Does the Threat of Private Litigation Increase the Usefulness of Reported Earnings? International Evidence

Abstract

In this cross-border study, we document the usefulness of reported earnings as conditioned by varying levels of litigation risk. We focus on litigation risk, since Ball (2001) suggests that although litigation rights are seldom discussed in the context of international accounting, the threat of private litigation can motivate corporate insiders to increase transparency in financial reporting. We operationalize the quality of reported earnings based on their ability to predict the firm's future cash flows. The focus on future cash flows enables us to examine the usefulness of reported earnings without having to assume pricing similarities across stock markets. We examine the relation between litigation risk and earnings quality for firms in a sample of 34 countries. We find that the higher the litigation threat, the greater the predictive ability of reported earnings for future cash flows.