Conservative reporting and securities class action lawsuits

Abstract

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 US 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. Two measures of unconditional conservatism are not associated with the litigation variables. Our study provides new empirical evidence supporting Watts’ (2003a) litigation explanation for accounting conservatism.