The Impact of Litigiousness on Earnings Conservatism's Negative Association with the Price-to-Book Ratio

Abstract

We hypothesize and find that litigiousness (the economy wide propensity of shareholders to file class action lawsuits) enhances earnings conservatism's previously documented negative cross-sectional association with the beginning-of-year price-to-book ratio (P/B). The basis for the hypothesis is as follows. Given the level of litigiousness at any time, investors are more likely to successfully sue managers and auditors of low-P/B firms to recoup losses in the value of their investments following stock price declines and less likely to sue managers and auditors of high-P/B firms to recoup such losses. To mitigate expected litigation costs stemming from allegations of overvalued earnings and assets, managers and auditors of low-P/B firms tend to use more conservative accounting than do managers and auditors of high-P/B firms. We call the absolute value of earnings conservatism's negative cross sectional association with P/B reactive conservatism, consistent with FASB Statement No. 2's (1980) view of conservatism as . . . a prudent reaction to . . . business situations, . . . because exposure of low-P/B firms to high litigation costs is a business situation that is likely to breed a high degree of conservatism. We hypothesize that reactive conservatism is positively associated with the level of litigiousness over time because greater litigiousness increases companies' expected litigation costs, thereby increasing the likely benefit of applying additional conservatism as P/B decreases. To test the hypothesis, we compare reactive conservatism before and after the 1995 Private Securities Litigation Reform Act. After showing that the Act greatly reduces litigiousness we hypothesize and find that reactive conservatism decreases significantly following the Act. Our results are robust to different measures of low-P/B and different sample construction methods. We also find that reactive conservatism increases and decreases following two later legal developments that increase and decrease litigiousness, respectively. Generally, accruals (not cash flows) drive our results.