Understanding investors’ propensity to litigate

Purpose The purpose of this paper is to examine investors’ propensity to litigate when harmful events occur subsequent to accounting choices. Consistent with Culpable Control Theory, the authors find that investors are more likely to pursue litigation against management when managers are perceived to have more financial reporting flexibility, such as when they apply imprecise, principles-based accounting guidance. Investors are more likely to pursue litigation when they find management more responsible for harmful events, and they find management more responsible for those events when they perceive management to have more reporting flexibility. To provide additional insight, the authors investigate how the relationship between reporting flexibility and assessed manager responsibility is mediated by investors’ perceptions of management’s self-interested behavior. The authors consider monetary and non-monetary motivations for litigation against management such as recouping financial losses and punishing management. The results suggest that recouping financial losses is not the sole motivation for litigation. The authors provide evidence that punishing management is an important non-monetary component of the litigation decision. The results contribute to the limited literature on investor litigation decisions and inform the debate surrounding the potential effects of more principles-based accounting standards. Design/methodology/approach The authors test the hypotheses using an experiment with a 2×1 between-subjects design in which the authors manipulate reporting flexibility at two levels by varying the precision of accounting guidance and measure all other variables of interest. Participants are 82 part-time executive MBA program students at a major public university in the USA. Most participants work full-time (94 percent), own or have owned stocks either directly or through retirement plans (84 percent), indicate general investment knowledge (97 percent), and report high levels of familiarity with corporate financial statements, including balance sheets and income statements (92 percent). Thus, the authors conclude that these executive MBA students are reasonable surrogates for investors. Findings Consistent with the predictions, perceived management reporting flexibility affects investors’ propensity to pursue litigation against management. The authors find that the assignment of responsibility to management for harmful events such as investor losses, employee job losses, and economic losses suffered by a community mediates the relationship between reporting flexibility and investors’ intention to litigate. The authors also find that the relationship between reporting flexibility and assignment of responsibility to management for harmful events is not direct but instead works through the effect of reporting flexibility on perceived management self-interested behavior. As predicted, assessed management responsibility for the harmful event is positively related to investors’ propensity to litigate against management, and this relation is only partially mediated by investors’ perceptions that the litigation will be successful. This result suggests that the litigation decision is driven at least in part by corporate governance goals such as the desire for retribution or punishment of management. The second experiment provides additional support for the theory that the desire to punish management is an important component of investors’ litigation decisions. Research limitations/implications The research makes important contributions to the literature on investor litigation and to the ongoing debate regarding principles- vs rules-based accounting standards. While some archival research addresses the conditions under which securities litigation occurs, little empirical research has directly addressed the investor decision to litigate. The paper provides additional evidence to address the question of why investors litigate. By doing so, the authors add to the debate on the desirability of shifting from more rules-based to more principles-based accounting standards. Practical implications The theory tested in this study could be used to design mechanisms to mitigate the differential propensity for investors to litigate under differing accounting regimes. As standard setters discuss a move to more principles-based standards in the USA, some observers have expressed concern that investor litigation will increase. The theory suggests that if the standard-setting body can control perceptions of management reporting flexibility such that investors believe principles-based standards provide no more flexibility than rules-based standards, they can limit an increase in the amount of investor litigation. Originality/value The authors contribute to theory by providing evidence regarding why investors desire to pursue litigation against management. The authors find that the assignment of responsibility to management for harmful events mediates the relationship between reporting flexibility and investors’ intention to litigate. The authors also find that the relationship between reporting flexibility and assignment of responsibility to management for harmful events is not direct but instead works through the effect of reporting flexibility on perceived management self-interested behavior. Furthermore, assessed management responsibility for the harmful event is positively related to investors’ propensity to litigate against management, and this relation is only partially mediated by investors’ perceptions that the litigation will be successful. Those findings provide theoretical contributions to the literature.