Empirical studies on the relationship between shareholder litigation and corporate disclosure obtain mixed results. We develop an economic model to capture the endogeneity between disclosure and litigation. Equilibrium disclosure is determined by two countervailing effects of litigation, a deterrence effect and an insurance effect. We derive four key results. (i) Decreasing litigation risk leads to less disclosure of very bad news, due to a weakening of the deterrence effect, but to more disclosure of weakly bad news, due to a weakening of the insurance effect. (ii) Given a sufficiently large information asymmetry, litigation risk dampens (boosts) overall disclosure of bad news for low (high) litigation risk firms. (iii) Capital markets respond more to the disclosure of bad news than of good news if the deterrence effect is strong, which arises if both insiders’ penalties and litigation risk are high. (iv) In an extension, we highlight real effects of litigation on corporate innovation and establish that innovation first decreases and then increases (strictly decreases) with litigation risk if insiders’ penalties are small (large). We reconcile our findings with results from a large set of U.S.-based empirical studies and make several novel predictions.

We examine whether the design of a firm’s internal management accounting system is associated with GAAP earnings management. We exploit the fact that ASC 280 mandates a “management approach” requiring multisegment firms to disclose their segment earnings as defined internally by their management accounting system. We posit that the less these segment earnings are decoupled from GAAP earnings, the higher are the costs of earnings management because earnings management spills over to segment earnings and distorts information used for internal decision-making. Thus, we predict that firms with more decoupled segment earnings engage in more earnings management. Using a large sample of U.S. firms from 1998 to 2020, we find support for this prediction. We also find that the decision usefulness of segment earnings for segment investment purposes decreases as earnings management increases, with this association being more pronounced for firms with less decoupled segment earnings measures. Data Availability: Data are available from the public sources cited in the text.