Relevance of debt- and tax-related motives for conditional conservatism of limited-liability and full-liability firms: evidence from Europe

Abstract

In contrast to shareholders of limited-liability firms, the owners of sole proprietorships and partnerships are fully liable for their firm’s liabilities. We expect owners’ full liability to mitigate agency problems of debt and to lower creditors’ demand for financial debt covenants and accounting conservatism. Using a European sample of private firms, we find robust evidence that full-liability firms exhibit about 20–25% less timely loss recognition than limited-liability firms, confirming previous findings for German firms. In addition, we find that full-liability firms exhibit significantly more timely loss recognition in countries with high book-tax conformity, while limited-liability firms do not. Furthermore, we find some, but not robust, evidence that the strictness of the bankruptcy code and timely loss recognition are partial substitutes. Our analyses contribute to prior literature by analyzing how owner liability is related to conditional conservatism and how the characteristics of the institutional framework are related to this association.