Does Litigation Deter or Encourage Real Earnings Management?

56 Pages Posted: 18 May 2017 Last revised: 13 Jul 2020

See all articles by Sterling Huang

Sterling Huang

Singapore Management University - School of Accountancy

Sugata Roychowdhury

Boston College

Ewa Sletten

The Ohio State University

Date Written: July 17, 2019

Abstract

In this paper, we rely on an exogenous shock to examine the impact of litigation risk on real earnings management (REM). We conduct differences-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.

Keywords: Real Earnings Management, Earnings Management, Deterrence, Litigation, Corporate Governance

JEL Classification: G30, G32, K22, M41, M1, M4

Suggested Citation

Huang, Sterling and Roychowdhury, Sugata and Sletten, Ewa, Does Litigation Deter or Encourage Real Earnings Management? (July 17, 2019). The Accounting Review, Forthcoming, Singapore Management University School of Accountancy Research Paper No. 2020-108, Available at SSRN: https://ssrn.com/abstract=2970311 or http://dx.doi.org/10.2139/ssrn.2970311

Sterling Huang (Contact Author)

Singapore Management University - School of Accountancy ( email )

60 Stamford Road
Singapore 178900
Singapore
6808 7929 (Phone)

Sugata Roychowdhury

Boston College ( email )

140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States
617-552-1764 (Phone)

Ewa Sletten

The Ohio State University ( email )

Fisher Hall
2100 Neil Avenue
Columbus, OH 43210
United States
6142922451 (Phone)

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