Litigation Reform, Accounting Discretion, and the Cost of Equity

Journal of Contemporary Accounting and Economics, Vol. 5, No. 2, pp. 80-94, December 2009

Posted: 25 Sep 2009 Last revised: 15 Jun 2010

See all articles by Jeff P. Boone

Jeff P. Boone

University of Texas at San Antonio - Department of Accounting

Inder K. Khurana

University of Missouri at Columbia - Robert J. Trulaske, Sr. College of Business

K. K. Raman

The University of Texas at San Antonio

Abstract

In this paper, we isolate a context - the 1995 Public Securities Litigation Reform Act - where information risk (accruals quality) is likely to change, and investigate whether the increase in accounting discretion associated with litigation reform is viewed by investors as basically opportunistic (i.e., as distorting reported earnings) or as improving the ability of reported earnings to reflect economic value. We measure accounting discretion using both positive (i.e., income-increasing) as well as absolute performance-adjusted abnormal accruals. Our analysis focuses on a constant sample of firms over a 10 year (1992-2001) period, and is structured in two stages. In the first-stage, we utilize an instrumental variable technique that isolates the increase in accounting discretion associated with the 1995 Act. In the second-stage, we relate the predicted increase in accounting discretion associated with litigation reform - obtained from the first-stage regression - to the ex ante equity risk premium for Big N audit clients. Our results suggest that the increase in accounting discretion associated with the 1995 Act was viewed by investors as basically opportunistic. Further, the exogenous nature of the 1995 Act suggests that the observed increase (and pricing) of accounting discretion is related to litigation reform rather than some omitted firm-specific operating characteristic. Overall, our findings suggest that litigation reform affects firm value through managers’ exercise of accounting discretion and cost of equity capital channels.

Keywords: Litigation reform, Accounting Discretion, Cost of equity capital

JEL Classification: M41, M49

Suggested Citation

Boone, Jeff P. and Khurana, Inder and Raman, K. K., Litigation Reform, Accounting Discretion, and the Cost of Equity. Journal of Contemporary Accounting and Economics, Vol. 5, No. 2, pp. 80-94, December 2009. Available at SSRN: https://ssrn.com/abstract=1478197

Jeff P. Boone

University of Texas at San Antonio - Department of Accounting ( email )

One UTSA Circle
San Antonio, TX 78249
United States

Inder Khurana

University of Missouri at Columbia - Robert J. Trulaske, Sr. College of Business ( email )

331 Cornell Hall
Columbia, MO 65211
United States
573-882-3474 (Phone)
573-882-2437 (Fax)

K. K. Raman (Contact Author)

The University of Texas at San Antonio ( email )

One UTSA Circle
San Antonio, TX 78249
United States
210-458-8749 (Phone)

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