Market Reaction to Earnings Surprise Warnings: The Incremental Effect of Shareholder Litigation Risk on the Warning Effect

We examine the incremental effect of shareholder litigation risk on market reaction to earnings surprise warnings, that is, the warning effect. Prior research examines earnings warnings by firms reporting large earnings news (at least 1% of share price), and finds a negative warning effect for bad news firms but no warning effect for good news firms. We find similar results for a larger sample of firms. In addition, we find negative and positive warning effects, respectively, for firms reporting small bad and good earnings news, suggesting that the insignificant warning effect for good news firms is restricted to large earnings news. More importantly, we find that litigation risk magnifies the warning effect—for bad news firms, the warning effect is more negative for high-litigation-risk firms than for low-litigation-risk firms, but for good news firms, the warning effect is more positive for high-litigation-risk firms than for low-litigation-risk firms.