The number of accounting-related class action lawsuits has increased in recent decades, imposing billions of dollars of direct and indirect costs on public companies and, eventually, their shareholders each year. Although accounting theory says that litigation risk generates accounting conservatism as a pre-emptive defense, there is little empirical evidence on whether and how this defense works. In our paper, available here, we provide evidence that accounting conservatism helps companies avoid GAAP-related litigation and improve its outcome.

Accounting conservatism refers to the practice of requiring more verification to recognize good news as gains than to recognize bad news as losses.  Accounting-related class action litigation frequently claims that managers overstated earnings intentionally or recklessly, and that subsequent revelation of the improper accounting caused stock-price decreases that harmed plaintiff shareholders. Conservative financial reporting arguably reduces the expected value of plaintiffs’ lawsuits by averting or reducing overstated earnings and stock price drops.

Recognizing losses more readily than gains can lead to systematic understatement of earnings and net assets in audited financial statements. Courts are more likely to rule that shareholder harm occurred when earnings and net assets have been overstated rather than understated. Conservative reporting can also reduce the value of litigation by decreasing the likelihood that plaintiff shareholders can prove they suffered financial harm through stock price drops. Timely recognition of bad news through accounting conservatism reduces the likelihood of temporarily overpriced stock and subsequently sharp stock-price crashes.

Pursuing litigation against public companies in the current legal climate is risky for plaintiffs and their attorneys. It is costly and the outcomes are uncertain. We argue that the expected value of litigation decreases when defendant companies report conservative earnings. Consequently, conservative reporting reduces the probability that plaintiffs and their lawyers will prevail should their case go to trial. Proceeding to trial is plaintiffs’ ultimate bargaining chip. Few cases ever go to trial due to the high costs involved, but reductions in the expected value of the plaintiffs’ case should affect the consequences of litigation that we more commonly observe.

Our study investigates the implications of this view. If reporting more conservatively reduces the expected value of litigation, shareholders of more conservative firms are less likely to initiate lawsuits. The initial market reaction to litigation should be less negative for a more conservative firm, because the market may expect that the lawsuit is more likely to be dismissed. The probability of dismissal is higher because the plaintiffs’ case is likely to be weaker. If a case is not dismissed, the amount of any judgment or settlement should be less, because the plaintiffs are less likely to prevail at trial. Finally, litigation should be shorter because it is costly to plaintiffs and their lawyers, and they will spend less if their expected recovery is lower.

We empirically test these implications using a sample of 363 shareholder lawsuits alleging violations of GAAP by U.S. firms filed from 1996 through 2011 and resolved by mid-2014. There are two types of conservative accounting. One is conditional conservatism, which recognizes losses from bad news more quickly than it recognizes gains from good news and relies, at least in part, on the news to determine the gain or loss. The other type is unconditional conservatism, which determines the value of an asset regardless of the news and the market reaction to it. We use four measures of conditional conservatism that have also been used in prior studies: (i) Basu’s (1997) measure of the sensitivity of earnings to bad news relative to the sensitivity of earnings to good news, (ii) negative non-operating accruals, (iii) how much earnings are skewed, and (iv) a composite measure based on the average rank of the three conditional conservatism measures. We capture unconditional conservatism using (v) Penman and Zhang’s (2002) conservatism index and (vi) a market to book equity ratio.

To test whether more conservative firms are less likely to be sued, we use a model that regresses a variable representing initiation or non-initiation of a shareholder lawsuit on each of the four conditional conservatism measures individually, plus both of the unconditional conservatism measures, and several control variables. Control firms are matched one-to-one with test firms based on ex ante probability of being sued for GAAP violations.

Consistent with expectations, we find that all four measures of conditional conservatism are negatively associated with the occurrence of future lawsuits. Firms in the top percentile of the average conservatism ranking face a 30 percent lower probability of a lawsuit than those in the bottom percentile. Neither of the unconditional conservatism measures is associated with subsequent litigation occurrence, suggesting unconditional conservatism does not affect litigation.

To test whether more conservative firms experience more favorable outcomes in litigation, we investigate the four outcomes of litigation previously mentioned. We estimate models that use conservatism metrics to explain the market reaction to the initiation of litigation, duration of the litigation, settlement amount, and courts’ dismissal or non-dismissal of lawsuits.

Consistent with expectations, we find that each of the four conditional conservatism measures is significantly associated with more favorable consequences for defendants, and the effects are economically meaningful. Specifically, first, the stock market reacts less negatively to the filing of lawsuits against companies with conservative accounting. Firms in the top percentile of the average ranking of conservatism experience market returns at lawsuit announcements that are less negative by around 930 basis points, compared with firms in the bottom percentile.

Second, cases are resolved more swiftly for more conservative firms. Firms in the top percentile based on the average ranking of conservatism resolve their cases sooner by an average of 385 days than firms in the bottom percentile, which is equivalent to a 36 percent reduction in the number of days for the average firm in our sample. Furthermore, courts are more likely to dismiss lawsuits against conservative defendants: the probability of a dismissal is higher by 31 percent for the top percentile firms than the bottom percentile. Finally, lawsuits that are not dismissed result in smaller court-approved settlements for conservative reporters. The top percentile firms pay a penalty amount that is on average $145 million less than for firms in the bottom percentile.

These results suggest substantial economic benefits to conditional conservatism. The unconditional conservatism metrics generally are statistically insignificant. Our results are robust after controlling for various firm-specific determinants of litigation risk and performing several sensitivity tests. Taken together, our results are consistent with conditional accounting conservatism serving as an effective mechanism for deterring lawsuits and mitigating adverse outcomes in shareholder class action lawsuits alleging violations of GAAP.

This post comes to us from Professor Michael Ettredge at the University of Kansas, Professor Ying (Julie) Huang at the University of Louisville, and Professor Weining Zhang at Cheung Kong Graduate School Business in Beijing, China. It is based on their recent article, “Conservative Reporting and Securities Class Action Lawsuits,” available here.