Releasing Bad Earnings News Earlier Means Fewer Lawsuits

“If a child does something wrong and tells his mother about it, he'll probably be in less trouble than if mom finds out about it on her own,” said Richard Mergenthaler, an accounting professor in the Tippie College of Business.

Likewise, Mergenthaler's new study finds that the earlier a firm announces bad earnings news, the less likely it will be sued by unhappy shareholders. In fact, his research found that companies that wait until the last few weeks of a quarter to announce they will not meet analysts' earnings expectations are 45 times more likely to face shareholder lawsuits than firms that make the announcement in the first weeks of the quarter.

“The earlier a company communicates the information to the market, the better off they'll be,” said Mergenthaler, whose study “The Timeliness of Earnings News and Litigation Risk” is co-authored by Dain Donelson, John McInnis and Yong Yu, all of the University of Texas at Austin.

Avoiding earnings-related shareholder lawsuits has huge financial implications, Mergenthaler said. From 1996-2005, U.S. firms shelled out more than $15 billion in total settlements for securities related class-action lawsuits, and billions more fighting lawsuits that never made it to settlement.

Firms that are sued by shareholders also suffer an enormous cost to their reputations, Mergenthaler said, so avoiding such suits helps companies' bottom lines.

Mergenthaler and his co-researchers looked at 423 firms that were sued by shareholders after reporting lower earnings than expected by analysts between 1996 and 2005. They then found 423 companies that reported similar earnings news during the same quarter but were not sued, then looked to see when analysts became aware that the company expected earnings to miss projections.

They found that most firms that were sued waited until near the reporting date to announce that they expected to miss forecasts. Non-sued firms, on the other hand, consistently reported bad earnings news earlier.

“At the halfway point of the quarter, more than 55 percent of the bad news is revealed on average for non-sued firms, compared to less than 25 percent for sued firms,” Mergenthaler said.

Mergenthaler suspects there are two reasons for this. First, when releasing bad news earlier, the market has time to digest the news before the earnings are actually released and the firm's stock doesn't suffer as much of a price shock.

The earlier release date also diminishes the likelihood that stockholders will interpret poorer than expected earnings as a sign of management fraud, and doesn't provide evidence that attorneys could use to accuse management of fraud. Since shareholders must prove fraud to win a lawsuit, an early warning provides them with less evidence.

Richard Mergenthaler, rick-mergenthaler@uiowa.edu; 319-335-0848; Tom Snee, University News Service, tom-snee@uiowa.edu, 319-384-0010 (office), 319-541-8434 (cell)