Litigation reform, accounting discretion, and the cost of equity

In this paper, we isolate a context - the 1995 Public Securities Litigation Reform Act - where information risk (accruals quality) is likely to change, and investigate whether the increase in accounting discretion associated with litigation reform is viewed by investors as basically opportunistic (i.e., as distorting reported earnings) or as improving the ability of reported earnings to reflect economic value. We measure accounting discretion using both positive (i.e., income-increasing) as well as absolute performance-adjusted abnormal accruals. Our analysis focuses on a constant sample of firms over a 10-year (1992-2001) period, and is structured in two stages. In the first-stage, we utilize an instrumental variable technique that isolates the increase in accounting discretion associated with the 1995 Act. In the second-stage, we relate the predicted increase in accounting discretion associated with litigation reform - obtained from the first-stage regression - to the ex ante equity risk premium for Big N audit clients. Our results suggest that the increase in accounting discretion associated with the 1995 Act was viewed by investors as basically opportunistic. Further, the exogenous nature of the 1995 Act suggests that the observed increase (and pricing) of accounting discretion is related to litigation reform rather than some omitted firm-specific operating characteristic. Overall, our findings suggest that litigation reform affects firm value through managers' exercise of accounting discretion and cost of equity capital channels.