Accounting for Contingent Litigation Liabilities: What You Disclose Can Be Used Against You

Abstract

In order to analyze firm value, investment analysts require information on potential losses from contingent liabilities such as litigation damages. However, revelation of the firm’s private estimates of the probability of loss and possible legal damages can be detrimental to the firm by increasing the costs of settlement. That is, opposing counsel may utilize the firm’s financial disclosures about contingent litigation costs to drive settlement demands. Thus, firms choose to shirk their responsibilities to disclose material litigation liabilities in their financial disclosures. Financial disclosures thereby contain insufficient information about the monetary value of potential litigation damages even for large cases with material litigation risks. This outcome is harmful to investors and management alike. I propose an accounting regulatory disclosure model that uses publicly-available data to provide noisy, but useful estimates of class action securities litigation damages in fraud on the market cases that does not require full disclosure of sensitive private information about the firm’s internal assessment of litigation merits. However, a collective action constraint prevents firms from voluntarily utilizing this information-enhancing solution without regulation to coordinate accounting disclosure requirements. I show that accounting requirements could be revised to induce mutually beneficial information disclosures that would improve the information content in financial statements with regard to contingent litigation liabilities in fraud on the market suits.