LITIGATION RISK AND MARKET REACTION TO RESTATEMENTS

Authors


  • We would like to thank the referee, Bruce Haslem, for his helpful comments. We would also like to thank Michael Willenborg, Fabrizio Ferri, Neeraj Gupta, Michael Trachtenberg, Derek Yonai, participants at the Financial Management Association meeting in Dallas, Texas; Eastern Finance Association meeting in Tampa, Florida; Southern Finance Association meeting in Ashville, North Carolina; and seminar participants at Fairfield University research seminar for valuable comments.

Abstract

A large negative stock price reaction to a restatement announcement could imply a significant accounting error, or one made by a firm with a high probability of being sued. We investigate the extent to which market reactions to restatement announcements are explained by litigation risk. We model the simultaneous relation between restatement announcement abnormal returns and litigation risk and find that about half of the −9.2% average restatement announcement effect is due to expected litigation costs. We also find that the significance of the accounting error only affects abnormal return indirectly because it increases the probability of being sued.

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