Private Litigation as a Regulator of Accounting Standards
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I examine the impact of the trend of private class actions targeting alleged violations of generally accepted accounting principles (GAAP). I document the specific allegations in GAAP lawsuits and find that allegations involving revenue recognition and asset impairment recognition are two of the most common areas of GAAP cited. I test whether lawsuits lead to a reduction in the allegedly improper behavior, whether sued firms and their peers make other financial reporting changes, and whether these changes change firms’ stock price characteristics. I find that following relevant lawsuits, sued firms, firms in the same industry, and firms with a shared auditor generally exhibit less aggressive revenue recognition, but firms may increase aggressive revenue recognition in certain cases. Next, I examine the impact of asset impairment recognition allegations on the reporting of negative special items. I find few changes directly associated with these allegations but show that other litigation is associated with both increases and decreases in the propensity and size of negative special item reporting. I note that GAAP violations most often arise in an attempt to meet or beat analysts’ estimates, and I show following litigation firms are often more likely to beat analysts’ expectations by a larger margin. I also find significant increases in real earnings management of sued firms and their peers following many lawsuits, indicating a shift away from accruals-based management towards real activities management. Finally, I find mixed evidence of changes in stock return attributes. In some cases I observe significant changes consistent with reduced litigation risk and in others I observe the opposite. The results have implications for accounting standard setting and show that the legal system plays a critical role in shaping the financial reporting environment.