Companies that use prudent accounting principles less likely to be sued, study finds

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LAWRENCE – Companies that use accounting practices that essentially require more checks for good news than bad news can more easily avoid securities class actions and improve litigation outcomes, according to study that includes accounting researcher from the University of Kansas.

“Previous research has suggested that the risk of litigation leads to more accounting conservatism. There has been little empirical evidence on if and how this works,” said Michael Ettredge, Crown / Sherr professor of commerce at KU.

Accounting conservatism refers to the practice of requiring more audits to recognize positive news from a business as gains than to recognize bad news as losses. In recent decades, following corporate accounting scandals, the number of accounting class actions has increased, which has imposed billions of dollars in direct and indirect costs on public companies and their shareholders.

The researchers’ conclusions were published recently in Accounting Horizons and featured in Columbia Law School’s Blog on business and capital markets. Its co-authors are Ying (Julie) Huang, KU graduate, associate professor in the Department of Accounting at the University of Louisville College of Business, and Weining Zhang, associate professor of accounting at the Cheung Kong Graduate School of Business in Beijing. .

In accounting class actions, plaintiffs often claim that managers intentionally or recklessly overestimate profits. Subsequent disclosure of incorrect accounting may cause stock prices to fall, which could adversely affect the investments of requesting shareholders.

Pursuing a class action lawsuit against publicly funded companies is risky for plaintiffs and their lawyers, and the costs are high with uncertain results. Accountants who use prudent financial reporting may reduce the expected value of plaintiff lawsuits because they avoid or reduce potentially overstated profits and declines in stock prices.

Recognizing losses more easily than financial gains can lead to a systematic underestimation of profits and net assets in audited financial statements. As a general rule, courts are more likely to find that shareholders’ injury occurred when profits and net assets were overestimated rather than underestimated.

“More cautious reporting can also reduce the value of litigation by lowering the likelihood that plaintiff shareholders can prove that they have suffered financial harm as a result of the decline in stock prices,” Ettredge said. “Timely recognition of bad news through accounting conservatism reduces the likelihood of temporarily overvalued stocks and subsequent sharp drops in stock prices. “

The researchers tested a sample of 363 shareholder lawsuits alleging violations filed from 1996 to 2011 and resolved in mid-2014.

Their main finding was that companies in the top percentile of the middle conservatism rankings face a 30% lower probability of prosecution than those in the bottom percentile.

The stock market reacts less negatively to the filing of lawsuits against prudently accounting companies.

They found that courts are 31% more likely to dismiss lawsuits against the most conservative accounting defendants compared to companies in the bottom percentile. And for judgments, companies in the top percentile pay an average penalty amount of $ 145 million lower than companies in the bottom percentile. In addition, the researchers found that cases are resolved faster for more conservative companies, in about a year.

“Our results suggest substantial economic benefits to conditionally conservative accounting policies,” Ettredge said.

Photo via Pexels.com.


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