term and short-term interests instead of considering shareholders’ interests alone.
The study examines the effect of constituency statutes on the conservatism aspect of financial reporting. The conservatism principle adopted in financial reporting asserts that bad news and losses are recognized in a timely fashion and good news and gains are recognized until they are reasonably certain. Accordingly, accounting conservatism avoids overstating financial performance. We find that compared to the pre-adoption period, the adoption of constituency statutes is related to a significant decline in accounting conservatism. Our finding suggests that when legal protections for nonfinancial stakeholders increase, firms face less pressure to be conservative in financial reporting.
Why do nonfinancial stakeholders value accounting conservatism?
Employees, customers, and suppliers typically face asymmetric payoffs in their relationships with a firm. They bear downside risk in events of corporate distress but receive limited upside potential when the firm performs well. This asymmetric exposure to downside risk and upside potential is particularly true when considering relationship-specific investments, such as custom R&D and specialized employee training. These relationship-specific investments have little value outside the relationships, and the costs of switching business partners and jobs can be substantial for these nonfinancial stakeholders.
In the traditional shareholder primacy regime, nonfinancial stakeholders may fear that directors and managers will act in the sole interest of shareholders to the detriment of their interests. As a result, in a regime without constituency statutes, nonfinancial stakeholders are likely to demand more conservative accounting to receive early warnings about firms’ financial health and mitigate the risk of expropriation.
What changes are constituency statutes likely to bring about?
As discussed earlier, constituency statutes allow firms’ directors and managers to consider nonfinancial stakeholders’ interests in making business decisions. In effect, the unshackling of the fiduciary responsibility towards shareholders by directors and managers allows them to take a holistic view of the business. Thus, with the protection accorded by the constituency statutes, the directors and managers are less likely to engage in activities that benefit shareholders at the expense of nonfinancial stakeholders, such as overpaying dividends or taking on excessive risk. Furthermore, constituency statutes allow directors and managers to adopt policies or mechanisms to protect stakeholder interests and thus establish credibility and trust in firms’ relationships with their nonfinancial stakeholders. As a result, nonfinancial stakeholders no longer demand accounting conservatism.
Since the adoption of constituency statutes at the state level is plausibly exogenous to individual firm-level decisions, these legislative changes provide an excellent setting to examine nonfinancial stakeholders’ demand for accounting conservatism. Using a generalized difference-in-differences design with over 124,000 firm-year observations from 1979 to 2012, we find that firms incorporated in states that adopted constituency statutes experienced a significant decline in accounting conservatism after the laws were enacted.
The demand for accounting conservatism from different stakeholder groups
We find that the effect of constituency statutes on reducing accounting conservatism is more substantial for firms with higher agency conflicts between shareholders and nonfinancial stakeholders. In particular, the reduction in accounting conservatism is more pronounced in firms with the following characteristics.
- Firms with suppliers or customers that make more relationship-specific investments as measured by suppliers or customers operating in R&D-intensive industries.
- Firms where employees are more vulnerable to downside risk as measured by states with poor unemployment insurance benefits.
Are the results attributable to constituency statutes reducing the demand for accounting conservatism by debtholders or shareholders?
We find evidence that the results are not likely attributable to the constituency statutes reducing the demand for accounting conservatism by debtholders and shareholders, i.e., financial stakeholders. In particular, we find that the reduction in accounting conservatism occurs even for firms with fewer agency conflicts with financial stakeholders, as elaborated below.
- The effect of constituency statutes on reducing accounting conservatism occurs even for firms with relatively low debt-to-asset ratios, where debtholders’ demand for accounting conservatism is relatively low.
- The effect is more substantial for firms that borrow from a bank with more expertise and private knowledge about them. These banks rely less on public accounting information and thus demand less accounting conservatism.
- The effect is more substantial for firms with lower ownership by dedicated institutional investors or higher ownership by inside managers. Prior literature shows that such firms have a lower demand for accounting conservatism from shareholders.
Do direct mechanisms protect nonfinancial stakeholders?
In additional tests, we find that firms become more stakeholder-friendly after adopting constituency statutes. In particular, the affected firms are more likely to:
- Improve employee treatment,
- Offer higher-quality products or services to customers, and
- Commit to longer-term relationships with suppliers.
Conclusion
The study shows that accounting conservatism protects nonfinancial stakeholders’ interests in a less friendly legal and institutional environment. Stakeholder-friendly legislative changes can reduce the need for conservative accounting practices by reducing agency conflicts between nonfinancial stakeholders and shareholders. The study adds to the understanding of the role of modern corporations and their accounting practices in society.
The full paper is open-access published in Journal of Accounting and Public Policy (click here to download) and also available at the SSRN (click here to download).
