Does Litigation Encourage or Deter Real Earnings Management?

Securities class actions may deter financial misreporting and flawed disclosure, but how effective are they at deterring managers from taking actions that sacrifice long-term value for higher profits? In a recent paper, we uncover a novel mechanism that extends the disciplining effect of litigation to such managerial actions, often referred to as real earnings management (REM).

Real earnings management differs from accrual earnings management, in which managers cook the books to overstate earnings, in that REM does not violate financial reporting rules. Instead, it allows managers to report higher profits in the short run via real choices that boost short-term … Read more