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25 November 2025

Does Litigation Risk Affect Meeting-or-Beating Earnings Expectations? Evidence from Quasi-Natural Experiment

and
1
Accounting and Finance Department, Oakland University, 275 Varner Dr, Rochester, MI 48309, USA
2
Department of Marketing, Quantitative Analysis and Supply Chain Logistics, Mississippi State University, 75 B. S. Hood Rd, Mississippi State, MS 39762, USA
*
Author to whom correspondence should be addressed.
J. Risk Financial Manag.2025, 18(12), 669;https://doi.org/10.3390/jrfm18120669
This article belongs to the Special Issue Financial Reporting Quality and Capital Markets Efficiency
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Abstract

This paper examines the impact of litigation risk on meeting-or-beating earnings expectations (MBE). Whether and how litigation risk affects MBE is largely inconclusive due to potential reverse causality and measurement error. To find a causal effect, this study employs differences-in-differences tests based on the unanticipated legal event that decreased litigation risk for firms headquartered in the U.S. Ninth Circuit states. The result indicates that Ninth Circuit firms are more likely to meet or beat their earnings target after the ruling, suggesting that litigation risk negatively affects the likelihood of MBE. Further analyses show that investors’ reactions are less positive to MBE premium for firms with a decrease in litigation risk. Taken together, this study contributes to the literature by documenting that litigation risk is a significant factor influencing managers’ benchmark beating behavior.

1. Introduction

Securities class action lawsuits in the U.S. offer a mechanism by which owners (i.e., shareholders) can sue firms or managers in the event of managerial misconduct. The underlying premise of litigation risk is that substantial financial and reputational penalties associated with litigation can discipline managers and deter them from future wrongdoing (e.g., ; ; ). Prior studies also document that litigations brought by shareholders play a crucial role in resolving the conflicts of interest between managers and shareholders (e.g., ). By posing a credible legal threat to managers, shareholders can efficiently discipline them. Also, shareholders require reliable and timely disclosures to monitor managers (). In this paper, I utilize unanticipated legal changes that affect shareholders’ ability to file class action lawsuits and investigate the effect of a firm’s litigation risk on managerial reporting strategies regarding mandatory disclosure (i.e., reported earnings around bright-line targets). Specifically, this study examines the effect of litigation risk on meeting-or-beating earnings expectations (hereafter “MBE”).
MBE is an important reporting outcome for firms and managers, and the incentives or benefits of MBE are well documented in prior studies (e.g., ; ). Further, prior studies document a discontinuity around earnings benchmarks (e.g., ; ) and interpret the results as evidence that managers manage earnings to meet or beat their benchmarks. In addition, according to survey evidence presented by (), approximately 70% of chief financial officers (CFOs) believe that firms should take actions (i.e., manage earnings) to report desirable earnings even though such earnings management may sacrifice some economic value, but not too large, of their firms. Prior studies also find that firms enjoy financial benefits of MBE by managing earnings expectations downward and that firms tend to warn investors on news about upcoming negative earnings (; ; ).
Despite the importance of MBE and shareholder lawsuits, whether and how litigation risk affects MBE is largely inconclusive due to potential reverse causality and measurement error. Specifically, while litigation risk can directly affect firms’ financial policies and outcomes, including MBE, it is also possible that MBE changes the level of litigation risk. For example, () find that litigation risk influences firms’ voluntary disclosures, whereas () show that missing earnings benchmarks, which are accompanied by sudden stock price declines, trigger shareholder class action filings.1 In addition, empirically constructing a firm-level litigation risk measure is challenging because such a measure is based on certain industries and firm characteristics that might be determined endogenously. Accordingly, this study exploits a quasi-natural legal event that generates a plausibly exogenous shock to corporate litigation risk to establish a causal effect of litigation risk on MBE.
On 2 July 1999, the U.S. Ninth Circuit Court of Appeals released an unexpected ruling (re: Silicon Graphics Inc. Securities Litigation). This ruling, which applied only to firms in the Ninth Circuit states, required plaintiffs to prove that defendants were “deliberately reckless” in making the alleged misstatement or omitting material information in the disclosures.2 In contrast, proving “mere recklessness” was sufficient for firms located in other states. The requirement from the 1999 ruling significantly increased hurdles for shareholders filing class action lawsuits against firms located in Ninth Circuit states and therefore decreased litigation risk of such firms (). Since the ruling only affects the litigation risk of a subset of U.S. firms (i.e., the Ninth Circuit firms), this study can control for other concurrent factors and time trends to mitigate the omitted variable bias by using this legal event.3 There are two competing hypotheses in relating litigation risk to MBE.
On one hand, the risk of securities litigation increases managers’ motivation/incentive to MBE (motivation-based hypothesis). A sudden stock price drop can be deemed as omission of negative information (the “fraud on the market” theory), and missing earnings expectations (i.e., a failure in MBE) likely triggers securities lawsuits (e.g., ; ). According to the “fraud on the market theory”, a large one-time stock price decline is more likely to precipitate the filing of securities class action lawsuits because it can be argued as evidence of omission of negative information, given that the stock market is informationally efficient (). In this context, subsequent to the lowered litigation risk by the 1999 ruling, managers in the Ninth Circuit firms face less pressure to MBE to avoid a stock price drop. Following this logic, litigation risk may positively affect the propensity to MBE.4
On the other hand, a threat of litigation may increase the costs of MBE borne by managers (cost-based hypothesis). Litigation risk, as a governance mechanism, is likely to deter managers facing severe capital market pressure from opportunistically managing earnings because of potential securities lawsuits regarding misstatement or omitting material information from earnings management (). In this setting, a decline in litigation risk for firms located in Ninth Circuit states after the 1999 ruling increases the degree of earnings management for MBE purposes (; ). Following this story, litigation risk may negatively affect MBE under the cost-based hypothesis.
Using a sample of firm-quarters over the period 1995–2003, this study finds that Ninth Circuit firms are more likely to meet or just-beat earnings expectations relative to other firms after the 1999 ruling, supporting the cost-based story that litigation risk decreases the propensity of MBE.5 The effect of litigation risk on MBE is incrementally significant after controlling for various firm aspects. To test a robustness of the results, the study also considers intervals of MBE (e.g., MBE by 2 and 5 cents versus missing by 2 and 5 cents, respectively) to examine the effect of litigation risk on narrow beaters versus narrow missers in which opportunistic incentives for earnings management are better captured in discontinuity around earnings benchmarks (e.g., ).6 Further analyses show that firms facing a decrease in litigation risk are more likely to report small positive earnings surprises (just-MBE) than small negative surprises (just missing benchmark).
Next, the study investigates how managers opportunistically employ earnings management tools when they face MBE incentives and/or costs associated with different levels of litigation risk. This study examines two commonly used earnings management channels, i.e., accrual-based earnings management (hereafter “AEM”) and real activity-based earnings management (hereafter “REM”). The results show that after the 1999 ruling, Ninth Circuit firms, compared to other firms, are more likely to MBE but miss the benchmark without considering discretionary accruals, suggesting that the MBE is achieved through AEM. However, the analyses do not provide similar results when the earnings management tool is REM.7
Furthermore, the study compares the stock market reaction to earnings announcements between the Ninth Circuit firms and other firms subsequent to the ruling. The results show that the three-day market reaction to MBE is less positive (i.e., smaller MBE premium) for firms located in Ninth Circuit states after the ruling. Taken together, the results imply that investors discount the reward MBE achieved when the litigation risk is unexpectedly reduced.
Finally, prior studies find that firms enjoy financial benefits of MBE by managing earnings expectations downward and warning investors about upcoming negative earnings news (; ). Managers can engage not only in AEM and REM, but also in expectation management (hereafter “EXM”) to meet or beat earnings benchmarks. The additional test results show that Ninth Circuit firms reduce their engagement in EXM as a channel for MBE after the ruling, suggesting that firms are less likely to rely on EXM as AEM becomes less costly and can be sufficient to meet or beat earnings benchmarks.
This paper makes contributions to the literature. First, this study contributes to the literature on MBE by identifying firms’ litigation risk as an important determinant of firms’ MBE. While prior studies on MBE consider litigation risk as one of the factors when examining the association between their variable of interests and MBE (; ; ; ; ), the reported association between MBE and litigation risk has largely been inconclusive. By using a quasi-natural experiment setting, this study extends the literature by documenting that the propensity of MBE increases as the threat of litigation dissipates. This paper has the potential to add insight into corporate governance literature because it documents that an important dimension of external corporate governance—the risk associated with shareholder class action lawsuits—influences firms’ reporting outcomes.
In addition, this study has implications for the literature on the role of litigation risk in different types of earnings management. Managers trade off the costs and benefits of AEM and REM (e.g., ; ; ; ; ). Relatedly, () and () show that litigation risk deters managers from AEM and REM, respectively, by using the same legal event adopted in this paper.8 While these studies are related to my earnings management analysis, this paper extends these studies by jointly focusing on both AEM and REM as a tool for MBE.9 The results of this study imply that investors and regulators need to scrutinize the possibilities of opportunistic earnings management as litigation risk changes.
The remainder of this paper proceeds as follows: Section 2 reviews the related literature and the legal background of the securities litigation regulation and develops my hypothesis. Section 3 describes data sources and outlines my research design. Section 4 and Section 5 describe empirical results and additional tests, and Section 6 concludes.

2. Background and Hypothesis Development

2.1. Legal Background of the Ninth Circuit Court Ruling

The Private Securities Litigation Reform Act of 1995 is crucial to the reform of federal securities laws governing securities class actions. When firms or managers breach their fiduciary duties, shareholder lawsuits play a role as a potential governance force (e.g., ; ). However, individual shareholders might not properly utilize such a tool to protect the interests of all the shareholders. Before the 1995 Reform Act, shareholders could file a lawsuit against firms or managers with minimal evidence of fraud, including a large stock price drop based on the “fraud on the market” theory. Thus, some shareholders filed a lawsuit with dubious merit to target firms with “deep-pocket” (), imposing huge burdens on firms. Such problems caused the birth of the 1995 Reform Act introduced several hurdles to plaintiffs. The 1995 Reform Act required shareholders to provide facts that give rise to a strong inference of fraudulent intent of the defendants.
However, interpretations of the pleading standards are independent from U.S. circuit courts (; ). Among various interpretations, the interpretation in 1999 by the Ninth Circuit Court of Appeals in the case of Silicon Graphics Inc. was the most surprising and stringent. On 2 July 1999, the Ninth Circuit Court ruling required plaintiffs to plead strong facts inferring that the defendants were “deliberately reckless” when they made the alleged misstatement or omitted material information in the statement. In other words, for firms headquartered in the Ninth Circuit, shareholders are not legally allowed to form a class without presenting evidence that managers behaved with deliberate, conscious recklessness. The 1999 ruling affected all class action lawsuits subsequently filed with the Ninth Circuit Court. In contrast, for firms located in other states, proving mere recklessness was sufficient to form a lawsuit. Such a change was important because evidence of a manager’s intention often only comes in the process of discovery, and the discovery process occurs after the class has been formed. Thus, shareholders of the Ninth Circuit firms must possess the evidence before they form a class.
Following the 1999 ruling, the number of securities class actions declined by more than 50 percent in the Ninth Circuit Court relative to the other circuit courts (). Put differently, firms in the Ninth Circuit states could expect a lower probability of shareholder lawsuits after the 1999 ruling. The 1999 ruling was not anticipated, and many U.S. circuit courts faced challenges in interpreting the 1995 pleading standard (Pub. L. No. 104-67; Private Securities Litigation Reform Act in 1995). Hence, the Ninth Circuit Court ruling in 1999 is a valid legal event to examine the impact of a decrease in litigation risk on MBE.

2.2. Related Literature and Hypothesis Development

The incentives or benefits of MBE are well documented in the literature. () document that MBE firms enjoy higher abnormal returns than firms missing benchmarks and that market premium for MBE is incremental to future expectation. The MBE premium is also incremental to the overall earnings surprise (). () survey 312 executives in public firms and show that MBE helps managers to “build credibility with the capital market” and “maintain or increase stock price”. Also, missing expectations by even a small amount can result in a large stock price reduction (). Given these benefits and costs, prior empirical evidence suggests that managers manage earnings to meet or beat various benchmarks (e.g., ; ). These studies investigate patterns of reported earnings around various earnings targets and document that management tries to avoid disclosing losses, a decrease in earnings from the previous year, and missing the analyst earnings forecasts.
Furthermore, other studies have examined various factors that constrain earnings management with a primary focus on corporate governance (e.g., ; ; ; ). Among them, a threat of litigation also plays a role as a governance mechanism through shareholder monitoring (e.g., ), and therefore threat of litigation affects both firms’ MBE behavior and their tools to achieve MBE (i.e., earnings management). However, the empirical evidence is mixed in prior studies. () finds that potential litigation cost motivates managers to manage discretionary accruals to increase reported earnings to meet their forecasts. () document a significantly positive impact of litigation risk on income-decreasing accruals choices (but no impact on income-increasing accruals), whereas () and () document a significantly positive impact of litigation risk on MBE. () and () indicate no significant impact of litigation risk on MBE. Overall, prior studies do not show consistent results on the association or causal relationship between litigation risk and MBE.
This study examines two competing hypotheses regarding the effect of litigation risk on MBE. The motivation-based hypothesis explains the notion that litigation risk directly increases the motivation of MBE, suggesting that litigation risk positively affects MBE. Stock price decline can be evidence of misstatement or omission of negative material information and increase the probability of future lawsuits (e.g., ; ; ). When firms miss their benchmarks (i.e., failing MBE), stock price reductions and shareholder lawsuits are more likely to occur. Thus, as managers try to mitigate litigation threats from missing earnings expectations, litigation risk increases managers’ MBE incentives. Following this logic, for Ninth Circuit firms after the 1999 ruling, a decrease in litigation risk reduces the potential shareholder litigation from failing MBE, expecting a reduction in the motivation of MBE. Therefore, litigation risk positively affects MBE under the motivation-based hypothesis.
However, the cost-based hypothesis explains the indirect channel that litigation risk increases the cost of MBE, suggesting that litigation risk negatively affects MBE. Previous studies document that managers manage earnings upward to meet or just-beat their earnings benchmarks, especially when pre-managed earnings miss the benchmarks by a small amount (e.g., ; ; ; ). Litigation risk is one of the powerful governance mechanisms to decrease managers’ engagement in earnings management because of potential lawsuits from misstatement or omission of material information in firms’ disclosures. Hence, litigation risk decreases the use of earnings management to meet or beat earnings expectations, and the threat of lawsuits from engaging in earnings management can be a cost of MBE. Following the same reasoning, for firms in Ninth Circuit states after the ruling, a decline in litigation risk increases the degree of earnings management for MBE (i.e., increases the propensity of MBE). Therefore, litigation risk negatively affects MBE under the cost-based story.
As the motivation-based (cost-based) story predicts the positive (negative) causal relationship between litigation risk and MBE, this study’s hypothesis proceeds as follows in null form:
Hypothesis 1.
Litigation risk does not affect benchmark-beating behavior.

3. Research Design and Methods

3.1. Sample

The study starts the sample selection process by obtaining data on all public U.S. firms from the Compustat-CRSP-I/B/E/S universe with information on historical locations of firms’ headquarters over the sample period (1995–2003).10 Empirical test compares the post-ruling period, 18 quarters after the ruling (from the third quarter, 1999 to the fourth quarter, 2003), with the pre-ruling period, 18 quarters before the ruling (from the first quarter, 1995 to the second quarter, 1999). I obtain firms’ financial information from the Compustat quarterly file, stock price and return information from the CRSP daily file, and analysts’ forecasts and firms’ actual earnings information from the I/B/E/S unadjusted file, respectively.
The sample excludes firms in financial (i.e., sic 6000–6999) and utilities (i.e., sic 4900–4949) industries and firms with stock prices less than $1.11 Also, the study requires the data availability of Compustat, CRSP, and I/B/E/S, which are necessary to calculate control variables. The final sample consists of 20,525 firm-quarter observations. All continuous variables are winsorized at the 1st and 99th percentiles.12

3.2. Empirical Model

The study investigates whether a decrease in litigation risk affects managers’ opportunistic incentives for MBE. It classifies firms as a treated group (i.e., Ninth Circuit firms) if firms’ headquarters are in one of the states controlled by the Ninth Circuit Court, and the remaining firms are considered a control group. The research design employs a differences-in-differences design to compare the changes in the propensity of MBE after the 1999 ruling for Ninth Circuit firms with the corresponding changes for other firms. Specifically, the study estimates the following regression model:
MBEi,t = δ1 Nine × Posti,t + δ2 Controlsi,t + δ year-quarter + δ firm + ε i,t
The indicator variable, Nine, equals one if the firm’s headquarters are in one of the Ninth Circuit states and zero otherwise. The indicator variable, Post, takes the value of one from the third quarter of 1999 to the fourth quarter of 2003 and zero from the first quarter of 1995 to the second quarter of 1999. The main variable of interest is the interaction term, Nine × Post. The dependent variable, MBE, is an indicator variable that takes the value of one if actual earnings per share are equal to or larger than the median value of analyst EPS forecasts, and zero if actual earnings are lower than the median value of analyst EPS forecasts. This study also defines just-MBE (JMBE), using narrower intervals surrounding earnings forecasts by ±2 cents and ±5 cents.13 The regression model includes firm and year-quarter fixed effects and excludes Nine and Post in the model because these two variables are absorbed in the firm and year-quarter fixed effects, respectively. Standard errors are clustered by the state of location, and Fama-French 48 industry classifications are used. The motivation-based (cost-based) story expects δ1 to be negative (positive).
The regression model considers several control variables that are expected to be associated with MBE. The model includes the firm’s size (Size) as prior research suggests that larger firms have less optimistic biases in analysts’ forecasts, which makes firms meet or beat analyst forecasts easily (e.g., ). The model also includes leverage (Leverage) to proxy for the firm’s closeness to debt default, which might serve as an incentive or a constraint to meet or beat benchmarks (). () shows that institutional ownership (IO) and implicit claims with stakeholders (R&D and Labor) motivate managers to MBE.14 Firm growth may affect investors’ reaction to earnings information (; ), and it is difficult for managers to manage earnings when there are large numbers of stocks because a larger amount of earnings should be managed per one cent of EPS (). Therefore, the book-to-market ratio (BM), sales growth (Sales Growth), and the number of shares outstanding (#Shares) are included. The number of analysts following (Coverage), the variation in analysts’ earnings forecasts (Dispersion), and earnings volatility (Vol_ROA) are included to control for difficulties in the forecasting environment (). Management earnings forecasts (MF) impact analyst forecasts, which may serve as an incentive or a constraint to meet earnings expectations (). Also, the model includes the fourth quarter dummy as a control variable because the fourth quarter might affect MBE and/or earnings management. Moreover, the firm’s profitability (ROA) and loss indicators (Loss) are included because MBE increases with firms’ performance (). Finally, the indicator variable for Regulation FD (RegFD) is included since management earnings forecasts may not capture the effect of Regulation FD.

4. Empirical Results

4.1. Descriptive Statistics and Univariate Analysis

Table 1 reports the summary statistics for the main and control variables used in empirical analyses. The full sample has 20,525 observations, and 39% of the sample are firm-quarters in Ninth Circuit states. About 74% of firm-quarters in the sample meet or beat the median value of analyst earnings forecasts. The sample of MBE firms with AEM and REM has 10,492 and 12,000 observations, respectively.
Table 1. Summary statistics.
Table 2 presents the univariate results of differences-in-differences tests and provides preliminary insights into the changes in MBE for Ninth Circuit firms after the 1999 ruling. The table reports the propensity of MBE for firms located in Ninth Circuit states and for those in other states, as well as the changes in MBE separately for pre- and post-1999 rulings. Subsamples based on narrower intervals of JMBE surrounding earnings forecasts by ±2 cents and ±5 cents have 11,051 and 15,791 observations, respectively. The decreases in subsamples’ observations are due to the narrow intervals of MBE (i.e., ±2 cents (±5 cents). The sample excludes firm-quarter observations of firms that beat or miss the target by more than 2 cents (5 cents). The results show that Ninth Circuit firms exhibit increases in MBE subsequent to the 1999 ruling. Such increases are statistically significant (p < 0.01). The table also reports the results of the main differences-in-differences tests, which compare the changes in MBE for Ninth Circuit firms relative to those for non-Ninth-Circuit firms between pre- and post-1999 ruling. The propensity to MBE significantly increases (p < 0.01) with all intervals. Taken together, the univariate tests show preliminary evidence consistent with a decrease in litigation risk causing a significant increase in MBE, supporting the cost-based hypothesis.
Table 2. Univariate tests.

4.2. Multivariate Analysis

4.2.1. Meeting-or-Beating Earnings Expectations (MBE)

Table 3 provides the logistic regression results of the changes in just-MBE for Ninth Circuit firms after the ruling (i.e., estimating Equation (1)). All coefficients on the interaction term, Nine × Post, are positive and significant for all three specifications (p < 0.01). The results indicate that the odds of MBE versus missing expectations for Ninth Circuit firms after the ruling are 49% higher than the odds for other firms based on the coefficient on MBE in column (1). The results suggest statistically significant increases in just-MBE and MBE, in general, following the 1999 ruling for firms located in Ninth Circuit states relative to those in other states, supporting the cost-based hypothesis that litigation risk reduces the propensity of MBE by increasing the cost of MBE.15 In other words, firms facing a decrease in litigation risk are more likely to report small positive earnings surprises than small negative surprises, suggesting that a decrease in litigation risk gives managers an edge in MBE at the margin.16
Table 3. The changes in meeting-or-beating earnings expectation (MBE).

4.2.2. Alternative Earnings Benchmarks

The study examines the role of litigation risk in MBE by using analyst earnings forecasts as a proxy for earnings expectations. Even though analysts provide benchmarks widely used to evaluate earnings, prior studies also suggest that other earnings benchmarks, such as earnings for the same quarter of the prior year and zero earnings, may be important to firms (; ). Therefore, as a sensitivity check, this study investigates whether managers of firms facing a decrease in litigation risk are more likely to meet or beat alternative earnings benchmarks. I reestimate Equation (1) but redefine the MBE indicator based on an alternative earnings benchmark. MBE_SRW takes the value of one if EPS is equal to or larger than EPS for the same quarter of the prior year, and zero if EPS is smaller than EPS for the same quarter of the prior year.
Table 4 reports the results. The coefficients on the interaction term, Nine × Post, are positive and significant (except for column (2)), suggesting that firms in Ninth Circuit states are more likely to meet or beat earnings expectations based on earnings for the same quarter of the previous year after the ruling. The results indicate that the odds of MBE versus missing expectations for Ninth Circuit firms after the ruling are 72% higher than the odds for other firms based on the coefficient on MBE_SRW in column (1). The result provides further evidence that the main results for the propensity of MBE are not primarily driven by the choices of earnings benchmark or analyst and manager interaction. Firms facing a decrease in litigation risk may focus their attention on meeting-or-beating not only analyst expectations but also alternative benchmarks (i.e., earnings for the same quarter of the prior year).17
Table 4. The changes in meeting-or-beating earnings expectation (MBE)—alternative benchmark.

5. Additional Analysis

5.1. Opportunistic Earning Management for Meeting-or-Beating Earnings Expectation (MBE)

To further investigate the method to achieve MBE, this study turns to the impact of litigation risk on two earnings management methods, AEM and REM. While the motivation hypothesis does not directly explain the relationship between litigation risk and earnings management, the cost-based hypothesis predicts that a threat of litigation decreases earnings management. Therefore, the study expects that Ninth Circuit firms are more likely to achieve MBE through managing earnings (AEM and REM) after the ruling relative to other firms, which is consistent with prior studies (; ).
To test the impact of litigation risk on opportunistic AEM and REM as a method for MBE, the study estimates the following logistic regressions:
OppMBE_AEMi,t = ϕ1 Nine × Posti,t + ϕ2 Controlsi,t + ϕ year-quarter + ϕ firm + ε i,t
OppMBE_REMi,t = τ1 Nine × Posti,t + τ2 Controlsi,t + τ year-quarter + τ firm + ε i,t
The dependent variable, OppMBE_AEM, takes the value of one if the firm meets or beats analyst forecasts, but would have missed expectations if abnormal discretionary accruals were removed from reported earnings, and zero otherwise. This study follows the modified Jones model () to estimate abnormal discretionary accruals. OppMBE_AEM is a proxy for suspicious firms that opportunistically engage in AEM to meet or beat earnings expectations. Similarly, OppMBE_REM is a proxy for suspicious firms that opportunistically engage in REM to meet or beat earnings expectations. Specifically, OppMBE_REM takes the value of one if the firm meets or beats analyst forecasts, but would have missed expectations if abnormal cuts of discretionary expenses were removed from reported earnings, and zero otherwise. The study closely follows () to estimate discretionary expenses.18 All control variables in Equation (1) are included as well.
Table 5 shows the logistic regression results of the changes in opportunistic AEM and REM for firms located in Ninth Circuit states after the ruling relative to firms in other states. The table presents the measures of opportunistic accrual and real earnings management, OppMBE_AEM and OppMBE_REM, in columns (1) and (2), respectively. The coefficient on the variable of interest, Nine × Post, is positive and significant in column (1) (p < 0.05), suggesting that the probability of meeting-or-beating analyst forecasts but would have missed the forecasts without accrual earnings management, increases as litigation risk reduces. In other words, firms are more likely to manage accruals as a tool for MBE after litigation risk decreases. The coefficient on the interaction term Nine × Post is not significant in column (2), suggesting that, as litigation risk decreases, firms are not likely to engage more in REM as a tool for MBE.19
Table 5. The changes in opportunistic accrual and real earnings management.

5.2. Market Reaction to Meeting-or-Beating Earnings Expectation (MBE)

A large body of literature documents that the incentive to meet or beat expectations is associated with equity market benefits (e.g., ; ). MBE increases contemporaneous stock returns, and a string of positive earnings surprises also increases the valuation premium for such firms (; ). Prior research has also examined the equity market reaction to firms’ use of earnings management. When earnings may have been increased through earnings management, investors discount premiums paid for MBE accordingly (e.g., ). Under a motivation-based (cost-based) story, as litigation risk decreases, firms are less (more) likely to manage earnings to achieve MBE. However, managing accruals or cutting discretionary expenses as a tool for MBE induces transitory components to reported earnings, causing an increase in the likelihood that future earnings and/or performance will reverse. Therefore, if equity investors rationally expect the lower (higher) likelihood of earnings management, at least partially, for firms with a decrease in litigation risk, then they will increase (discount) the MBE premium for such firms.
To investigate the changes in MBE premium (i.e., investors’ reaction) for Ninth Circuit firms after the ruling, the study performs a market reaction test surrounding the earnings announcement date. Specifically, the empirical analysis estimates the following OLS regression:
CAR(−1, +1)i,t = η1 Nine × Post × JMBEi,t + η2 Nine × Posti,t + η3 MBEi,t +
η4EarnSURPi,t + η5 Controlsi,t + ηyear-quarter + ηfirm + εi,t
CAR(−1, +1) is the three-day market-adjusted cumulative abnormal return surrounding the earnings announcement date. EarnSURP is the earnings surprise (actual earnings minus the median value of I/B/E/S one-quarter-ahead street earnings forecasts). Controls include the same control variables in previous tests as well as PreRet and Beta. PreRet is the cumulative returns for the prior six months before the earnings announcement dates, and Beta is estimated for the prior 36 months. Consistent with the prior studies, I expect η3 and η4 to be significantly positive because the MBE premium after controlling for earnings surprises exists (e.g., ). The variable of interest is the interaction term, Nine × Post × MBE. If investors rationally expect lower litigation risk and a higher degree of opportunistic earnings management for Ninth Circuit firms after the ruling than other firms, the market reaction to MBE premium is less positive for Ninth Circuit firms after the ruling.
Table 6 presents the results. In line with prior literature, the coefficients on EarnSURP and MBE are all positive and significant. More importantly, all coefficients on the interaction terms, Nine × Post × MBE, are negative and significant at the 1% level (except for 5% in Column (1)), suggesting that the MBE premium decreases for Ninth Circuit firms after the ruling relative to other firms. The results indicate that investors react to MBE premium (after controlling for forecast errors) less positively for firms with a relatively lower level of litigation risk than other firms with higher litigation risk. This study interprets the results as investors being suspicious about the quality of disclosed earnings for benchmark beaters who experience a decrease in litigation risk. Overall, the results indicate that a decrease in litigation risk results leads to a decline in MBE premium.
Table 6. The changes in market reaction to meeting-or-beating earnings expectations (MBE).

5.3. Expectation Management

Managers can engage not only in earnings management, AEM, and REM, but also in EXM to meet or beat earnings expectations. () and () show that firms are more likely to warn investors about forthcoming negative earnings news. () find that firms enjoy financial benefits by managing earnings expectations downward to a beatable level. Such behavior is consistent with the notion that EXM is another tool for MBE.20
To examine the impact of litigation risk on another tool for MBE (i.e., EXM), the study first estimates the EXM proxies (EXM and OppMBE_EXM). Following (), (), and (), this study measures the degree of EXM (EXM) as the first analyst earnings forecast minus the last analyst earnings forecast and requires that the first analyst forecast be issued at least one day after the previous quarter’s earnings announcement. Also, this analysis requires analyst forecasts to be issued at least two times between the previous and current quarter’s earnings announcement to measure EXP proxy. For the measure of opportunistic expectation management, I identify suspect firms that manage expectations to meet or beat analyst forecasts. OppMBE_EXM takes the value of one if the firm meets or beats the latest analyst forecasts, but misses the first forecasts, and zero otherwise. Then, the study reestimates Equation (2) with OppMBE_EXM as a dependent variable.
Table 7 reports the results. The coefficient on the interaction term, Nine × Post, is negative and significant (p < 0.05), indicating that Ninth Circuit firms are less likely to manage expectations to meet or beat analyst forecasts after the ruling. It implies that, as litigation risk decreases, managers reduce their engagement in EXM to meet or beat earnings expectations. One possible interpretation is that AEM (not REM) is sufficient to meet or beat earnings benchmark after litigation risk decreases, so that managers are less likely to rely on EXM. Such an explanation is consistent with the results of previous AEM tests in this study; managers’ engagements in AEM as a channel for MBE increase after the ruling because the cost of AEM decreases. Therefore, the tests on earnings and expectation management show that, to meet or beat analyst earnings forecasts, managers are more (less) likely to use AEM (EXP) as litigation risk declines, but do not significantly change their engagement in REM.
Table 7. The changes in expectation management.

6. Conclusions

Shareholders can use various courses of action to deter managers or directors from breaching their fiduciary duty and engaging in actions that transfer wealth away from the owners. Shareholders can form a class and file a lawsuit against firms or managers, and such litigation brings serious reputational penalties and negative career implications to managers. This mechanism plays a role as corporate governance for firms and management, and prior studies have examined the disciplining impact of litigation risk on managers’ voluntary disclosures and earnings management (; ; ; ). Extending the literature, this paper investigates the effect of litigation risk on the propensity of firms to meet or just-beat earnings expectations by using mandatory earnings disclosures.
To establish a causal relation, this study conducts differences-in-differences tests based on the unexpected legal event that decreased litigation risk for firms headquartered in the Ninth Circuit. The study has shown that firms experiencing a decrease in litigation risk are more likely to meet or just beat their earnings expectations, suggesting that a threat of litigation negatively affects just-MBE. In other words, firms facing a decrease in litigation risk tend to report small positive earnings surprises rather than small negative surprises, indicating that a decrease in litigation risk gives managers an edge in MBE at the margin. Further, the results show that managers are more (less) likely to manage discretionary accruals (analyst expectations), but not discretionary expenses, to meet or beat earnings benchmarks when the probability of potential litigation reduces. Finally, this study finds that investors’ reactions are less positive to the MBE premium for firms with a decline in litigation risk. Overall, the study contributes to the literature by documenting that a threat of litigation is a significant factor affecting managers’ opportunistic benchmark beating behavior through earnings management.

Author Contributions

Conceptualization, J.K.; Methodology, J.K.; validation, J.K. and J.S.; writing—original draft preparation, J.K.; formal analysis, J.K.; resources, J.K. and J.S.; writing—review and editing, J.K. and J.S.; supervision, J.K. All authors have read and agreed to the published version of the manuscript.

Funding

This research received no external funding.

Institutional Review Board Statement

Not applicable.

Data Availability Statement

All data used in this study are publicly available as indicated in the main text of the manuscript.

Conflicts of Interest

The author declares no conflicts of interest.

Appendix A. Variable Definitions

VariableDescription
NineIndicator variable that equals one if firms are located in the Ninth Circuit States.
PostIndicator variable which equals one from the third quarter of 1999 to the fourth quarter of 2003 and zero from the first quarter of 1995 to the second quarter of 1999
JMBEIndicator variable which equals one if actual I/B/E/S EPS is equal to or larger than earnings target by 2 and 5 cents, and zero if actual I/B/E/S EPS is smaller than earnings target by 2 and 5 cents, respectively. I define earnings target using the median value of I/B/E/S most recent analyst forecasts based on estimates in the 90 days prior to the earnings announcement date.
MBEIndicator variable which equals one if actual I/B/E/S EPS is equal to or larger than earnings target, and zero otherwise. I define earnings target using the median value of I/B/E/S most recent analyst forecasts based on estimates in the 90 days prior to the earnings announcement date.
JMBE_SRWIndicator variable which equals one if actual Compustat EPS (Compustat item EPSFXQ) is equal to or larger than EPS for the same quarter last year by 2, 5, 7, and 10 cents, and zero if actual Compustat EPS is smaller than EPS for the same quarter last year by 2, 5, 7, and 10 cents, respectively.
MBE_SRWIndicator variable which equals one if actual Compustat EPS (Compustat item EPSFXQ) is equal to or larger than EPS for the same quarter last year, and zero otherwise.
OppMBE_AEMIndicator variable that equals one if the firm meets or beats analyst forecasts, but would have missed expectations if abnormal discretionary accruals were removed from reported earnings, and zero otherwise. Abnormal discretionary accruals are defined as follows.
The residuals from quarterly industry estimations of the following modified (). () model with controlling ROA:.
Accruals/TAi,t−1 = υ0 + υ1 (1/TAi,t−1) + υ2 (PPEi,t/TAi,t−1) + υ3 ((ΔSalei,t − ΔRECi,t)/TAi,t−1) +
         υ4 ROAi,t + εi,t		(A1)
Accruals is total accruals computed as earnings less cash flow from operations; TA is the total assets of the firm; PPE is gross property, plant, and equipment; ΔSale is a change in sales; ΔREC is a change in accounts receivable; ROA is return on assets
OppMBE_REMIndicator variable that equals one if the firm meets or beats analyst forecasts, but would have missed expectations if abnormal cuts of discretionary expenses were removed from reported earnings, and zero otherwise. Discretionary expenses are defined as follows.
The residuals from quarterly industry estimations of the following discretionary expenditure model developed by ():
Disexp/TAi,t−1 = υ0 + υ1 (1/TAi,t−1) + υ2 (ΔSalei,t/TAi,t−1) + εi,t(A2)
Disexp is SG&A expenses plus R&D expenses
OppMBE_EXMIndicator variable which equals one if the firm meets or beats last analyst forecasts but has missed first analyst forecasts, and zero otherwise.
VariableDescription
CAR (−1, +1)The three-day (−1, +1) market-adjusted cumulative abnormal return around the earnings announcement date.
SizeThe natural logarithm of total assets at the end of quarter.
LeverageTotal debt divided by total assets at the end of quarter: (DLTTQ + DLCQ)/ATQ.
BMBook value of equity divided by market value of equity at the end of quarter: CEQQ/(PRCCQ × CSHOQ).
Sales GrowthThe change in sales (Compustat item SALEQ) from the current quarter t to the same quarter of the prior year.
ROAIncome before extraordinary item scaled by total assets at the end of the quarter: IBQ/ATQ
CoverageThe natural logarithm of the number of equity analysts following plus one during the quarter.
DispersionThe standard deviation of the I/B/E/S most recent analyst forecasts before the earnings announcement date.
R&DResearch and development expense scaled by total assets at the end of quarter: XRDQ/ATQ
LaborLabor intensity is defined as one minus total plant and equipment scaled by total assets: (1 − PPENTQ)/ATQ
#SharesThe natural logarithm of the number of shares outstanding.
Vol_ROAThe standard deviation of return on assets (IBQ/ATQ) over prior eight quarters.
IOPercentage of shares held by institutional investors.
MFIndicator variable which equals one if the firm discloses at least one management guidance during the quarter, and zero otherwise
LossIndicator variable that equals one if the firm’s income before extraordinary items (Compustat item IBQ) is negative, and zero otherwise.
FourthQIndicator variable which equals one if the firm’s fiscal quarter is the fourth quarter, and zero otherwise
RegFDIndicator variable which equals one if the firm’s calendar quarter is on or after the fourth quarter of 2000, and zero otherwise
EarnSURPEarnings surprise, computed as actual I/B/E/S EPS minus the median value of I/B/E/S analyst forecasts based on estimates in the 90 days prior to the earnings announcement date, scaled by closing stock price as of the end of the prior quarter.
PreRetThe cumulative returns for prior six months before the earnings announcement date
BetaThe slope coefficient of a regression of monthly stock returns on value weighted market returns over prior 36 months.
Notes: When one or more items are missing to measure the variables in the Appendix A, the observations are dropped in my sample.

Notes

1
() document that, of the 297 class actions, 289 (97%) cases demonstrated a decrease in stock price during the period that damages were claimed or the last three weeks of the damaged period. It implies that failing MBE increases the likelihood of future shareholder lawsuits.
2
The Ninth Circuit states include Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington.
3
The ruling resulted in a 43% decrease in the number class action lawsuits in the Ninth Circuit states relative to a 14% increase in other states ().
4
There is a possibility that changes in the propensity to MBE influences litigation risk (i.e., reverse causality or simple correlation). However, diffrerences-in-differences test using exogenou shock could mitigate those potential issues by testing the causality.
5
I primarily use analyst forecasts as an earnings benchmark, but using seasonal random walk-based forecasts (i.e., earnings for the same quarter of last year) yields qualitatively similar results (see Section 4.2).
6
The study also considers ±7 cents and ±10 cents intervals of MBE, and the results are robust. However, these two intervals are wider than previous studies. Thus, the restuls are not presented in this study.
7
This sutdy finds that Ninth Circuit firms, after the 1999 ruling, increase the use of both AEM and REM, indicating that litigation risk reduces overall AEM and REM (but not earnings management as a method for MBE) (; ). There are several reasons for such different results because AEM and REM are different in nature (e.g., ; ; ; ; ). First, AEM does not affect the firm’s operation while REM does impact the real operation of the firm. Second, AEM and REM have different constraints; there are tradeoffs between them. Previous aggressive accrual managements and/or accounting inflexibility reduces managers’ ability to manage accruals in the current or future period. However, the overall financial health of the firm can be a constraint for REM. Lastly, AEM (REM) is likely to be easier (harder) to be detected. The possibility of detection makes AEM more vulnerable than REM to litigation risk, which is consistent with the results of this study. Another possibility of the different results between AEM and REM is that the post-ruling sample is close to SOX periods where the switch from AEM to REM after SOX () was not observed yet.
8
Unlike (), I use quarterly settings in all empirical analysis because MBE is a quarterly phenomenon and annual REM measures fail to capture managers’ inter-quarter reporting incentives.
9
Note that () focuses on restatements not on AEM.
10
Since Compustat does not provide information about a firm’s historical location, I merge the firms to their SEC filings by CIK codes to identify their historical addresses and determine which states the firms’ headquarters were located. The data on headquarter addresses from SEC filings are compiled by Bill McDonald. The compiled data is available at https://sraf.nd.edu/sec-edgar-data/10-x-header-data/ (accessed on 15 November 2025). When firms’ historical addresses are not available in the compiled data, I use Compustat headquarter states to determine their location.
11
These restrictions are widely used in accounting literature since financial/utility firms and firms with stock price below $1 behave differently compared to firms in other industries. However, removing these three restrictions does not change the main result of this study, which mitigates potential sample selection bias.
12
The main results using different winsorization cutoffs (i.e., 3% and 5%) are robust.
13
JMBE, is also an indicator variable which takes the value of one if actual earnings are equal to or larger than median value of analyst EPS forecasts by the 2 or 5 cents, and zero if actual earnings are lower than median value of analyst EPS forecasts by the 2 or 5 cents, respectively. In the prior studies that use cents, the interval for defining “just MBE” versus “just missing” has not been consistent. () and () use the interval, 0 ≤ Actual EPS—Forecast ≤ 0.01 cent. () defines an interval as −0.08 ≤ Actual EPS—Forecast ≤ 0.04. () use the interval, -£0.02 ≤ Actual EPS—Forecast < £0.02. () utilize their primary scaled measure with an unscaled interval of −0.02 ≤ Actual EPS—Forecast ≤ 0.02. I use four different intervals, ±2 cents, ±5 cents, ±7 cents, and ±10 cents, for the just MBE tests.
14
Institutional ownership data is obtained from the 13F filing data provided by the LSEG (formerly Thomson Reuters).
15
I exclude the year of the Ninth Circuit Court ruling (i.e., 1999) following () and conduct the same tests, and the results are robust. In addition, using the mean value of analyst forecasts instead of the median yields qualitatively similar results. Furthermore, the same regression model including Nine and Post (Nine) with (1) industry and (2) industry and state ((3) indestry, state, and year-quarter) fixed effects yields consistent resutls. Last, for a placebo test, the same test is conducted for the U.S. Sixth Circuit firms instead of Ninth Circuit firms. All coefficients on JMBE and MBE are not significant, suggesting that the main results in this study are robust.
16
In a securities class action against Tellabs, Inc., the Seventh Circuit initially ruled in favor of the company, drawing upon a 1999 Ninth Circuit decision as precedent. However, the Supreme Court, in Tellabs, Inc. v. Makor Issues and Rights Ltd. (2007), overturned the Seventh Circuit’s stance, holding that a “strong inference” of scienter must be established. This decision effectively weakened the Ninth Circuit’s earlier restrictive interpretation of the Private Securities Litigation Reform Act (PSLRA) and, in turn, heightened litigation exposure for firms headquartered within that jurisdiction. The 2007 ruling therefore provides an additional empirical setting for employing a differences-in-differences framework to assess whether the outcomes associated with the 1999 decision are reversed after the Supreme Court’s intervention. Therefore, this study further examines the period spanning four years before and after 2007 (i.e., 2003–2011, excluding the ruling year itself). I estimate the same Equation (1) conditional on the Supreme Court’s decision. The results show that the interaction term, NINE × POST, yields significantly negative coefficients, supporting the main result of this study.
17
This study does not find a significant causal relationship for zero earnings benchmark. Hence, the results suggest that, as litigation risk decreases, firms are more likely to meet or beat last year’s earnings, but not zero earnings threshold.
18
The approach to focus on discretionary expenditures (DEXP) for estimating REM proxy is consistent with prior studies excluding other REM estimations from their primary empirical analysis (; ; ). () document a support for cash flow from operation (CFO) and DEXP, but not production costs (PRD) while () shows results for DEXP and PRD. Many studies tend to exclude one or more REM proxies suggested by (). For example, () and () exclude CFO and () exclude both CFO and PRD. It seems that, except for DEXP, REM proxies are used inconsistently and show inconsistent results.
19
Prior studies document that AEM is constrained by outsiders’ scrutiny and accounting inflexibility (; ; ). Given these constraints, managers cannot manage accruals, for the same purpose, too aggressively or consistently. In addition, REM is constrained by overall financial health of a firm. REM is a departure from managers’ optimal decisions, so the results of REM are unlikely to enhance a long-term value of a firm. In addition, there is tradeoff between AEM and REM (; ; ). These studies show a positive relation between AEM (REM) and costs of REM (AEM), so managers tend to use AEM (REM) when the cost of REM (AEM) is high. The timing of AEM and REM is also different; REM should occur during a fiscal period and be realized by the end of fiscal period while AEM can occur even after the fiscal period-end (). For the mechanism with respect to litigation risk, shareholder class action lawsuits typically allege that managers disclose misleading information or omit material information. Such facts make AEM directly susceptible to shareholder lawsuits. In other words, ex post aggressive accounting methods based on accruals face higher risk for shareholder lawsuits and Securities and Exchange Commission (SEC) scrutiny. On the other hand, REM is not directly susceptible to such litigation because the “business judgment” principle provides legal cover for REM; the principal gives an allowance for the possibility that managers employed their best judgment in deciding their actions although such actions resulted in negative outcomes ex post. Since the manipulation of real activity is not a violation of GAAP, REM techniques are expected to face a lower cost of legal detection than AEM even though REM may sacrifice future economic benefits of firms. Therefore, it is possible that, after a decrease in litigation risk, AEM can be enough to manage earnings to meet the expectation so that firms do not have to sacrifice future benefits of the firm by engaging REM for MBE.
20
I develop a framework for the earnings guidance game between managers and analysts based on three underlying factors. First, managers can affect analyst earnings forecasts by disclosing discretionary information, and analysts tend to cooperate. Second, in general, analysts’ initial earnings forecasts are likely to be optimistic. Lastly, the investors appear to reward firms that meet or beat analysts’ latest earnings forecasts with higher MBE premium than those that miss the forecasts, not considering the path to the target (i.e., through EXM). According to this framework, EXM allows managers to maintain favorable stock market reactions and reputation after earnings announcements.

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