Bogging Down Investors: An Unintended Consequence of Litigation Risk

Abstract

This study examines the effect of litigation risk on the readability of corporate financial reports using the 1999 Silicon Graphics Inc. court ruling as a quasi-natural experiment. This ruling unexpectedly reduced the litigation risk of firms located in the states of the Ninth Circuit Court (treated firms). We find that the treated firms increase the readability of their financial reports after the ruling, relative to the control firms located in other states. This effect is concentrated in firms prone to shareholder litigation, firms with greater external financing needs, and firms reducing forward-looking disclosures following the ruling. The improvement of readability, however, is muted among firms engaging in earnings management. We also find that the treated firms with low pre-ruling 10-K readability have more informative 10-K reports after the ruling. Collectively, our findings support the notion that litigation risk contributes to low financial reporting readability.