ACCTG 502 | Session 6 | Does Litigation Deter or Encourage Real Earnings Management? - 2020

Sterling Huang, Sugata Roychowdhury, Ewa Sletten

Introduction:

The study examines how litigation risk affects real earnings management (REM). Using a difference-in-differences approach around a 1999 Ninth Circuit Court ruling that unexpectedly decreased litigation risk, the authors find that firms based in the Ninth Circuit significantly increased their use of REM compared to firms in other circuits. The evidence indicates that litigation risk acts as a deterrent to REM, mainly because it limits managers' ability to issue optimistic or misleading disclosures that hide opportunistic motives. Increases in REM were especially notable when managers had strong incentives to manipulate earnings and when governance mechanisms were weak.