An International Meeting of the American Accounting Association American Accounting Association 2006 Annual Meeting August 6–9, 2006 Washington, D.C.

Yvonne Lu
University of Southern California

Abstract: This study examines the relation between earnings management and shareholder litigations. On a sample of 781 firms sued in class action securities litigation from 1988 to 2000, I find that accruals and the changes in revenues are abnormally high during alleged periods of manipulation, and tend to reverse subsequently. This evidence is consistent with defendant firms using discretionary accruals to overstate earnings. Because litigation is costly, concerns for litigation risk may affect firms’ earnings management behavior. This suggests that earnings management and litigation risk are both endogenously determined. Employing a simultaneous-equations framework to examine the relation between earnings management and securities litigation risk, this study finds that contrary to common wisdom, (i) firms with higher litigation risk tend to engage in larger amount of income-increasing earnings management; (ii) income-increasing earnings management does not increase firms’ litigation risk.

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