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The Effect of Litigation Risk on Management Earnings Forecasts

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  • Zhiyan Cao
  • Ganapathi Narayanamoorthy
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    Abstract

    We examine the effect of litigation risk on managers' decision to issue earnings forecasts. We use a new ex ante measure of litigation risk, namely, the Directors and Officers liability insurance premium. This choice bypasses significant problems associated with the estimation of ex ante litigation risk in prior studies. By using this measure of litigation risk, our results are more intuitively appealing. We find that when faced with ex ante litigation risk, managers with bad news are more likely to issue an earnings warning. For good news firms, we do not see this effect. We also examine three forecast characteristics: forecast horizon, extent of news revealed and forecast precision. Firms with higher litigation risk tend to issue earnings forecasts earlier if they have bad news but not so when they have good news. They also reveal less news in the forecasts if they have good news. As litigation risk increases, bad news earnings forecasts become more precise. Good news earnings forecasts, however, tend to become less precise relative to bad news forecasts. This differential effect of litigation risk on management earnings forecasts, based on the direction of news, has not been documented by previous studies.

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    Bibliographic Info

    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2379.

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    Date of creation: 01 Nov 2005
    Date of revision: 01 Feb 2009
    Handle: RePEc:ysm:somwrk:amz2379

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    Web page: http://icf.som.yale.edu/
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    Related research

    Keywords: litigation risk; voluntary disclosure; management earnings forecasts; directors and officers insurance;

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    1. Harrison Hong & Terence Lim & Jeremy C. Stein, 2000. "Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies," Journal of Finance, American Finance Association, vol. 55(1), pages 265-295, 02.
    2. Field, Laura & Lowry, Michelle & Shu, Susan, 2005. "Does disclosure deter or trigger litigation?," Journal of Accounting and Economics, Elsevier, vol. 39(3), pages 487-507, September.
    3. Hughes, J.S.John S. & Pae, Suil, 2004. "Voluntary disclosure of precision information," Journal of Accounting and Economics, Elsevier, vol. 37(2), pages 261-289, June.
    4. Verrecchia, Robert E., 1983. "Discretionary disclosure," Journal of Accounting and Economics, Elsevier, vol. 5(1), pages 179-194, April.
    5. Sanjai Bhagat & John Bizjak & Jeffrey L. Coles, 1998. "The Shareholder Wealth Implications of Corporate Lawsuits," Financial Management, Financial Management Association, vol. 27(4), Winter.
    6. Core, John E, 2000. "The Directors' and Officers' Insurance Premium: An Outside Assessment of the Quality of Corporate Governance," Journal of Law, Economics and Organization, Oxford University Press, vol. 16(2), pages 449-77, October.
    7. Amy P. Hutton & Gregory S. Miller & Douglas J. Skinner, 2003. "The Role of Supplementary Statements with Management Earnings Forecasts," Journal of Accounting Research, Wiley Blackwell, vol. 41(5), pages 867-890, December.
    8. Zhiyan Cao & Ganapathi Narayanamoorthy, 2005. "Accounting and Litigation Risk," Yale School of Management Working Papers amz2514, Yale School of Management, revised 01 Jul 2006.
    9. Skinner, Douglas J., 1997. "Earnings disclosures and stockholder lawsuits," Journal of Accounting and Economics, Elsevier, vol. 23(3), pages 249-282, November.
    10. Nagar, Venky & Nanda, Dhananjay & Wysocki, Peter, 2003. "Discretionary disclosure and stock-based incentives," Journal of Accounting and Economics, Elsevier, vol. 34(1-3), pages 283-309, January.
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