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E-MailRichard Mergenthaler is Associate Professor in Accounting at Penn State Smeal College of Business. This post is based on a recent paper by Mr. Mergenthaler; Musaib Ashraf, Assistant Professor of Accounting and Information Systems at Michigan State University Broad College of Business; Dain Donelson, Professor of Accounting at University of Iowa Tippie College of Business; and John McInnis, Professor of Accounting at the University of Texas at Austin McCombs School of Business.
Managers, investors, auditors, and other stakeholders are concerned about the impact of fair value accounting on firms’ litigation risk (e.g., Pickerd and Piercey 2021; Christensen et al. 2012; Bell and Griffin 2012; Herz et al. 2008; Laux and Leuz 2009). This is particularly salient given U.S. accounting standards (GAAP) have shifted to require more fair value accounting. For example, GAAP requires fair value accounting to assess whether assets are impaired, value nonmonetary transactions, allocate revenue, assess and classify lease liabilities, value derivatives, value assets or liabilities held for sale, and value assets or liabilities whose valuation is highly subjective (e.g., goodwill).
The concern that fair value accounting will lead to heightened litigation risk stems from the fact that fair value accounting requires significant judgments when there are not active markets to determine the fair value of an asset or liability. Furthermore, some are concerned that marking assets and liabilities to market will lead to increased earnings volatility and thereby increased returns volatility. Increased judgment and volatility could affect litigation risk for two reasons. First, managers worry that managerial judgments inherent in fair value measurement can be second-guessed and thereby expose them to ex-post claims that their judgments were opportunistic and misleading. Second, if fair value accounting does lead to increased earnings and return volatility, then the likelihood of large stock price drops could increase–potentially leading to unwanted attention from litigators.
In our paper, we examine whether empirical evidence suggests that fair value accounting increases firms’ litigation risk. Contrary to the above-noted arguments, our paper notes that there are at least two reasons fair value accounting may actually lead to lower litigation risk for firms. First, though judgments can be second-guessed, as noted above, it is difficult to provide specific evidence of scienter because managers’ judgments are inherently subjective. Second, the underlying transactions that require fair value accounting and fair value measurements are often complex. Given this, the argument that the misstatement was simply an error made in good faith is more plausible (Donelson et al., 2012). Ultimately, it is an empirical question whether fair value accounting increases, has no effect, or decreases firms’ litigation risk.
We tackle our research question by performing three main tests. First, we examine whether firms whose assets and liabilities require more fair value measurement have heightened litigation risk. Second, we examine whether material fair value GAAP violations are more likely to result in class action lawsuits than are material GAAP violations that do not require fair value measurement. Third, we examine the incidence of litigation before and after new fair value standards are passed to examine whether litigation risk increases in the area of GAAP that changed to require more fair value accounting. In each of these tests, we do not find evidence that fair value accounting increases firms’ litigation risk. On the contrary, our evidence is more consistent with fair value accounting decreasing litigation risk or at least represents an area of relatively low litigation risk for firms.
Our paper provides the first evidence we know of on fair value accounting and litigation risk. Such evidence can be used to help managers, investors, auditors, and other stakeholders better understand how fair value accounting affects firms’ litigation risk. Further, such evidence adds to the academic literature that explores how attributes of accounting, like accounting conservatism or rules-based attributes of accounting standards, impact firms’ litigation risk (Manchiraju et al., 2021; Donelson et al., 2012).
The complete paper is available for download here.
