Does Litigation Encourage or Deter Real Earnings Management?
58 Pages Posted: 18 May 2017 Last revised: 10 May 2018
Date Written: May 4, 2018
We examine whether litigation risk encourages or deters real earnings management (REM). The literature documents that litigation risk restricts earnings management via accruals. Reduced ability to manipulate accruals in the presence of high litigation risk can encourage managers to engage in REM, which is more opaque and difficult to litigate against. However, a significant number of class action lawsuits accuse managers of issuing misleading disclosures whose origins are rooted in REM. This occurs because REM can lead to situations in which managers are forced to misrepresent the true intent underlying their actions. Thus by disciplining disclosure decisions, litigation can also deter REM. We conduct differences-in-differences tests centered on an unanticipated court ruling that reduced shareholders’ ability to initiate class action lawsuits against firms headquartered in the Ninth Circuit. We observe significant increases in REM following the ruling for Ninth-Circuit firms relative to other firms, consistent with litigation deterring REM. Additional analyses reveal that REM rises more for firms that exhibit more positive tone and higher obfuscation in the MD&A sections of their 10-K reports, and issue optimistic forecasts. Finally, results confirm that the deterrence role of litigation is more salient when managers have incentives to manipulate earnings and when governance mechanisms are weaker.
Keywords: Real Earnings Management, Earnings Management, Deterrence, Litigation, Corporate Governance
JEL Classification: G30, G32, K22, M41, M1, M4
Suggested Citation: Suggested Citation