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 profits at the expense of long-term value. A classic example of REM is aggressive reduction in research and development spending. Such reduction sacrifices long-term returns from innovative activities but allows managers to report lower expenses and thus higher profits in the current year. In anonymous surveys, executives admit to a preference for this method of managing earnings relative to manipulating accruals. This is cause for concern, as existing evidence indicates that REM is more opaque to external stakeholders and associated with negative future performance and stock returns. While various corporate governance mechanisms have been proposed to curtail these real choices, little is known about the effect of shareholder litigation on REM.

Conceptually, the influence of litigation risk on REM is ambiguous. Given the information asymmetry about real operations between a firm’s managers and its external stakeholders, REM is more opaque and thus harder to detect than financial reporting violations and accrual manipulations. Further, REM involves business decisions, which managers could justify as sound given their interpretation of the economic circumstances, even though there were negative consequences. The invoking of this business judgment rule provides legal cover for REM. However, it is important to consider that REM does not exist in a vacuum. A significant number of class-action lawsuits accuse managers of issuing misleading disclosures rooted in REM. This is because when managers engage in REM, they bear the risk of having to explain to investors and financial analysts the rationale for short-term actions that boost earnings but harm long-term value. REM can thus require managers to misrepresent business circumstances or the true intent of their actions. Such statements, when revealed later to be misleading and deceptive, can trigger lawsuits.

For example, from 2009 to 2010, analysts and auditors suspected Green Mountain Coffee of overproducing inventory over successive periods to under-report their cost of goods sold (by taking advantage of absorption costing). Green Mountain Coffee managers repeatedly represented the sustained inventory increases as a response to “booming” business and surging demand. When Green Mountain eventually started missing sales and earnings targets, shareholders sued the company alleging that managers had misrepresented business conditions and misled shareholders about their inventory policies. Because of this link between REM and misleading disclosures, the increased threat of litigation can deter managers from engaging in REM.

On the other hand, litigation may also encourage REM. Managers intending to overstate earnings tend to shift from manipulating accounting accruals to real actions when accounting practices are under intense regulatory or court scrutiny. Consistent with this notion, prior studies document that firms switched from accruals management to REM after the Sarbanes-Oxley Act (SOX), which strengthened regulatory oversight of financial reporting. Since higher litigation risk is known to constrain accruals manipulation, it may induce managers to engage in more REM. Overall, the net effect of litigation risk on REM is not obvious.

We empirically examine the relation between litigation risk and earnings management following the creation of stricter standards for securities class actions in the U.S. Ninth Circuit Court of Appeals. On July 2, 1999, the Ninth Circuit Court required plaintiffs in the Silicon Graphics Inc. Securities Litigation to prove that defendants acted with “deliberate recklessness.” The requirement significantly increased the hurdle for successful litigation against corporations headquartered in the Ninth Circuit and reduced their litigation risk. Since the ruling affected only firms located in the Ninth Circuit, we were able to compare those companies’ post-ruling changes in REM to those of firms located in other circuits in differences-in-differences tests.

Using a sample of firm-years spanning four years before and four years after the 1999 ruling, we find significant post-ruling increases in REM for these firms relative to firms located in other circuits. This finding is remarkably resilient to controlling for many possible sources of systematic differences between Ninth Circuit firms and other firms in multiple ways. The collective evidence is strongly indicative of litigation risk acting as a deterrent to REM.

In our second set of tests, we examine settings in which the effect of litigation risk on REM is likely to be particularly strong. Specifically, we expect the negative relation between litigation risk and REM to be stronger when managers make misleadingly optimistic disclosures, or when managers have greater incentives to report higher earnings and face weaker governance constraints on their ability to do so. The intuition is that REM is likely to be accompanied by misleading disclosures and misrepresentations, and an increased ability of management to issue such disclosures is likely to increase REM. Similarly, in the presence of a reduced threat of litigation, managers are more likely to engage in REM when they need to boost earnings either to meet or beat earnings expectations or to personally benefit from insider trading. Finally, corporate governance may curtail opportunistic behavior, reducing the role of shareholder litigation. Consistent with our predictions, we find that the relation between REM and litigation risk is more pronounced for firms that issue optimistic disclosure, narrowly meet or beat earnings expectations, have weaker corporate governance, and have managers who engage in non-routine insider trading.

Research on factors that constrain REM has focused on various aspects of corporate governance: the appropriate design of executive compensation packages, the checks and balances within a firm, and the monitoring role of long-term institutional investors. Our results suggest that litigation is another channel to constrain REM because it provides recourse to shareholders when governance, incentive mechanisms, and other sources of monitoring fail. The ex post settling-up opportunity that litigation provides also makes it an effective ex ante deterrent to REM. Our findings indicate that opportunistic actions can attract scrutiny and require managers to misrepresent the purpose or the circumstances of these actions, which in turn can lead to litigation. Thus, higher litigation risk can discipline managers’ actions by tightening the constraints on managers’ ability to issue misleading disclosures.

This post comes to us from professors Sterling Huang a Singapore Management University, Sugata Roychowdhury at Boston College, and Ewa Sletten at Ohio State University. It is based on their paper, “Does Litigation Deter or Encourage Real Earnings Management?,” forthcoming in The Accounting Review and available here.