Does Litigation Deter or Encourage Real Earnings Management?

Abstract

In this paper, we rely on an exogenous shock to examine the impact of litigation risk on real earnings management (REM). We conduct difference-in-differences tests centered on an unanticipated court ruling that reduced litigation risk for firms headquartered in the Ninth Circuit. REM increases significantly following the ruling for Ninth Circuit firms relative to other firms, consistent with litigation risk deterring REM. Additional analyses reveal that REM rises more following the ruling when firms issue more optimistic disclosures. The evidence is consistent with litigation deterring REM by constraining managers' ability to issue optimistic and misleading disclosures that can conceal the myopic and opportunistic motives underlying REM. We further document that an increase in REM in response to a decline in litigation risk is more pronounced when managers have higher incentives to manipulate earnings and governance mechanisms are weaker.

Shareholder litigation rights and capital structure decisions

“…The ruling increases the hurdle for bringing securities class action litigation against corporations headquartered in the Ninth Circuit by mandating plaintiffs to prove clear evidence of intentional managerial misbehavior. This higher requirement decreases securities class action risk for firms headquartered in the Ninth Circuit significantly (Pritchard and Sale, 2005;Huang, Roychowdhury and Sletten, 2019). Crane and Koch (2018) report that the number of class action lawsuits in the Ninth Circuit decreased by 43% following the ruling while the number of class action lawsuits increased by 14% in other circuits.…”

The Role of Gatekeepers in Capital Markets

“…Further, how do judicial preferences impact real outcomes like investment behaviors? For example, Huang, Roychowdhury, and Sletten [] investigate the impact of a specific court ruling that reduced litigation risk for firms in the Ninth Circuit, perceived as liberal leaning and investor friendly until that point, and find that managers respond by increasing earnings management through real actions.…”

Shareholder litigation risk and real earnings management: a causal inference

“…Taken together, we provide corroborative evidence of the strong intensifying effect of lesser shareholder litigation threats on opportunistic financial reporting behavior. One contemporaneous study (Huang et al, 2017) also examines a research question similar to ours. Our study is different from theirs in the following dimensions: first, we test all three individual REM and two aggregate REM measures.…”

“…Our study is different from theirs in the following dimensions: first, we test all three individual REM and two aggregate REM measures. The cash flow REM measure and its related aggregated REM measure are excluded in Huang et al (2017); second, we use nearest neighbor matching to pair each of the treated firms to a control firm, making the number of firms equal in both groups to deal with any bias introduced by the unbalanced number of firms in each group; third, our study introduces a hypothesis to test the important moderating effect of internal corporate governance. We also test our primary result in another environment with high litigation risk: the pre-IPO period (Lowry and Shu, 2002;Venkataraman et al, 2008)[12].…”