Florida International Conservative Reporting & Securities Class Action Lawsuits Paper This assignment requires to respond to the following introductory que

Florida International Conservative Reporting & Securities Class Action Lawsuits Paper This assignment requires to respond to the following introductory questions:Introductory section:What is the paper about? Why are the issues examined interesting?What do we know from the prior research on related issues? ACCOUNTING HORIZONS
Vol. 30, No. 1
March 2016
pp. 93–118
American Accounting Association
DOI: 10.2308/acch-51308
Conservative Reporting and Securities Class Action
Lawsuits
Michael L. Ettredge
The University of Kansas
Ying (Julie) Huang
University of Louisville
Weining Zhang
Cheung Kong Graduate School of Business
SYNOPSIS: Positive accounting theory predicts that conservative financial reporting averts GAAP-based litigation.
However, very little empirical evidence addresses whether and how accounting conservatism provides these
benefits. Using a sample of lawsuits against public companies for alleged violations of U.S. GAAP, we examine the
association of accounting conservatism with subsequent initiation of lawsuits and with four litigation outcomes:
market reactions to lawsuits, duration of lawsuits, dismissals of lawsuits, and penalties approved by courts. We find
that firms with greater degrees of conditional conservatism experience more favorable consequences on all five
dimensions of litigation occurrence and outcomes. Several measures of unconditional conservatism are not
associated with the litigation variables. Our study provides new empirical evidence supporting Watts’s (2003a)
litigation explanation for accounting conservatism.
Keywords: accounting conservatism; litigation; lawsuit dismissal; lawsuit settlement.
JEL Classi?cations: M41.
INTRODUCTION
A
ccounting-related class action lawsuits have increased in frequency during recent decades. Every year such lawsuits
impose billions of dollars of direct and indirect costs on public companies and, eventually, on their shareholders
(Cornerstone Research 2013). Although positive accounting theory asserts that litigation risk engenders accounting
conservatism as a preemptive defense (Watts 2003a), there is little empirical evidence on whether and how this defense works.1
Accounting conservatism refers to ‘‘the accountant’s tendency to require a higher degree of verification to recognize good news
as gains than to recognize bad news as losses’’ (Basu 1997, 7). In this paper, we provide evidence that conditional accounting
conservatism (but not unconditional conservatism) averts the ex ante occurrence and improves the ex post outcomes of GAAPrelated litigation.
Accounting-related class action litigation frequently involves plaintiffs attempting to show that companies’ managers
reported overstated earnings numbers intentionally or with reckless negligence, and that subsequent revelation of the improper
accounting caused stock price decreases that harmed plaintiff shareholders (Chalmers, Naiker, and Navissi 2012). Conservative
We are grateful for helpful comments provided on prior versions of this paper by Sudipta Basu, Dain Donelson, Guojin Gong, Karla Johnstone, Teri Yohn,
Frank Zhang, and seminar participants at the University of Pittsburgh, the 2015 Canadian Academic Accounting Association Annual Conference, and the
2013 American Accounting Association Annual Meeting. We also thank Paul A. Griffin (editor) and the reviewer. All remaining errors are ours.
Editor’s note: Accepted by Paul A. Griffin.
Submitted: February 2015
Accepted: October 2015
Published Online: October 2015
1
A number of studies document that higher ex ante litigation risk motivates more preemptive conservative reporting, but this is not the same as evidence
that conservatism actually reduces ex post litigation incidence and costs. See Basu (1997), Holthausen and Watts (2001), Ryan and Zarowin (2003),
and Seetharaman, Srinidhi, and Swanson (2005).
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Ettredge, Huang, and Zhang
financial reporting arguably reduces the expected value of plaintiffs’ contemplated or actual investments in lawsuits by averting
or mitigating these elements of alleged harm: overstated earnings and stock price drops.
The asymmetric recognition of losses versus gains can lead to systematic understatements of earnings and net assets in
audited financial statements (Watts 2003a).2 Courts are more likely to rule that shareholder harm occurs when earnings and net
assets have been overstated rather than understated (Kellogg 1984; St. Pierre and Anderson 1984). Conservative reporting also
can reduce the expected value of plaintiffs’ investments in litigation by decreasing the likelihood that plaintiff shareholders can
prove they suffered financial harm through stock price drops. Timely recognition of bad news via accounting conservatism
prevents managers from deferring the revelation of bad news for extended periods. As a result, conservative financial reporting
reduces the likelihood of temporarily overpriced stock and subsequent sharp stock price ‘‘crashes’’ (Kim and Zhang 2013).3
Pursuing litigation against public companies in the current legal climate is a risky investment for plaintiffs and plaintiffs’
attorneys. It is costly and the monetary outcomes are uncertain. The expected value of litigation decreases when defendant
companies report conservative earnings.4 Consequently, conservative reporting reduces the probability that plaintiffs and their
lawyers will prevail should their case go to trial. Proceeding to trial is the 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 more commonly are observed. This study investigates the implications of this view. If reporting more
conservatively reduces the expected value of litigation, then shareholders of more conservative firms are less likely to initiate
lawsuits. The initial market reaction to a litigation event 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, then the amount of any court-approved penalty or settlement should be
less because the plaintiffs are less likely to prevail at trial. Finally, the duration of the litigation process should be shorter
because litigation is costly to plaintiffs and their lawyers, and they will invest less if the expected value of the outcomes is
lower.
We empirically test these implications using a sample of 363 shareholder lawsuits alleging violations of GAAP by U.S.
firms filed in 1996 through 2011 and resolved by mid-2014. Similar to Zhang (2008), our proxies for conditional conservatism
consist of (1) Basu’s (1997) measure of the sensitivity of earnings to bad news relative to the sensitivity of earnings to good
news, (2) negative non-operating accruals (Givoly and Hayn 2000), (3) the skewness of earnings (Basu 1995; Givoly and Hayn
2000), and (4) a composite measure based on the average rank of the three conditional conservatism measures. We capture
unconditional conservatism using (5) Penman and Zhang’s (2002) conservatism index, and (6) a market-to-book equity ratio
(Roychowdhury and Watts 2007).
To test whether more conservative firms are less likely to be sued, we use a logistic model that regresses a dichotomous
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 the 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 as measured does not play a role in the litigation process. To test whether more conservative firms
experience more favorable outcomes, given litigation is initiated, we investigate the four outcomes of the litigation process
previously mentioned. We use ordinary least squares (OLS) models to explain the market reaction to litigation initiation,
duration of the litigation process, and litigation settlement amount dependent variables, and we use a logistic model to explain
courts’ dismissals or non-dismissals 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. The unconditional
conservatism metrics generally are statistically insignificant. Specifically, first, the stock market reacts less negatively to
lawsuits initiated against more conditionally conservative accounting reporters. 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,
2
3
4
Whether conservatism does so depends on how much bias managers introduce into the measurement system ex ante, for instance by being
unconditionally aggressive. See, for example, the discussion of Corollary 2 in Gao (2013, 262).
Furthermore, audited financial reports arguably discipline other management disclosures, such as earnings guidance, by providing benchmarks against
which managers can be held accountable ex post (Ball, Jayaraman, and Shivakumar 2012, 137). LaFond and Watts (2008) argue that this
‘‘benchmarking’’ role of financial reports is particularly effective when the financial reports are conservative. As a result, conservative firms’ stock
prices should be less likely to be poised for crashes, because both ‘‘hard’’ information (audited financial reports) and ‘‘soft’’ information (such as
managers’ forecasts) are less likely to overstate past and expected future gains, and to understate past and potential losses.
For example, Ettredge, Huang, and Zhang (2012) find that conservative reporters are less likely to have to restate prior financial reports, suggesting that
they are less likely to violate GAAP.
Accounting Horizons
Volume 30, Number 1, 2016
Conservative Reporting and Securities Class Action Lawsuits
95
compared to 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 settlement amounts for conservative reporters. The top percentile firms pay a penalty amount that is, on
average, $145 million less than firms in the bottom percentile. Overall, these results suggest substantial economic benefits to
large differences in conditional conservatism. Our results are robust to controlling for various known firm-specific determinants
of litigation risk, as well as to several sensitivity tests.
This paper’s main contributions are as follow. First, we contribute to the literature documenting benefits of conservative
reporting. Prior studies have examined various country-level and firm-specific factors that explain the contracting demand for
conservatism described by Watts (2003a). However, less research has been devoted to the economic consequences of or
benefits from conservative accounting in the litigation context. Second, we contribute to the literature on the relation between
accounting properties and litigation. Studies such as Kim and Skinner (2012) that explain initiation of lawsuits have not
previously investigated the role of conservative reporting. Prior studies of accounting litigation tend not to investigate any event
other than the initiation of lawsuits (St. Pierre and Anderson 1984; Kellogg 1984; Palmrose and Scholz 2004; Chalmers et al.
2012). In contrast, we investigate four other outcomes of lawsuits: market reaction to litigation, dismissals of lawsuits, courtapproved penalties, and duration of litigation. Our results suggest that conditional conservatism provides reporting firms with
protection against GAAP-based litigation, but unconditional conservatism does not. Finally, our results contribute to a literature
that raises questions regarding the FASB’s criticism of accounting conservatism (FASAC 2005; FASB 2010). Conservatism
(prudence) has been eliminated from the FASB and IASB’s joint conceptual framework (FASB 2010). However, recent studies
arguably support the value of conservatism in reducing information asymmetry and aligning interests between managers and
suppliers of capital.5 This study provides new evidence on a different and important benefit arising from conservative financial
reporting: reductions in lawsuit occurrences and mitigations of adverse lawsuit outcomes.
The remainder of the paper is organized as follows. The second section briefly reviews the relevant literature and develops
our hypotheses. The third section describes our sample, empirical model, and variables. The fourth section presents descriptive
statistics and the results of multivariate regressions. The fifth section presents our conclusions.
BACKGROUND, RELATED LITERATURE, AND HYPOTHESES
Background
Shareholder litigation against public companies is a persistent feature of the corporate environment and is costly both to
plaintiffs and defendants. Firms likely experience negative abnormal stock returns when litigation against them is announced.
In addition to the amounts of any settlements, firms targeted by class actions also incur the legal costs of defending themselves,
their officers, and directors. These costs include not only payments made to in-house and external defense attorneys, but also
the costs of directors and officers insurance, and the opportunity costs of devoting attention to litigation rather than to operating,
investing, and financing decisions. When lawsuits are not dismissed, firms bear the costs of court-approved awards or of private
settlement costs. On rare occasions claims are litigated in court, adding yet more costs. Litigation is costly not only to the firms
that are defendants, but also to plaintiffs and their legal counselors.
Significant numbers of lawsuits continue to be filed since passage of the Private Securities Litigation Reform Act (PSLRA)
of 1995 increased evidentiary standards in order to deter frivolous lawsuits (Johnson, Nelson, and Pritchard 2007; Chalmers et
al. 2012). A study of class action litigation by PricewaterhouseCoopers (2008) reports that 2,159 securities class action lawsuits
were initiated during 1996–2007, an average of 180 lawsuits per year. Cornerstone Research (2013) reports that from 1997
through 2012, 191 class action filings were initiated each year on average. Firms subjected to class actions lost $652 billion in
market capitalization per year on average, computed over the firms’ class action periods and totaled for all firms sued in a year.
Accounting violations are among the factors that courts consider meritorious under PSLRA (Johnson et al. 2007). Accountingrelated class action lawsuits constituted more than 50 percent of the total securities lawsuits in each year during 1996–2007
(PricewaterhouseCoopers 2008). Cornerstone Research (2013) reports that in recent years, securities lawsuits usually have
alleged misrepresentations in financial documents (95 percent and 97 percent in 2012 and 2013, respectively) and often have
alleged violations of GAAP (23 percent and 24 percent in 2012 and 2013, respectively).
We turn now to a discussion of related research.
5
See LaFond and Watts (2008), LaFond and Roychowdhury (2008), Go?x and Wagenhofer (2009), Francis and Martin (2010), Kim, Li, Pan, and Zuo
(2013), Watts and Zuo (2011), Gao (2013), and Balakrishnan, Watts, and Zuo (2014).
Accounting Horizons
Volume 30, Number 1, 2016
Ettredge, Huang, and Zhang
96
Related Literature
Consistent with the litigation explanation for conservatism (Watts 2003a), prior research documents that changes in legal
liability over time appear to motivate changes in conservatism over time (Basu 1997; Ball, Kothari, and Robin 2000;
Holthausen and Watts 2001; Ryan and Zarowin 2003; Sivakumar and Waymire 2003; Raonic, McLeay, and Asimakopoulos
2004; Seetharaman et al. 2005). Cross-sectional differences in litigation risk across legal jurisdictions also are associated with
cross-sectional differences in conservatism (Huijgen and Lubberink 2005; Lobo and Zhou 2006; Bushman and Piotroski 2006;
Qiang 2007; Khan and Watts 2009; Shroff, Venkataraman, and Zhang 2013). For example, Qiang (2007) studies whether the
four explanations for accounting conservatism—contracting, litigation, regulation, and taxation—motivate greater levels of
conditional and unconditional conservatism. In the litigation context, Qiang (2007) finds that conditional and unconditional
conservatism are both increased by proxies for higher litigation risk.6
Although these studies suggest that greater litigation risk and increases in litigation risk motivate higher levels of
conservatism, to our knowledge, no published research establishes that conservative reporting of income reduces actual
litigation occurrence and costs. Two early studies (St. Pierre and Anderson 1984; Kellogg 1984) report results suggesting that
overstatements of net assets and income are more likely to generate litigation than are understatements. Those results can be
interpreted as consistent with conservatism averting litigation occurrence. However, the two studies are based on relatively
small samples, and they predate both current litigation rules (under the PSLRA of 1995) and contemporary research into
conservative reporting, i.e., Basu (1997) and subsequent studies. Thus those early studies do not employ currently accepted
measures of reporting conservatism in the contemporary litigation environment. Nor do those studies investigate litigation
outcomes other than occurrence.
Researchers have identified two broad types of conservative reporting that could affect litigation differently: unconditional
and conditional conservatism. A key aspect of the distinction between the two relates to the role of information in recognizing
gains and losses. Unconditional conservatism only utilizes information known at the inception of an asset’s life. Conditional
conservatism utilizes information when it is received in future periods. Although both types of conservatism eventually reduce
income and equity, only conditional conservatism reveals new information and enables contracting responses (Basu 2005).7
Thus it is possible that conditional conservatism and unconditional conservatism affect litigation against reporting firms
differently. Lack of conditional conservatism might increase litigation occurrence and costs because such lack potentially ties to
the legal concept of scienter or wrongful intent. Plaintiffs can argue that managers employing discretion to overstate earnings in
violation of GAAP did so with intent to deceive. In contrast, it would be more difficult to obtain a judgment against a firm
whose managers’ report unconservatively in compliance with GAAP. Therefore, we investigate both unconditional and
conditional types of conservatism in our litigation setting.8
One unpublished manuscript, Blunck (2009), is somewhat similar to our study in that it investigates the association
between a measure of conditional conservatism and several of the litigation occurrence and outcome …
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