Earnings quality and Rule 10b-5 securities class action lawsuits

Abstract

This study examines the earnings quality of firms sued under accounting-related Rule 10b-5 securities fraud class action lawsuits, following a decline in their stock prices, relative to earnings quality of a return-matched control sample of firms. Our analysis is conducted in pre- and post-Private Securities Litigation Rule Act (PSLRA) periods. We measure accruals (earnings) quality using the Dechow and Dichev (2002) model, and provide evidence of significantly lower quality earnings (earnings overstatement) in both the pre- and post-PSLRA periods, for the test sample firms in the four quarters immediately prior to the sued quarter, followed by a sharp decline in the level of earnings of the sued quarter and subsequent four quarters. These consistent results in the pre- and post-PSLRA suggest that lower earnings quality is merit-related indicia of evidence of fraud and that accounting based securities class action lawsuits target only firms with lower earnings quality. Our findings suggest that further policy reforms making it more difficult for shareholders to file an accounting based securities class action lawsuit would be unwarranted.