Fair value accounting standards and securities litigation

Abstract

We examine the effect of fair value standards on firms' litigation risk. The discretion required by fair value allows plaintiffs to “second guess” managers' judgments, potentially increasing litigation risk. Alternatively, the complexity of fair value may decrease litigation risk if it's more difficult to demonstrate scienter. Our evidence suggests firms that rely more on fair value standards are relatively less likely to be sued. We find no evidence of a relation between fair value and the risk of misstatements or fraud, but do find evidence of a slight increase in firms' litigation risk via an increase in volatility. However, the primary effect of fair value standards in reducing litigation risk dominates the volatility effect. Finally, we find average litigation rates increase after the passage of new standards, but less so for fair value standards. On balance, our evidence suggests fair value is a relatively low litigation risk area in GAAP.