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Litigation Reform, Auditor Incentives, and the Cost of Equity Capital
Jeff P. Boone, University of Texas - San Antonio
Inder K. Khurana, University of Missouri - Columbia
K. K. Raman, University of North Texas
ABSTRACT. In this paper, we examine whether the increase in earnings management associated with litigation reform is priced by investors and reflected in the cost of equity capital. Specifically, we focus on the 1995 Public Securities Litigation Reform Act which lowered auditors’ legal exposure and reduced auditor incentives to limit earnings management by audit clients. Our analysis focuses on a constant sample of firms over a 10 year (1992-2001) period, and is structured in two stages. In the first-stage, we utilize an instrumental variable technique that isolates the increase in earnings management associated with the 1995 Act. Essentially, we parse out actual earnings management (as measured by performance-adjusted abnormal accruals) into three components attributable to firm-specific characteristics, the 1995 Litigation Reform Act (an exogenous event), and statistical noise. In the second-stage, we relate the component attributable to the 1995 Act (i.e., the predicted increase in earni
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