Legal Expertise and the Role of Litigation Risk in Firms’ Conservatism Choices

Abstract

Firms face a greater risk of lawsuits for overstated rather than understated earnings or net assets, suggesting conservatism can reduce firms’ expected legal costs. Because managers with legal expertise are more likely than other managers to recognize the legal benefits of conservatism, this study examines whether legal expertise among members of senior management promotes greater conservatism. Consistent with this prediction, we find that firms with a general counsel (GC) in senior management (our proxy for legal expertise) report more conservatively. We also find that GC firms recalibrate their conservatism levels in response to changes in the legal environment—their conservatism choices are more responsive to litigation against peer firms and to two judicial rulings that affected the litigation risk for firms located in the Ninth Circuit. 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.