| This thesis examines the relation between earnings management and class action securities litigation. Using a database that covers virtually all class action securities lawsuits filed in federal courts from 1988 to 2000, the study finds strong evidence of earnings management by firms sued by shareholders for securities fraud. Further, earnings management is found to have significant explanatory power for investors' loss of wealth upon corrective disclosure, as well as incidence of accounting-related allegations and lawsuit settlement amounts. Finally, employing a matched sample of sued and non-sued firms, the study examines the joint determination of firms' litigation risk and earnings management behavior. The analysis using a simultaneous-equations approach suggests that controlling for other factors, (1) securities litigation risk acts as an incentive for, rather than a deterrence against firms' earnings management using positive accruals; (2) firms' income-increasing earnings management does not increase the probability of getting sued by shareholders for securities fraud.; This study makes several contributions to the literature of earnings management in general, and revenue and accruals management in the securities litigation setting in particular. First, the thesis improves the methodology of measuring earnings management, by developing an alternative model of discretionary accruals using an instrumental variable approach. Conceptually, this model overcomes the errors-in-variable problem present in widely-used accruals expectation models. Empirically, this model represents an improvement over existing models in terms of both specification and power in earnings management tests. The model also provides a measure of revenue management. Second, by documenting strong evidence of earnings management by a large sample of defendant firms, and a significant relation between earnings management and (1) shareholder damage, (2) existence of accounting allegations, and (3) lawsuit settlement amounts, this study has important implications for assessing merits of private securities litigation. Finally, the research is the first academic study to examine the joint determination of firms' earnings management behavior and securities litigation risk. The finding adds to the literature about incentives for earnings management as well as the literature about the disciplinary role of private securities litigation on accounting frauds. |
