Understanding earnings quality - MIT Sloan School of Management

usefulness of earnings in debt markets relative to equity markets provides an opportunity 1) to
examine accounting choices that are irrelevant to quality characteristics of interest to equity markets,
and 2) to assess trade-offs between multiple incentives for producing high-quality earnings.
6.2 Non-market consequences of earnings quality
The categories of non-market consequences of EQ are: 1) litigation against the firm, 2)
compensation, 3) executive and director turnover, 4) audit opinions, 5) analysts’ forecasts, and 6)
real activities including disclosure decisions and investment/financing activities. A noteworthy
feature of these categories is that many of them are also the “determinants” variables that were
discussed in Section 5, which emphasizes the importance of considering causality when interpreting
the evidence.
6.2.1 Consequences of earnings quality for litigation
Palmrose and Scholz (2004) find that the likelihood of litigation increases with restatements,
and Lev, Ryan, and Wu (2008) find that a restatement that depicts a different pattern of earnings
than was previously reported is associated with a greater likelihood of shareholder litigation. Gong,
Louis, and Sun (2008) and DuCharme, Malatesta, and Sefcik (2004) exploit high-risk settings –
stock-for-stock swaps and IPOs and SEOs, respectively – to examine whether abnormal accruals are
associated with litigation propensity. They find a positive association between abnormal accruals in
the period leading up to the transactions and post-transaction litigation.
Because the restatement studies (Palmrose and Scholz, 2004; Lev et al., 2008) control for the
magnitude of the restatement, they conclude that it is the restatement itself that affects litigation
propensity. They suggest that a restatement is the type of evidence that increases the likelihood that
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