We survey commercial bank lenders to better understand how they evaluate and react to variation in financial statement quality and how they view recent changes in accounting standards. A unique aspect of this study is that our respondents focus on medium‐size loans to private companies. In fact, more than 90 percent of the survey respondents primarily make credit decisions on loans between $250 thousand and $50 million. This is in contrast to prior archival research, which focuses primarily on very large loans to public firms or very small loans to private firms. We find that lenders in our sample distinguish among financial statements in terms of quality, including conservatism, primarily on the basis of accrual patterns and restatements. While this general result holds throughout our sample, financial statement quality is substantially more important for lenders making larger loans (over $10 million) as compared to very small loans (under $1 million). In addition, bank lenders are much more likely to respond to low‐quality reporting with collateral and guarantee requirements than with an increase in the interest rate charged. This finding is consistent for lenders making both larger and smaller loans. Finally, despite concerns in the academic literature, bank lenders in our sample actually hold a neutral‐to‐positive view of recent changes in accounting standards. In addition, most do not support current efforts to exempt private companies from some accounting standards.

This study examines how frequently firms restate when they materially misstate their financial statements using stock option backdating as the setting. Stock option backdating provides a unique opportunity to study this issue because it is possible to estimate misstatements with publicly available information to a high level of confidence, and the extensive media coverage of backdating notified boards of directors of the significant risk of misstatement. After identifying firms that materially misstated earnings due to stock option backdating with 95 percent (99 percent) probability, we find that only 11.5 percent (16.1 percent) of these firms subsequently restated. Restating firms are larger, have greater board independence, higher litigation risk and ROA, a lower market‐to‐book ratio, less discretionary accruals, and are more likely to have a CFO that was not involved in backdating. Restating firms are also more likely to disclose other adverse news, face securities litigation, and turn over the CFO than firms that appear to materially backdate but do not restate. Since nearly 9 of 10 firms failed to restate, our results give pause to researchers who use restatements as an indicator of misreporting, and to regulators who levy penalties on those who do self‐report.

We explore how securities litigation affects corporate reputation. Experts remain concerned that nonmeritorious securities class actions—those that will be dismissed or settled for nuisance amounts—cause reputational damage. Although several prior studies show reputational costs for nonmeritorious cases, they generally use indirect measures based on returns or total market losses, which are mechanically associated with securities litigation elements. In contrast, we use a relatively direct reputation measure from Fortune 's “Most Admired Companies” list. We find significant reputational damage after meritorious litigation, with the strongest cases having the largest effects. However, we find no evidence of reputational damage after nonmeritorious litigation. We also find that Fortune 's reputational damage measure is associated with more negative returns around the litigation filing date. We show possible mechanisms for our results, as initial legal filings contain information allowing market participants to assess case merits. Our results imply that reputational damage is primarily due to fraud, which securities litigation helps reveal to the market, rather than litigation itself. Thus, reputational damage is not an issue in over 70% of securities class actions due to the high frequency of nonmeritorious cases.

This study examines the effect of shareholder scrutiny of corporate tax avoidance behavior and its related financial reporting. Specifically, we explore the factors associated with shareholder tax litigation and its effect on the future tax behavior of the sued firm and its peers. We find that sued firms have lower cash and GAAP effective tax rates (ETRs) and engage in extreme tax avoidance before litigation. After litigation, they decrease tax avoidance activities, relative to matched control firms. Peer firms in the same industry as sued firms similarly reduce their level of tax avoidance and the likelihood of extreme tax avoidance after the litigation, relative to control firms. Additional analyses suggest that sued firms change their tax avoidance behavior, rather than merely their tax financial reporting. Finally, the spillover results are strongest for peer firms with the most tax avoidance (i.e., the lowest cash ETRs) when the sued firm's alleged misconduct is revealed.

Does personal litigation risk for independent directors materially affect firm valuation, compensation‐related issues for independent directors, and board composition decisions? We use the unexpected In re Investors Bancorp decision in 2017 by the Delaware Supreme Court, which lowered the liability threshold only for directors in derivative litigation over their own equity grants and increased their future litigation risk, to examine these issues. Understanding changes in independent director litigation risk is important because such changes may affect directors' willingness or ability to serve on boards and advise executives. Consistent with our predictions, investors and firms reacted to the decision. First, Delaware firms experienced significant negative short‐window returns, concentrated in high‐litigation‐risk firms where equity compensation is most important. Second, Delaware firms responded by increasing the use of director compensation caps, highlighting that they did not pay excessive amounts. Third, Delaware firms with higher abnormal director compensation decreased director compensation, while those with lower abnormal director compensation did not. Finally, Delaware firms added higher‐quality directors to the compensation committee, consistent with concerns about heightened litigation risk for those positions. Notably, these new, higher‐quality directors did not accept lower pay, unlike holdover directors who previously served on the committee. Overall, results are consistent with director litigation concerns having a significant effect on shareholder value and firm and director behavior.

A heated debate exists as to whether discontinuities in earnings distributions are indicative of earnings management. While many studies attribute discontinuities in earnings distributions to earnings management, other studies argue that earnings discontinuities are artifacts of sample selection and research design. Overall, there is limited direct evidence of a connection between earnings discontinuities and earnings management. In this study, we provide direct evidence linking earnings management to earnings discontinuities for a sample of firms that settle securities class action lawsuits and restate earnings from the alleged GAAP violation period. We compare the distribution of restated (“unmanaged”) earnings to originally reported (“managed”) earnings. We find that discontinuities are not present in the distribution of analyst forecast errors and earnings changes using unmanaged earnings but are present using managed earnings. The discontinuity in the earnings level distribution is attenuated, but not eliminated, on an unmanaged basis. These shifts among our sample of firms are caused by earnings management and cannot be explained by sample selection or research design issues. Our findings are important because many studies use earnings discontinuities as a proxy for intentional earnings manipulations and we provide the first direct evidence of a link between these two phenomena.

Critics assert that securities class actions are economically burdensome and yield minimal recoveries, whereas proponents claim they deter wrongdoing. We examine key events in the recent Goldman Sachs Supreme Court case to test the net effect of securities litigation risk on shareholder value. We find that investors view securities class actions as value‐increasing. However, the strength of this effect varies based on external monitoring. Investors view securities class actions as more value‐enhancing when institutional ownership is low. We also use this setting to examine the effect of securities litigation risk on mandatory disclosure because the Goldman Sachs case focuses on mandatory disclosure properties. Using a difference‐in‐differences design, we find firm risk factor disclosures become shorter and less similar to industry peers, and they contain more uncertain and weak terms. Overall, our results show nuanced effects of securities litigation risk on shareholder value and firm disclosure.

Prior research indicates that most audit legal disputes settle. There is, however, little evidence of the factors that drive the settlement norm and its exceptions in audit legal disputes. To better understand these factors, we rely on theory related to how professionals manage risks and, as a result, how professions defend jurisdictional claims. We use this theoretical lens to help motivate four research questions that we probe by interviewing 27 prominent attorneys experienced in audit litigation. Consistent with our lens, our interview data indicate that attorneys manage their risks, including the risk of reputational loss, by settling based on their expectations of trial verdicts. Unlike trials, settlements simultaneously enable attorneys on both sides to limit costs and avoid catastrophic jury verdicts and, by doing so, claim “wins” for their clients. Attorneys also stress that they settle many audit disputes without any legal filings. Thus, a large subset of disputes is invisible to the public and researchers. Attorneys characterize trials as exceptions to the settlement norm that emerge due to abnormal conditions sometimes present in disputes. However, trial verdicts in these abnormal conditions help attorneys justify the use of settlements to clients, as attorneys stress that by settling they can avoid the dreaded possibility of extreme unfavorable verdicts. We conclude that as individual attorneys manage their risks, especially the risk of reputational loss, their profession maintains its public image and thereby defends its jurisdictional claims. Among the many questions we pose for future research is whether the settlement norm reduces society's ability to monitor the audit profession and, more generally, whether this norm's benefits outweigh its drawbacks.