Event Details

"Does Litigation Encourage or Deter Real Earnings Management?"

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 instead. However, an alternative scenario is also possible. Specifically, since the intention of REM is to mislead shareholders, managers’ efforts to conceal REM can induce them to make misleading disclosures that become the subject of future lawsuits. This ex post settling-up by shareholders can ex ante deter managers from engaging in 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 issue optimistic forecasts and exhibit more positive tone and higher obfuscation in the MD&A sections of their 10-K reports. These findings provide evidence on the channel through which litigation constrains REM: the as-yet unexplored link between misleading disclosures and opportunistic real activities. Further results confirm that the deterrence role of litigation is more salient when managers have incentives to manipulate earnings and when governance mechanisms are weaker.