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Litigation and Accounting; Studying the Impact of Law on Accounting Firms

Dain DonelsonMy research primarily focuses on the connection of accounting and law. My recent work includes “Discontinuities and earnings management: Evidence from restatements related to securities litigation,” published in Contemporary Accounting Research in 2013. In this study, we provide new evidence on a long-debated issue in the accounting literature: the relation between unusual patterns (discontinuities) in reported earnings of firms and earnings management. We use accounting restatements and the legal standards applicable to securities class action cases to identify a sample of firms with measurable earnings management. We find that the unusual patterns around earnings benchmarks are present only when earnings are managed (measured by the combination of a restatement and a settled securities class action suit).

“The potential for catastrophic auditor litigation,” published in American Law and Economics Review in 2013, examines claims by the major (Big Four) accounting firms that they are subject to litigation that could force them out of business. This study finds a relatively low likelihood of catastrophic litigation by using more comprehensive data than had previously been examined. Thus, legal reform does not appear to be a pressing issue based solely on the risk of catastrophic litigation.

In “Scienter pleading and rule 10b-5: Empirical analysis and behavioral implications,” published in Case Western Law Review in 2013, we examine empirically the outcomes of cases based on the factors cited by courts in making decisions. We find little consistency in case outcomes based on either the discussions of courts or empirical analysis of those opinions, and conclude that current standards applied by courts provide little guidance for potential litigants.

In “Litigation risk and agency costs: Evidence from Nevada corporate,” forthcoming in Journal of Law and Economics in 2014, we utilize an exogenous shock to test the relation between litigation risk and agency costs. The shock is based on a legislative change that greatly reduced director and officer liability for Nevada corporations. We find decreased firm value, especially for firms with the highest expected agency costs. We also find that managerial incentives are reduced as reflected by lower CEO pay-for-performance sensitivity. Finally, we find an adverse impact on operating performance and increased error-based restatements for Nevada firms subsequent to the change. These findings emphasize the importance of state corporate law and demonstrate that officer and director litigation risk appears to be an effective mechanism in constraining agency costs.