Stealth Disclosure of Accounting Irregularities: Is...

Stealth Disclosure of Accounting Irregularities: Is Silence Golden?

Edward P. Swanson*

Professor

Texas A&M University

[email protected]

Senyo Tse

Professor


[email protected]

Rebecca Wynalda

Ph.D. Student


[email protected]

*Corresponding Author.

Edward P. Swanson

Mays Business School


4353 TAMU

College Station, TX 77843-4353

Current Draft: August 21, 2007

Keywords: accounting restatements, press release disclosure, voluntary disclosure

Data Availability: The data used in this study are publicly available from the sources indicated in the text.

Acknowledgments: We would like to thank Devin Shanthikumar, Nate Sharp, and workshop participants at

Texas A&M University and at the 2007 AAA Annual Meeting for their comments. We are indebted to Jason

Call, Vikas Hegde, and Natasha Thomas for their research assistance. The authors gratefully acknowledge

financial support from the Mays Business School of Texas A&M. Swanson would also like to acknowledge

funding from the Durst Chair in Accounting.

mailto:[email protected]




ABSTRACT: Managers are allowed considerable discretion over how they announce an

accounting restatement. Some firms issue a press release that discloses the restatement in

the headline (high prominence); others provide a press release with a headline on a

different subject (for example, earnings news) but discuss the misstatement in the press

release (medium prominence); and most of the remaining firms simply change the

comparative-period amounts reported in an earnings release, with no direct mention of

the restatement (low prominence). Mean three-day returns are negative and differ

substantially across these categories of disclosure prominence (-8.3%, -4.0%, and -1.5%

for high, medium, and low prominence, respectively). We investigate whether this

pattern is due to differences in the severity of the accounting irregularity or in the relative

transparency of the three press release formats. Our tests support the latter explanation.

We also find that companies providing less prominent press release disclosure of their

restatement are less likely to be sued for securities fraud. In sum, both return and

litigation tests indicate that ―silence can be golden.‖

1


I. INTRODUCTION

Key leaders of the business community argue that new regulations and high litigation

costs are making U.S. capital markets less competitive (Interim Report of the Committee on

Capital Markets Regulation 2006). In a widely covered speech before the Economic Club of

New York, Treasury Secretary Henry Paulson expressed concern that U.S. competitiveness is

being impaired by a ―broken‖ legal system. He cited tort costs that have reached a record

quarter-trillion dollars (2.2 percent of GDP), which is twice the relative cost in Germany and

Japan, and three times the level in the UK. Paulson suggested these costs could be lowered

by reducing the number of accounting restatements, which he said are often caused by

companies‘ well-intentioned attempts to follow complex and changing accounting rules.1

The Treasury Secretary has since announced plans to ―commission a rigorous analysis of

factors driving financial restatements, and their impact on investors and the capital markets.‖

(Financial Times, May 17, 2007).

This legal environment may help explain why many corporate managers provide only

minimal disclosure when announcing an accounting irregularity. We discovered this while

reading companies‘ press releases underlying the GAO report (2002), which was prepared

for the U.S. Senate Committee on Banking, Housing, and Urban Affairs, chaired by Senator

Sarbanes. We observed three levels of disclosure: Some companies disclose their

restatement prominently in the headline of a press release which is usually dedicated to the

accounting irregularity (high prominence). Other firms provide less prominent disclosure,

typically citing an earnings release in the headline, but still discussing the misstatement in the

1 See Solomon 2006 and the text of Paulson‘s remarks at http://www.treasury.gov/press/releases/hp174.htm).

http://www.treasury.gov/press/releases/hp174.htm

2

body of the press release (medium prominence). And the remaining firms simply restate

prior-period comparative balances in an earnings release, with no disclosure of the

restatement other than a footnote stating that the financial figures for the prior year have been

changed (low prominence). With the last two practices, an investor who does not read each

press release might not be aware of the accounting irregularity. A report by Glass Lewis

(2006) uses the expression ―stealth restatements‖ to refer to the practice of disclosing an

accounting irregularity within an earnings release. The poor quality of many restatement

disclosures has recently come to the attention of the SEC and received press coverage (Reilly

2006a, b).2

We use these differences in disclosure prominence to investigate the broader question

of whether firms are rewarded or penalized for openness in disclosing bad news. This

question has been studied previously in the context of earnings warnings. Kasznik and Lev

(1995) find that returns for warning firms are lower than returns for firms with similar risks

and earnings news that do not warn. Their paper led to an article in The Economist, ―Silence

is golden‖ (1994, 91), which concludes: ―But so long as openness is penalized, it is unlikely

to become the voluntary norm.‖ 3 Tucker (2007) replicates Kasznik and Lev‘s (1995) result

using a similar window. She then extends the window to five (or more) months and finds

that warning firms have more unfavorable non-earnings news (e.g., product news, alliances,

and management changes), suggesting that their long-window returns would have been lower

2 Glass Lewis suggests that companies hope investors ―may dismiss a restatement as relatively minor‖ if it is

tucked ―away quietly in the current period‘s results.‖ Subsequent to our test period, the SEC clarified that

restatements ―constitute information that is material to investors and thus needs to be formally disclosed in a

restatement filing clearly labeled as such.‖ (Reilly 2006a). However, a recent working paper by Sharp (2007)

shows that the SEC clarification has not ended the practice. We focus on the press release because we find little

market reaction to the SEC filings. 3 Consistent with The Economist, we use expressions such as penalty for openness or reward for silence

interchangeably.

3

than non-warning firms‘ returns even without the warning. She concludes that firms are not

penalized in the long-run for providing voluntary management forecasts.

The question of whether firms are rewarded or penalized for openness in disclosing

bad news has also been studied in the context of shareholder litigation. Skinner (1994, 1997)

conjectures that litigation concerns could explain why some firms warn investors in advance

of a large negative earnings surprise. Francis, Philbrick and Shipper (1994), however, find

that firms that issue an earnings warning are more likely to be sued than a control sample of

firms that do not warn, which suggests that silence is rewarded. However, Field, Lowry, and

Shu (2005) use a research design that attempts to control for the endogenous relation between

earnings warnings and litigation and conclude that warnings may deter litigation. Most

recently, Rogers and Van Buskirk (2007) find that firms that are sued reduce the frequency of

management forecasts (and conference calls) in the year following the lawsuit filing. This

finding suggests that managers believe reduced disclosure lowers the likelihood of another

lawsuit.

Existing evidence is therefore mixed about whether firms are rewarded or penalized

for openness in disclosing bad news. Our paper provides new evidence, but in the context of

disclosures of accounting irregularities rather than earnings shortfalls. Accounting

irregularities provide an important setting in which to extend this line of research. Since the

passage of the Private Securities Litigation Reform Act of 1995, accounting litigation has

shifted to firms disclosing the need for an accounting restatement and away from class

actions alleging a failure to provide timely warning of an earnings shortfall (Grundfest and

Perino 1997).

4

Our first finding is that the magnitude of the market response to a restatement is

related to press release format. The differences are substantial with average returns for the

three categories of disclosure prominence of -8.3%, -4.0%, and -1.5% for high, medium, and

low prominence, respectively. (The average return for low-prominence disclosures is not

statistically different from zero.) We consider two scenarios in which this return pattern

could occur. In the first scenario, press release prominence conveys the severity of the firm‘s

accounting irregularity, and the return responses simply reflect misstatement severity. This

scenario is consistent with market efficiency. In the second scenario, press release

prominence is not closely related to misstatement severity. This could occur if some

managers provide less prominent press release disclosure in an effort to reduce the stock

price decline and the likelihood of litigation. Specifically, some managers may use medium

(or even low) prominence disclosure for a severe accounting irregularity to avoid attracting

market attention. In this case, the less negative returns associated with less prominent

disclosure would constitute a ―reward for silence.‖ This scenario is consistent with limited

attention theory (Hirschleifer and Teoh 2003).

We evaluate the scenarios by first examining whether the return differences

associated with disclosure prominence decline over time, as investors presumably learn more

about the accounting irregularity. We observe a negative price drift in the 20 days after the

restatement announcement for firms that do not disclose the restatement in a headline (i.e.,

medium and low prominence), and this drift significantly reduces return differences across

the three categories. This response is consistent with the delayed market reaction to less

transparent disclosure predicted by limited attention theory (Hirshleifer and Teoh 2003).

Importantly, over the longer window (-1, +20), returns for each category differ significantly

5

from zero (-7.9%, -6.4%, and -3.2%). This evidence indicates that market participants are

initially misled by the differences in press release format used to announce restatements.

We next examine whether press release format is associated with announcement date

returns (-1, +1) when we control for misstatement severity. Our prominence variable should

no longer be significant if press release format simply reflects misstatement severity, but we

find that prominence is still highly significant. We then use the same model to explain

returns over the longer window (-1, +20) that allows market participants more time to assess

the accounting irregularity, and find that press release prominence is no longer statistically

significant. In sum, our returns tests indicate that firms providing less prominent press

release disclosure of an accounting irregularity are rewarded with less negative returns at the

announcement date; however, much of the reward is short-term.

Next, we examine the association between disclosure prominence and the incidence

of a class action lawsuit. About twenty percent of the companies in our sample are sued as a

result of their accounting restatement, with the frequency declining monotonically across the

three categories of disclosure prominence (27%, 16%, and 0% for the high, medium, and low

prominence firms, respectively). To determine whether the lower rate of litigation for

restatements disclosed without a headline (i.e., medium and low prominence) is due to a less

severe accounting irregularity or a less transparent press release, we estimate a logistic

regression model of the likelihood of litigation that includes controls for misstatement

severity, determinants of lawsuits identified in prior research, and announcement-date

returns. We find that the coefficient of the prominence index is positive and significant,

despite the inclusion of controls for misstatement severity. This finding suggests that press

release format is a separate determinant of lawsuit likelihood, and that managers not

6

providing headline disclosure are rewarded with a lower likelihood of litigation. We find this

result is robust to the treatment of dismissed lawsuits, so in contrast to the return differences,

the effect is permanent.

The results of this study should be of interest to regulators, corporate executives, and

academics with an interest in corporate disclosure. This paper adds to the (limited) evidence

indicating that press release emphasis affects investor responses to the accounting

information reported (e.g. Bowen, Davis and Matsumoto 2005, Gordon et al. 2007). The

paper also provides evidence about whether firms are rewarded or penalized for openness in

disclosing bad news. Prior studies on earnings warnings provide conflicting evidence about

whether the market and legal system exact a penalty for openness. Our paper provides new

evidence of a penalty. Regulators, especially the SEC, may want to standardize press release

disclosure and thereby reduce the large differences in returns and lawsuit outcomes for

substantively similar economic events. Lastly, our findings should be of interest to the

commission formed by Secretary Paulson, in their effort to understand how restatements

impact investors and the capital markets (see introductory paragraph).

The rest of the paper is organized as follows. In Section II, we present the

hypotheses. In section III, we describe the sample. We summarize the multivariate models

used to explain returns and litigation in section IV. In section V, we present the results based

on market returns, including robustness checks and extensions. In section VI, we report

litigation results. We conclude in section VII.

7

II. HYPOTHESES

Guidelines about how to write an effective press release stress the importance of the

headline. Mahoney (1991, 284) comments, ―The headlines drive an idea, instead of simply

identifying a subject.‖ And Feid (2005) states ―Don‘t Bury the News—A headline should

convey the entire key message at the top of the press release. Then the lead paragraph should

reiterate it with the basic facts.‖

To-date, the effect of press release format on market reactions has received little

attention in the accounting literature. A relevant exception is a study by Bowen, Davis and

Matsumoto (2005) which investigates whether investors‘ relative response to GAAP earnings

versus pro forma earnings depends on placement in the firm‘s press release. They find that

the relative strength of the price response to each earnings metric is greater if that metric is

emphasized by its placement in the press release. Using an approach similar to that in

Bowen et al. (2005), we define a three-level index of disclosure prominence. We code as 3

(high prominence) any press release in which the restatement is mentioned in the headline;

we use 2 (medium prominence) for any press release in which the restatement is not

mentioned in the headline but is discussed in some detail within the body of the report;4 and

we assign 1 (low prominence) to those press releases that mention the restatement only in the

footnotes to comparative period results.5

4 Firms in this category typically present other company information in the press release. Fifty-eight percent

present current earnings information, and the remaining firms issue a variety of other announcements, such as a

new credit facility (Sybron Dental 2002), the settlement of past litigation charges (Cognos 2002), and the

adoption of new tax rules (First American Financial Corporation 2000). Kothari, Shu, and Wysocki (2005, 3)

posit that managers often delay disclosing bad news, apparently gambling that subsequent corporate events (i.e.,

future corporate turnaround or restructuring) will allow them to ―bury‖ the bad news.

5 Bowen et al. (2005) use a 4-point scale for each earnings metric: 1 = discussed in the headline; 2 = discussed

in the 1st or 2

nd paragraph; 3 = discussed further down in the body of the release; and 4 = only discussed in the

financial statements provided at the end of the release (i.e., the footnotes). Our index combines scores 2 and 3

into one measure.

8

Concurrent research by Gordon et al. (2007) also examines the effect of press release

characteristics on returns in a three-day window centered on the restatement announcement.

Two of their characteristics are similar to those we consider, and their results are consistent

with our findings. First, they find that firms reporting the restatement in the headline (using a

dummy variable) experience a larger price decline. Second, they find that firms providing

more details about the restatement, including the restatement amount, experience a less

negative market reaction. In other respects, the papers are complementary but quite

different.6

Theory differs about whether the format of a press release would affect investor

response. In an efficient market, security prices respond promptly and fully to all publicly

available information, so it should not matter whether the restatement is in the headline.

However, limited attention theory (Hirshleifer and Teoh 2003) predicts that the speed and

completeness of price reactions are both reduced when information is disclosed in a form that

investors may overlook. Thus, price reactions to restatements that are omitted from the press

release headline (for example, restatement disclosures in an earnings press release) may be

smaller and/or extend over a longer period than headline announcements. We therefore test

the following null hypothesis:

H0 1: The extent of prominence given to an accounting restatement in the press

release does not affect the magnitude of the market‘s response.

Disclosure prominence may also affect the likelihood of shareholder litigation. This

could occur if potential litigants are themselves subject to limited attention. For example,

6 Gordon et al. (2007) focus on determining whether disclosure credibility is associated with market

reactions to restatement announcements. Disclosure credibility consists of situational incentives at the time

of the disclosure (which they argue is homogenous among restating firms), management credibility

(determined by the amount and tone of prior discretionary disclosures), and the characteristics of the

restatement announcement. Their research therefore complements and extends the capital markets analysis

in our paper. Note that Gordon et al. (2007) do not consider whether restatement disclosure practices

influence the likelihood of litigation.

9

class action law firms typically have staff assigned to clip newspaper articles about corporate

events with lawsuit potential, and a headlined event is less likely to be overlooked. We test

the following null hypothesis:

H0 2: The extent of prominence given to an accounting restatement in the press

release does not affect the likelihood of class action litigation.

Note that lawsuit likelihood may increase with the stock price decline that triggers the

lawsuit, and those returns may in turn be driven by disclosure prominence. We control for

this possibility by including announcement-period returns in testing H0 2.

III. SAMPLE SELECTION AND DATA DESCRIPTION

Our sample is taken from the GAO (2003) database, which lists 919 companies that

announced an accounting restatement between January 1, 1997 and June 30, 2002. The GAO

list is restricted to ―accounting irregularities‖ and excludes restatements that arise from

normal corporate activity or simple presentation issues.7 The GAO tracks restatements based

on the press release announcement date, not the date on which adjusted financial statements

are filed. In addition to the company name and announcement date, the database reports the

ticker, entity that prompted the restatement (e.g. auditor, company, SEC, unknown), and the

accounting issue(s) underlying the misstatement (selected from nine categories). The GAO

list of restating companies is important because it influenced passage of the Sarbanes-Oxley

Act of 2002 by showing Congress that accounting irregularities were widespread. About

7 The GAO report (2002, 2) states: ―For the purposes of this report, an accounting irregularity is defined as an

instance in which a company restates its financial statements because they were not fairly presented in

accordance with generally accepted accounting principles (GAAP). This would include material errors and

fraud.‖ The GAO report further states that accounting irregularities include so-called ―aggressive‖ accounting

practices, intentional and unintentional misuse of facts applied to financial statements, oversight or

misinterpretation of accounting rules, and fraud.‖ An important advantage of the GAO list is that the researcher

does not make the judgment about which restatements constitute aggressive accounting practices. A second

advantage is that the list is publicly available, so other researchers can extend (or replicate) research results.

10

10% of all companies listed on the NYSE, NASDAQ and Amex have a restatement cited in

the database (GAO 2002, 16).

Table 1 reconciles our sample to the GAO list. We require that our sample firms

have short-interest data, and drop 452 firms (from the 919) that do not meet this requirement.

Most of the eliminated firms are small or trade over-the-counter. We use the level of short

interest to control for information available to a sophisticated investor about accounting

problems. Desai et al. (2006) and Efendi et al. (2005) show that the level of short interest

increases before a restatement announcement. Of direct importance to our use of short

interest, Efendi et al. (2005) show that the entire increase occurs for companies with severe

accounting irregularities. 8

Our sample is further reduced by 61 firms for which we could not

locate the press release; 9 17 firms that do not have return information on CRSP; and eight

firms whose returns are in the top or bottom one percent of the cumulative market-adjusted

returns distribution. The final sample consists of 381 restatement firms.

<Insert Table 1 Here>

We obtain information about litigation from the Securities Class Action

Clearinghouse (http://securities.stanford.edu/). This website covers more than 2500 issuers

that have been named in federal class action securities fraud lawsuits since passage of the

Private Securities Litigation Reform Act of 1995. It includes information about complaints,

briefs, filings, and other litigation-related materials. We review this information to determine

8 We would like to acknowledge these authors for allowing us to use their proprietary database, which contains

short interest for firms listed on the NYSE, AMEX, and NASDAQ. 9 To ensure that we are capturing management‘s disclosure choices, we use press releases sent out over either

PR Newswire or Business Wire, when available. These services distribute the exact press release issued by a

firm, while other media outlets may alter the press release to conform to their format guidelines, space

requirements, etc. Almost all of the press releases in our sample are from one of these two sources.

11

whether any litigation filed against a sample firm is a direct consequence of the accounting

restatement.

Table 2 provides descriptive information about the sample. Panel A shows that

restating firms are widely distributed across 49 two-digit industries. To provide insight into

whether some industries have a higher than normal rate of restatements, we compare the

industry distribution of the sample to the Compustat population. The differences are modest:

Business services provides 15.49% of the restatement sample (59 of the 381 companies),

which is higher than the industry‘s 11.01% representation in Compustat. Only five other

industries provide more than 12 sample firms, and only two of them have at least a three

percent difference from Compustat: 1) Industrial and commercial machinery and computer

equipment (8.66% vs. 4.89%); and 2) electronic and other electrical components, except

computer equipment (8.66% vs. 5.58%). Table 2, Panel B reports the distribution of the

sample announcements over time. Restatement frequency increases over the sample period,

peaking at 117 restatements in 2001.10

Table 2, Panel C provides a cross-tabulation of

accounting issue with the three categories of disclosure prominence. Because some firms

restate for more than one accounting issue, the 442 accounting issues exceed the 381

companies in the restatement sample. Revenue recognition is the most common type of

accounting misstatement for each of the three prominence categories. Of particular note, a

large portion of the companies providing footnote-only disclosure restate revenue (25 of the

37). This is the primary reason that the 2.17 prominence score for revenue restatements is

low compared to the full sample average of 2.33. (Later in the paper, we report robustness

tests to determine the effect of revenue restatements on our findings.)


10

Recall that the GAO dataset ends June 30, 2002 so our sample does not include all restatements for 2002.

12

IV. MULTIVARIATE MODELS

For H0 1, we use an OLS regression model to investigate whether disclosure

prominence is associated with the magnitude of returns around the restatement

announcement. For H0 2, we use a logistic regression to examine whether disclosure

prominence influences the likelihood of class action litigation. For each hypothesis, we

control for factors other than press release format that could influence the response to the

accounting irregularity.

Abnormal Returns Surrounding Restatement Announcements

We estimate the following OLS regression model to test our first hypothesis:

,111098

7654

321

FINANCIALTECHMKTCAPINTERESTSHORT

COUNTCHANGERULEREVENUEFRAUD

SECAMTTRESTATEMENINDEXPROMINENCECAR

(1)

where CAR is the cumulative abnormal return calculated as the raw stock return minus the

CRSP equally-weighted market return. CAR is measured over a three-day window centered

on the restatement announcement date (-1, +1). Additional analyses extend the window to 20

days after the announcement date (-1, +20).

We read each press release to code the primary variable of interest, PROMINENCE

INDEX, which takes on the value of 3, 2, or 1. As discussed in developing the hypotheses,

we code headline disclosure of the restatement as 3, discussion of the misstatement but

without a headline citing the restatement as 2, and footnote-only disclosure as 1. Press

releases also vary by whether an estimate of the restatement amount is provided. We code

RESTATEMENT AMT as 1 if the press release reports the magnitude of the restatement and 0

13

otherwise.11

We expect a positive sign because reporting an amount signals that managers

know the extent of the accounting irregularity, while a press release that omits an amount

would indicate that managers do not yet grasp the extent of the accounting problems. Wu

(2003) shows that announcement-day returns are lower for firms that omit the restatement

amount.

We control for misstatement severity using several variables, most of which have

been used in prior studies (Lev, Ryan, and Wu 2007; Palmrose and Scholz 2004; Palmrose,

Richardson, and Scholz 2004; Wu 2003). SEC takes on the value of 1 if the press release

mentions an SEC inquiry and 0 otherwise. Based on prior research, we expect a positive sign

(i.e., a smaller decline at the announcement). A rationale is that the market would usually

know a restatement is forthcoming when it is of sufficient importance to involve the SEC,

and the actual announcement reduces uncertainty by providing information about the nature

of the accounting irregularity FRAUD is coded 1 if the press release mentions an allegation

of fraud and 0 otherwise. We expect a negative sign if fraud is alleged (i.e., greater price

decline). REVENUE is coded 1 if the restatement is at least partly due to revenue recognition

problems and 0 otherwise. We expect a negative sign because prior research finds that

investors react more negatively to revenue restatements than to other accounting

irregularities. RULE CHANGE takes on the value of 1 for firms that cite an accounting

pronouncement as the reason for their restatement and 0 otherwise. We expect the RULE

CHANGE coefficient to be positive because these restatements are caused by a change in

11

We do not use the dollar magnitude of the restatement as a measure of severity. First, many firms do not

report an amount. Second, some firms report only the restated amounts in the press release, and it is difficult to

locate the corresponding amounts originally reported in the financial statements in order to calculate the amount

of the adjustment. Third, revenue growth was emphasized as much as earnings at the top of the late 1990s

market bubble (Ertimur and Livnat 2003), and many of the misstatements that affect revenue have little effect

on earnings (Efendi, Srivastava, and Swanson 2007).

14

rules or a new interpretation of existing accounting rules, rather than by a clear violation of

GAAP. COUNT records the number of distinct accounting issues cited in the GAO database

(2003). We expect the market to react more negatively to restatements stemming from

multiple GAAP violations. The last measure, SHORT INTEREST (calculated as 100 *

(number of shares sold short)/(total shares outstanding) as of the month prior to restatement

announcement), proxies for the information about accounting problems available to

sophisticated investors before the restatement is announced. Efendi et al. (2005) show that

the level of short interest is positively associated with the severity of the accounting

irregularities.

We also include some general control variables. MKTCAP is the natural log of the

firm‘s market capitalization measured at the fiscal year-end prior to the restatement

announcement. Tucker and Zarowin (2006) find that large firms are more likely than small

firms to provide timely disclosure of bad news. We include dummy variables for firms

operating in technology and financial (SIC 6000-6999) industries. Based on prior research,

we anticipate more negative price reactions for TECH firms and less negative price reactions

for FINANCIAL firms.

Disclosure Prominence and the Likelihood of Class Action Lawsuits

We investigate the association between disclosure prominence and the likelihood of

shareholder litigation by estimating the following logistic regression model:

,15

141312

1110

987

6543

21

FINANCIAL

TECHCAPMARKETTURNOVERSHARE

RETURNSTOCKPOSTRETURNSTOCKPRIOR

RETURNCONCURRENTINTERESTSHORTCOUNT

CHANGERULEREVENUEFRAUDSEC

AMTTRESTATEMENINDEXPROMINENCELITIGATION

(2)

15

where LITIGATION is equal to 1 if a class action lawsuit was filed against a firm in response

to their restatement and 0 otherwise.

Eleven of the fifteen variables in model 2 are also used in model 1 to explain CARs.

The expected signs are the same, but the rationale changes for two variables: SEC is now

expected to have a positive coefficient because a restatement subject to an SEC inquiry is

more likely to elicit litigation. MKTCAP is still expected to have a positive coefficient, but

the rationale differs—due to their deep pockets, large companies have greater litigation risk

(Beaver and Malernee 1990).

We add four variables to the litigation model. Prior research shows that SHARE

TURNOVER is positively associated with the likelihood of litigation. The rationale is that,

when shares trade rapidly, more investors are potentially harmed by any mispricing (Field et

al. 2005; Gande and Lewis 2006). The calculation of this variable is based on Field et al.

(2005): [1-Πt(1-volume tradedt/total sharest)], accumulated over the 1-year period ending on

the second day prior to the restatement announcement date. The other variables we add

capture changes in stock price. CONCURRENT RETURN is the compounded raw return

over the three-day period centered on the date of the restatement announcement (-1, +1). The

likelihood of litigation is expected to increase with a greater decline in share price around the

announcement (Palmrose and Scholz 2004). PRIOR STOCK RETURN is the compounded

raw return over the one-year period ending two days before the restatement announcement

(-252, -2). Weak stock price performance in the recent past has been shown to increase the

incidence of lawsuits (Jones and Weingram 1996; Gande and Lewis 2006). POST RETURN

is the compounded raw return over the (+2, +20) interval following the restatement

16

announcement. This return window allows for a delayed market reaction as investors assess

the accounting irregularity.

V. RESULTS FOR MARKET RETURNS

Returns over Short and Longer Windows

Table 3 reports mean abnormal returns for a three-day window centered on the

announcement date (-1, +1), the next nineteen days (+2, +20), and the combined window

(-1, +20). The ―Full sample‖ column reports returns of -5.5%, -1.1%, and -6.7%,

respectively, for those three windows.

The full sample return of -5.5% for the three-day announcement window is an

average of returns that differ substantially depending on the prominence provided to the

restatement in the press release. Abnormal returns for high, medium and low prominence in

the three-day window are -8.3%, -4.0% and -1.5%, respectively. The returns for high and

medium prominence are significantly different from zero, and the high prominence return

(i.e., for headline disclosure) differs significantly from the returns for medium and low

prominence. Therefore, our first finding is that the magnitude of the market response to a

restatement differs by press release format, with smaller declines for firms providing less

prominent disclosure.


We consider two scenarios in which this return pattern could occur (as discussed in

the introduction). In the first scenario, press release prominence conveys the severity of the

firm‘s accounting irregularity, and the return responses simply reflect misstatement severity.

This scenario is consistent with market efficiency. In the second scenario, press release

17

prominence is not closely related to misstatement severity. This could occur if some

managers provide less prominent press release disclosure in an effort to reduce the stock

price decline and the likelihood of litigation. Specifically, some managers may use medium

(or even low) prominence disclosure for a severe accounting irregularity to avoid attracting

market attention. In this case, the less negative returns associated with less prominent

disclosure would constitute a ―reward for silence.‖ This scenario is consistent with limited

attention theory (Hirschleifer and Teoh 2003). 12

We evaluate the scenarios by first examining whether the return differences

associated with disclosure prominence decline over time as investors presumably learn more

about the accounting irregularity. As reported in Table 3, over the period +2 to +20, returns

change by 0.6%, -2.3%, and -1.6% across the three disclosure categories. As a result, over

the longer (-1, +20) window, the average return for the full restatement sample declines to -

6.7% (from -5.5%), and the spread in returns across the three disclosure categories is smaller

with mean returns of -7.9%, -6.4%, and -3.2%, respectively. Importantly, each return now

differs significantly from zero. This result, which is consistent with the delayed market

reaction to less transparent disclosure predicted by limited attention theory, indicates that

market participants are initially misled by the differences in press release format used to

announce restatements.

12

Research on managers‘ disclosure practices is ambiguous about how managers would disclose a

restatement. Ninety-one percent of the CFOs surveyed by Graham, Harvey and Rajgopal (2005) ―believe

that developing a reputation for transparent reporting is the key factor motivating voluntary disclosures.‖

To develop a reputation for transparency, managers may use prominence to signal restatement severity

(scenario 1) or disclose all accounting irregularities prominently (scenario 2). This second set of firms may

expect the long-term benefits of disclosure reputation to offset any short-term adverse effects from using

high prominence (e.g. headline) disclosure when the level of severity justifies medium or low prominence.

On the other hand, Gibbins, Richardson and Waterhouse (1990) find anecdotal evidence that firms manage

the visibility of their disclosure by burying sensitive information in verbiage. This strategy is consistent

with severe restatements being less prominently disclosed in a press release (scenario 2).

18

Correlations among Variables

Table 4 reports correlations for the variables used in the multivariate models. The

short window CAR, which is reported in the second column, is significantly associated with

three explanatory variables used in the return models: PROMINENCE INDEX, REVENUE,

and RULE CHANGE. Coefficient signs indicate that returns are lower for restatements with

greater press release prominence and for revenue restatements. Returns are higher for

restatements arising from an accounting rule change. Each of these associations is consistent

with our expectations. Two of the variables used only in the litigation model are

significantly correlated with CAR. First, LITIGATION is positively associated with CAR,

which is consistent with our rationale for using returns as a variable in the litigation model.

Second, SHARE TURNOVER and CAR are negatively associated. We do not include this

variable in the returns model because we have no a priori reason to expect share turnover to

be associated with returns around the restatement, and because this variable has not been

used to explain returns in prior research.

LITIGATION, which is reported in the third column of Table 4, is significantly

associated with seven explanatory variables: PROMINENCE INDEX, SEC, FRAUD, RULE

CHANGE, SHORT INTEREST, SHARE TURNOVER, and MKTCAP. The coefficient signs

indicate that litigation is positively associated with disclosure prominence, SEC involvement,

an allegation of fraud, the level of short interest, share turnover, and market capitalization.

Litigation is negatively associated with restatements arising from an accounting rule change.

A complete discussion of the litigation results is provided in Section V.

PROMINENCE INDEX, which is the primary explanatory variable of interest in both

the return and litigation models, is reported in the third column. A positive sign on the

19

correlation with RESTATEMENT AMT indicates that firms providing more prominent

disclosure of a restatement are more likely to disclose the dollar magnitude of the

misstatement. Negative correlations indicate that PROMINENCE INDEX tends to be lower

for restatements that arise from recognition of REVENUE or a RULE CHANGE, and for large

firms (MKTCAP). As discussed previously, PROMINENCE INDEX is also associated with a

lower CAR and more LITIGATION.

The indicator variable, RESTATEMENT AMT, is also correlated with several

variables. The associations show that an estimate of the dollar amount is less likely to be

provided for restatements due to REVENUE recognition or a RULE CHANGE, and for firms

with high SHORT INTEREST or SHARE TURNOVER. An amount is more likely to be

provided when the restatement involves a high COUNT of accounting issues.

The correlation coefficient signs for the remaining variables seem logical. And

multicollinearity is not likely to be a serious problem, due to the moderate size of the

correlations. (Note that no VIF in our model is greater than 2.0).


Multivariate Analysis

Abnormal Returns Surrounding Restatement Announcements

Table 5, Panel A reports regression results for a model of cumulative abnormal

returns over a three-day window centered on the restatement announcement. We report three

versions of the model in separate columns of the table. Column 1 provides a baseline result

by omitting the disclosure variables. We find the REVENUE coefficient is significantly

negative, which indicates that returns are more negative when revenue is not recognized in

accord with GAAP. The RULE CHANGE coefficient is significantly positive, so returns are

20

less negative when the restatement arises from a change in rules or a new interpretation of

existing accounting rules (rather than from a clear violation of GAAP). Among the general

control variables, the FINANCIAL coefficient is significantly positive, indicating that returns

are less negative for restatements by firms in the financial industry. The model in column 2

adds one variable, RESTATEMENT AMT, to the model but the coefficient on this variable is

insignificant, indicating that short-window returns are not affected by whether the press

release reports the dollar magnitude of the misstatement.

The model in column 3 adds the other disclosure variable, PROMINENCE INDEX, to

the variables in column 2. The PROMINENCE INDEX coefficient is negative and highly

significant, and the overall explanatory power of the model increases considerably (to 9.45%

from 6.43% in column 2). Press release format is thus a separate factor explaining

announcement date returns. The negative sign shows that after controlling for misstatement

severity and other factors, firms that disclose the restatement more (less) prominently in their

press release are penalized (rewarded) with a more (less) negative return. The coefficient of -

0.04 indicates that announcement day returns are reduced by about 4% for each level of the

prominence index (from high to medium to low prominence). Considering the economic

effect of the severity variables, returns are more negative by 5.9 percent when revenue is not

recognized in accord with GAAP. Returns are less negative by 3.0 percent when the SEC is

involved and less negative by 5.3 percent when the restatement arises from a change in rules

or a new interpretation of existing accounting rules (rather than from a clear violation of

GAAP). Among the general control variables, the FINANCIAL coefficient is significantly

positive, indicating that returns are less negative by 3.2 percent for restatements by firms in

the financial industry.

21


Table 5, Panel B reports results for a model with the same variables as in Panel A

when the return window is extended to 20 days after the restatement announcement. The

purpose is to determine whether the negative returns associated with press release

prominence in the three-day window reverse when investors have additional time to assess

the accounting irregularity. To facilitate comparisons to the short window results, the first

column of Panel B repeats the full regression (column 3) from Table 5, Panel A. The model

in the second column reports abnormal returns over a longer window that includes the

announcement day (-1, +20).13

The primary finding is that PROMINENCE INDEX is no

longer significantly associated with abnormal returns. Interestingly, RESTATEMENT AMT is

now significant, so returns are less negative over the longer window by an average of 3.8

percent when managers report the dollar magnitude of the restatement. The other three

significant variables are the same as in the short (-1, +1) window model.

To summarize, we find that PROMINENCE INDEX is significant in explaining short

(-1, +1) window returns but not returns over a longer (-1, +20) window. This result provides

additional evidence of a reward for silence at the announcement day, but suggests that much

of the reward dissipates within 20 days of the restatement announcement. Based on the

evidence presented, we reject hypothesis 1, which states that the prominence given to an

accounting restatement in the press release does not affect the magnitude of the market‘s

response.

Extensions and Robustness Tests

Restatement Amount

13

We also ran a similar regression over a window that omits the announcement day (+2, +20). The model

was not significant and therefore is not reported in Table 5.

22

In the analysis just presented, RESTATEMENT AMT is significant in explaining

longer (-1, +20) window returns. This variable appears to replace PROMINENCE INDEX,

which is significant in explaining the short (-1, +1) window returns. To better understand the

relation between these two variables, we provide a breakdown of market-adjusted returns by

whether or not an amount is reported and by the three categories of press release disclosure

(i.e., six cells). The returns in each cell are determined from multivariate models that include

the misstatement severity and control variables presented in Table 5. The models, which are

reported in Table 6, Panel A omit the prominence index and restatement amount variable,

and substitute a set of dummy variables to capture the interaction between the prominence

index and restatement amount. We then add the individual dummy variable coefficients to

the intercept to obtain returns for each of the six cells that are independent of the effect of the

misstatement severity and control variables.


Table 6, Panel B reports adjusted returns for the short window (-1, +1). Note that the

returns increase monotonically from the high prominence to the low prominence group,

consistent with the significantly negative PROMINENCE INDEX coefficient in the short-

window returns model. This is true whether or not the restatement amount is reported,

although the return differences among the three prominence categories are greater when the

restatement amount is not reported. The greatest price decline among the six cells is for

firms that provide high prominence disclosure but omit the amount of the restatement

(-8.9%). The data in Table 6, Panel B therefore provide additional support for the finding in

Table 5 that disclosure prominence is a separate factor in explaining the short window

returns.

23

We report similar information for the longer (-1, +20) window in Table 6, Panel C

and find that increased prominence is monotonically associated with lower returns only for

companies that do not report the restatement amount. Note that returns in Panel C are also

consistently lower for firms that do not report an amount than for firms that report an

amount. In addition, returns are substantially lower in the long window than in the short

window for firms that omit an amount. Specifically, the returns in the second row of Panel C

are lower than the corresponding second row returns in Panel B by 3.6%, -3.9%, and -3.9%

for the high, medium, and low prominence categories, respectively. These returns indicate

that after the initial price declines at the restatement announcement, investors further revise

prices downward for firms that omit the restatement amount from the press release. As a

result, the mean long window return of -12.5% for firms that provide high prominence

disclosure but do not report the amount of the restatement is even lower than the

corresponding short-window return of -8.9%. Most importantly, the data in Table 6, Panel C

show that disclosure prominence remains a separate factor in explaining long window returns

when the restatement amount is not reported.

Revenue Restatements

The descriptive statistics in Table 2, Panel C show that revenue restatements are the

most common type of accounting issue and the average prominence score for revenue

restatements is lower than the sample average. To determine whether the return results are

sensitive to revenue restatements, we rerun the return models omitting firms that restated

revenue. We find similar results to those reported for both the short and longer windows

(untabulated), and only one difference is noteworthy: With revenue restatements omitted,

SHORT INTEREST is negative and significant in explaining returns in both the short and

24

longer windows. Short sellers appear to be more successful in identifying non-revenue

accounting irregularities.

Share Turnover

The correlations reported in Table 4 show that SHARE TURNOVER is significantly

associated with short window CAR. We calculated this correlation because prior studies find

that SHARE TURNOVER is significantly associated with the likelihood of litigation. Recall

that we exclude this variable in the returns model because we do not have an a priori reason

to expect returns around the restatement to be associated with share turnover. As a

sensitivity test, we reran the returns models to include this variable. We find that the SHARE

TURNOVER coefficient is significantly negative and the financial industry coefficient is no

longer significant. The coefficients of the remaining variables are unchanged.

Restatement Initiator

Some prior studies of accounting restatements use the initiator field in the GAO

database (2003) to develop a measure of misstatement severity, and typically view

restatements initiated by an entity other than the company as more severe (Palmrose et al.

2004; Efendi et al. 2007). We rerun our return models with this variable and find that the

coefficient is insignificant.

Earnings Surprise

The announcement of an accounting irregularity often coincides with the release of

current earnings news. To ensure that our results are robust to controlling for earnings

surprise, we rerun our model on a reduced sample of firms that announce current period

earnings in the same three-day window as their restatement announcement. This occurs for

25

173 firms in our sample (45% of the sample), comprised of 11% of the high prominence

firms, 40% of the medium prominence firms, and 74% of the low prominence firms.

We calculate earnings surprise (SURPRISE) as the difference between actual

quarterly earnings per share and the most recent consensus analyst earnings forecast prior to

the earnings announcement (both reported by I/B/E/S) scaled by stock price measured just

before the forecast date. BEAT is a dummy variable used to indicate firms whose earnings

exceed analyst expectations, and is defined as 1 if SURPRISE >0 and 0 otherwise.

Requiring consensus analyst forecasts and stock price availability, plus deleting likely

outliers on the basis of news magnitude, reduces our sub-sample to 120 firms.

Table 7 shows the estimation results including SURPRISE and BEAT .14

In the short

window (-1, +1), earnings surprise is positively and significantly associated with abnormal

returns. The BEAT coefficient is also significant, indicating that firms that exceed analyst

expectations on average experience a 6% higher return than those that do not. As we would

expect, the addition of these variables increases the R2 dramatically: Using the same sub-

sample of firms, the R2 value jumps from 10.98% to almost 27% after controlling for

earnings surprise. More importantly, the PROMINENCE INDEX coefficient remains

negative and highly significant after we control for the earnings surprise and estimate the

model on a sample that is less than one-third of our original sample.

In the longer window (-1, +20), we find that the PROMINENCE INDEX coefficient is

statistically insignificant, consistent with our earlier finding that much of the short window

return penalty dissipates within 20 days after the restatement announcement. The only

notable difference from the full sample model is that RESTATEMENT AMT is insignificant.

14

No firms in this sub-sample mention allegations of fraud in their press releases, so we exclude FRAUD

from the model specification in Table 7.

26

As a further robustness check, we also add the earnings surprise controls to a model

utilizing our full sample of restatement firms (refer to Table 5, column 3), as opposed to the

sub-sample discussed above. Firms not announcing earnings are given a value of zero for

both SURPRISE and BEAT. Our findings do not change—PROMINENCE INDEX remains

highly significant and all other variables are of the same sign and significance as Table 5,

with the exception of SEC, which is no longer a statistically significant predictor of abnormal

returns (results untabulated).

In summary, analyses that control for the releases of earnings again demonstrates that

returns around the restatement announcement are negatively associated with disclosure

prominence, but the role of prominence in explaining returns is reduced in the twenty days

after the announcement. Next, we consider if firms announcing restatements more

prominently face an increased likelihood of lawsuits.


VI. LITIGATION RESULTS

Table 8 reports on the frequency of class action lawsuits arising from accounting

restatements. Of the 381 companies in our sample, 73 (19 %) are served with a class action

lawsuit. The litigation rate increases monotonically across the three categories of disclosure

prominence. The rate is 27% (42 of 157) for firms providing high prominence disclosure,

16% (31 of 189) for firms providing medium prominence disclosure, and 0% for the 35 firms

providing low prominence disclosure. A chi-square test of association shows that lawsuit

incidence is significantly associated with disclosure prominence (at the 0.001 level). This

test complements the earlier finding that PROMINENCE INDEX and LITIGATION have a

significant positive correlation of 0.19 (see Table 4).

27


The correlations in Table 4 show that several other factors are significantly associated

with LITIGATION: SEC, FRAUD, SHORT INTEREST, CONCURRENT RETURN (-1, +1),

RULE CHANGE, SHARE TURNOVER, and MKTCAP. We therefore use a logit model to

estimate litigation likelihood with disclosure prominence as an explanatory variable, along

with controls for other potential determinants of litigation likelihood. We report estimation

results in Table 9. The explanatory variables are grouped into three categories: disclosure

variables, misstatement severity variables, and control variables. We find that the

PROMINENCE INDEX coefficient is positive and highly significant (at the 0.009 level). The

odds ratio of 2.3 indicates that a change of one category in the PROMINENCE INDEX more

than doubles the odds of having a lawsuit. This evidence therefore indicates that disclosure

prominence is penalized with an increased likelihood of litigation.


The significance of the misstatement severity variables is also of interest.15

We find

that all five of the severity variables that have significant pair-wise correlations with the

litigation variable (as shown in Table 4) are significant in the logistic regression model on

Table 9 (specifically, SEC, FRAUD, SHORT INTEREST, CONCURRENT RETURN (-1, +1),

and RULE CHANGE). One additional variable, COUNT, is significantly positively

associated with litigation likelihood. Of those variables, the influence of FRAUD is striking.

Its odds ratio of 20.799 indicates that firms that cite fraud as a cause of the restatement are

over 20 times more likely to face litigation than other firms. The likelihood of litigation also

increases with an SEC inquiry, the level of short interest, and the count of accounting issues.

15

To the best of our knowledge, no published study provides this information for the GAO (2003) sample

of restatements. These restatements are particularly important because they influenced passage of the

Sarbanes-Oxley Action of 2002.

28

Litigation likelihood declines for restatements attributed to an accounting rule change and

with greater announcement-period returns. Results for the general control variables indicate

that litigation likelihood increases with share turnover in the prior year and market

capitalization, but declines with greater returns in the prior year.

Dismissed Lawsuits

During the discovery phase of litigation, extensive information about the nature of the

accounting irregularity is revealed. Dismissal rates therefore provide another indicator of

restatement severity. If greater prominence indicates a more severe accounting irregularity,

we would expect fewer dismissals for restatements disclosed with high prominence. To

determine which lawsuits are dismissed, we used the Stanford Securities Class Action

Clearinghouse website at the end of 2006 to review the status of each of the court cases.

Table 10, Panel A reports that almost a quarter of the class action suits are dismissed, but the

rate of dismissal is almost identical for high (24%) and medium prominence (23%)

disclosures. These dismissal rates suggest that some severe accounting irregularities have

been disclosed with medium prominence or some less severe misstatements have been

disclosed with high prominence. (Note that the negative post-announcement drift in returns

for medium prominence disclosure, reported in Table 3, supports the former explanation.)


To provide direct evidence about the effect of dismissals on the likelihood of

litigation, we reran the logistic regression model with a reduced sample that omits dismissed

lawsuits. The results are reported on Table 10, Panel B. We find that PROMINENCE

INDEX remains significant (although the significance level drops from 0.009 to 0.036 and

the odds ratio declines from 2.292 to 2.071). The results for the misstatement severity

29

variables are similar to those reported on Table 9, except that COUNT is no longer

significant. Among the general control variables, MKTCAP loses its significance while the

FINANCIAL industry indicator variable is now significant.

Based on the litigation analyses presented above, we reject hypothesis 2, which states

that the extent of prominence given to an accounting restatement in the press release does not

affect the likelihood of class action litigation. Instead, we conclude that companies that

provide less prominent press release disclosure are rewarded with a lower likelihood of

litigation. We find this result is robust to the treatment of dismissed lawsuits, so in contrast

to the return differences, the reward is permanent.

Robustness Tests

Because the average prominence score for revenue restatements is low compared to

the sample average (see Table 2, Panel C), we rerun the litigation model to determine if the

litigation results are robust to the exclusion of those firms. We find results very similar to

those reported (untabulated).

Some prior studies of accounting restatements use information on the initiating entity

(i.e., the restating firm, the auditor, or the SEC) as a measure of severity (Palmrose et al.

2004; Efendi et al. 2007). To our knowledge, prior literature has not yet examined the

relationship between restatement initiator and the likelihood of litigation. We find that the

coefficient on this variable is negative and significant when we include it in the litigation

regression. Coefficient signs and significance levels are unchanged for the other variables.

Thus our results indicate that restatements initiated by an external party are less likely to

result in litigation than those initiated by the firm.

30

VII. CONCLUSION

We investigate the effect on market prices and litigation of the extent of prominence

given to a restatement in the press release making the announcement. We find that firms

providing less prominent press release disclosure of a restatement are rewarded with a less

negative return at the announcement, but much of this reward dissipates over the next 20

days. We also find that companies providing less prominent disclosure are less likely to be

sued for securities fraud, and the decrease in litigation is a permanent reward. In sum, both

return and litigation tests indicate that ―silence can be golden.‖

We contribute to the disclosure literature by extending the notion of a penalty

(reward) for openness (silence) in corporate disclosure into a new arena: press release

prominence. Prior research focuses on managers‘ decision whether to issue a press release

warning of an earnings shortfall. Press release format constitutes a promising avenue for

future research because press releases are the primary disclosure medium used to convey

information to the market on a timely basis -- especially since Reg. FD now restricts selective

communications. The findings in this study are important to investor relations executives

and other corporate managers with responsibility for press release disclosure. Regulators,

especially the SEC, may want to issue guidelines to standardize press release disclosures so

firms will not be rewarded for providing less prominent disclosure of an accounting

restatement.

31

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34

TABLE 1

Sample Selection

Number of

Observations

Restatement firms in General Accounting Office studya 919

Less: firms without short selling informationb (452)

Less: firms without press release information available (61)

Less: firms without CRSP data (17)

Less: possible outliersc (8)

Final Sample 381

a The General Accounting Office (GAO 2002) prepared a report for the U.S. Senate

Committee on Banking, Housing and Urban Affairs, chaired by Senator Sarbanes.

This report identifies 919 firm restatements from January 1, 1997 to June 30, 2002 that

correct ―accounting irregularities.‖ (See text for further description.) b Short selling information is taken from a proprietary database which contains short

interest for firms listed on the NYSE, AMEX, and Nasdaq. Most of the companies

deleted are small and trade in the over-the-counter (OTC) market. c Observations whose abnormal returns around the restatement date fall in the top or

bottom 1% of the distribution are deleted as possible outliers.

35

TABLE 2

Sample Description

Panel A: Distribution of Restatement Firms by Industry

SIC

Industry Description

Sample

Firms

Sample

Percentage

Compustat

Percentagea

10 Metal Mining 1 0.26 1.32%

13 Oil and gas extraction 5 1.31 3.76%

15 General building contractors 2 0.52 0.54%

16 Heavy construction other than building

construction contractors

3 0.79 0.23%

20 Food and kindred products 10 2.62 1.74%

23 Apparel and other textile products 4 1.05 0.74%

24 Lumber and wood products 2 0.52 0.39%

25 Furniture and fixtures 2 0.52 0.42%

26 Paper and allied products 4 1.05 0.74%

27 Printing, publishing and allied industries 4 1.05 1.09%

28 Chemicals and allied products 22 5.77 5.69%

29 Petroleum refining and related industries 2 0.52 0.47%

30 Rubber and misc. plastics products 4 1.05 0.98%

32 Stone, clay, glass and concrete products 2 0.52 0.56%

33 Primary metal industries 2 0.52 1.02%

34 Fabricated metal products; except machinery

and transport equip.

3 0.79 1.18%

35 Industrial and commercial machinery and

computer equipment

33 8.66 4.89%

36 Electronic and other electrical components;

except computer equip.

33 8.66 5.58%

37 Transportation equipment 6 1.57 1.54%

38 Measuring, analyzing and controlling

instruments

26 6.82 4.77%

39 Misc. manufacturing industries 2 0.52 0.99%

42 Motor freight transportation and warehousing 2 0.52 0.58%

44 Water transportation 1 0.26 0.40%

47 Transportation services 1 0.26 0.34%

48 Communications 6 1.57 3.98%

49 Electric, gas and sanitary services 12 3.15 2.99%

50 Wholesale trade-durable goods 8 2.10 2.22%

51 Wholesale trade-non-durable goods 4 1.05 1.37%

52 Building materials, garden supply and mobile 1 0.26 0.20%

53 General merchandise stores 5 1.31 0.48%

54 Food stores 3 0.79 0.60%

55 Automotive dealers and service stations 1 0.26 0.29%

56 Apparel and accessory stores 10 2.62 0.54%

57 Home furniture, furnishings and equipment

stores

7 1.84 0.47%

58 Eating and drinking places 2 0.52 1.35%

59 Misc. retail 5 1.31 1.71%

60 Depository institutions 29 7.61 8.53%

36

61 Non depository credit institutions 1 0.26 1.45%

62 Security, commodity brokers and services 3 0.79 1.03%

63 Insurance carriers 11 2.89 2.12%

65 Real estate 2 0.52 1.19%

67 Holding and other investment offices 10 2.62 6.97%

73 Business services 59 15.49 11.01%

78 Motion pictures 1 0.26 0.93%

79 Amusement and recreation services 3 0.79 1.06%

80 Health services 6 1.57 1.67%

82 Educational services 4 1.05 0.29%

87 Engineering and management services 4 1.05 1.80%

99 Unclassified establishments 8 2.10 1.35%

381 100% 100%

Panel B: Distribution of Announcement Dates

Time Period Number of Firms Percentage of Sample

Calendar 1997 24 6.3%

Calendar 1998 20 5.3%

Calendar 1999 75 19.7%

Calendar 2000 87 22.8%

Calendar 2001 117 30.7%

To June 30, 2002 58 15.2%

Panel C: Cross Tabulation of Accounting Issue by Press Release Prominence

Coded as

High

Prominence

(3)

Medium

Prominence

(2)

Low

Prominence

(1)

Frequencyb

Average

Prominence

Scorec

Revenue 52 81 25 158 2.17

Cost or expense 28 42 3 73 2.34

Restructuring, assets or

inventory 26 24 3

53

2.43

Other 17 13 2 32 2.47

Acquisitions and

mergers 14 13 1 28 2.46

Securities related 12 12 0 24 2.50

IPR&D 4 15 2 21 2.10

Reclassification 8 10 1 19 2.37

Related-party

transactions 6 7 0 13 2.46

Unspecified 6 3 0 9 2.67

Loan-loss 6 1 0 7 2.86

Tax related 2 3 0 5 2.40

Total Obs. 181 224 37 442 2.33

a

Based on Compustat companies in 2000.

b Each restatement can be caused by one or more accounting issues. Therefore, the total number of accounting issues

(442) is greater than the number of firms in our sample (381). c Disclosure emphasis is coded as 3 (high prominence) for any press release that mentions the earnings restatement

in the headline. Disclosure quality is coded 2 (medium prominence) for press releases that do not mention the

37

restatement in the headline, but that discuss the restatement in some detail within the body of the report. A code of 1

(low prominence) is assigned to press releases that only mention the restatement in the footnotes of the report.

Average Prominence Score = [(# High Prominence)*(3) + (# Medium Prominence)*(2) +

(# Low Prominence)*(1)] / # Total

38

TABLE 3

Mean Abnormal Returns Around the Restatement Announcement for the Full

Sample and by Restatement Disclosure Prominencea

Event

Window

Full

Sample

High

Prominence

(3)

Medium

Prominence

(2)

Low

Prominence

(1)

Differenceb

(2-3)

Difference

(1-2)

Difference

(1-3)

(-1, +1) -5.5%*** -8.3%*** -4.0%*** -1.5% 4.3%*** 2.4% 6.8%***

(+2, +20) -1.1% 0.6% -2.3%* -1.6% -2.9% 0.7% -2.2%

Entire Event

Window:

(-1, +20)

-6.7%***

-7.9%***

-6.4%***

-3.2%*

1.5%

3.2%

4.7%**

Number of

Obs.

381

157

189

35

*** Significantly greater than zero at the p = 0.01 level or better (two-tailed).

** Significantly greater than zero at the p = 0.05 level or better (two-tailed).

* Significantly greater than zero at the p = 0.10 level or better (two-tailed).

a CAR = cumulative abnormal return, calculated as the raw stock return minus the CRSP equally-weighted market portfolio

return measured over the windows specified above, with day 0 indicating the restatement announcement. Firms in the ‗High

Prominence,‘ ‗Medium Prominence,‘ and ‗Low Prominence‘ categories are coded as 3, 2, and 1, respectively.

b t-test of the differences between the two groups noted (for example, High Prominence vs. Medium Prominence), where

*, **, or *** indicates that the two groups had significantly different abnormal returns during the event window at the 0.10,

0.05, 0.01 alpha level, respectively.

39

TABLE 4

Pearson Correlation Table

Variable

CAR

Litigation

Prominence

Index

Restatement

Amt

SEC

Fraud

Revenue

Rule

change

Count

Short

Interest

Share

Turnover

LITIGATION -0.34

PROMINENCE INDEX -0.19 0.19

RESTATEMENT AMT -0.05 0.02 0.32

SEC 0.05 0.12 0.09 0.07

FRAUD 0.00 0.12 0.05 0.00 -0.04

REVENUE -0.16 0.08 -0.20 -0.14 -0.10 -0.05

RULE CHANGE 0.17 -0.20 -0.36 -0.27 -0.14 -0.06 0.31

COUNT -0.05 0.09 0.02 0.10 0.00 0.07 0.07 -0.14

SHORT INTEREST -0.05 0.24 -0.06 -0.10 0.06 -0.05 0.13 -0.00 -0.03

SHARE TURNOVER -0.18 0.30 -0.05 -0.11 0.06 -0.11 0.23 0.00 -0.05 0.44

MKTCAP -0.04 0.12 -0.17 -0.08 0.10 -0.00 0.09 0.04 -0.06 0.19 0.28

40

Bold values are significant at the 0.05 level.

Variable Definitions: CAR = cumulative abnormal return, calculated as the raw stock return minus the CRSP equally-weighted market portfolio return measured over the

three-day window (-1,+1) with day 0 indicating the restatement announcement ; LITIGATION = 1 if a class action lawsuit was filed against the firm as a response to the

restatement of their financial statements and 0 otherwise; PROMINENCE INDEX takes on the value of either 1, 2, or 3. Disclosure emphasis is coded as 3 (high

prominence) for any press release that mentions the earnings restatement in the headline. Disclosure quality is coded 2 (medium prominence) for press releases that do not

mention the restatement in the headline, but that discuss the restatement in some detail within the body of the report. A code of 1 (low prominence) is assigned to press

releases that only mention the restatement in the footnotes of the report. RESTATEMENT AMT = 1 if the press release includes information on the amount of the

restatement and 0 otherwise; SEC = 1 if the press release indicates an SEC inquiry and 0 otherwise; FRAUD = 1 if the press release mentions an allegation of fraud and 0

otherwise; REVENUE = 1 if any part of the restatement is due to revenue recognition problems and 0 otherwise; RULE CHANGE = 1 if a change in accounting rules was

mentioned in the press release as the reason for the restatement and 0 otherwise; COUNT = the number of different accounting issues, as reported in the GAO database;

SHORT INTEREST = the percent of short interest [100 * (number of shares sold short)/(total shares outstanding)] as of the month prior to the restatement announcement;

SHARE TURNOVER = [1-Π(1-volume tradedt/total sharest)], accumulated over the 1-year period ending on the second day prior to the restatement announcement date;

MKTCAP = market capitalization (closing stock price * common shares outstanding) measured as of the end of the fiscal year prior to t.

41

TABLE 5

Multivariate Analysis of Abnormal Returns around Restatement Announcement

Panel A: Model with Short CAR Window (-1,+1)

CAR = α + β1PROMINENCE INDEX+ β2RESTATEMENT AMT + β3SEC + β4FRAUD + β5REVENUE +

β6RULE CHANGE + β7COUNT + β8SHORT INTEREST + β9MKTCAP + β10TECH + β11FINANCIAL + ε

OLS Regression Coefficients (p-value in parentheses)

Variablea Predictions (1) (2) (3)

Intercept ? -0.043 -0.037 0.065

(0.147) (0.237) (0.122)

Press Release

PROMINENCE INDEX ? -0.040

(<0.001)

RESTATEMENT AMT ( + ) -0.009 0.004

(0.260) (0.390)

Misstatement Severity

SEC ( + ) 0.026 0.027 0.030

(0.112) (0.106) (0.075)

FRAUD ( - ) -0.002 -0.003 0.002

(0.487) (0.481) (0.485)

REVENUE ( - ) -0.056 -0.056 -0.059

(<0.001) (<0.001) (<0.001)

RULE CHANGE ( + ) 0.072 0.069 0.053

(<0.001) (<0.001) (0.001)

COUNT ( - ) -0.002 -0.002 -0.004

(0.440) (0.454) (0.406)

SHORT INTEREST ( - ) -0.001 -0.001 -0.001

(0.311) (0.583) (0.274)

Controls

MKTCAP ? -0.001 -0.002 -0.003

(0.678) (0.653) (0.331)

TECH ( - ) -0.004 -0.005 -0.005

(0.397) (0.385) (0.382)

FINANCIAL ( + ) 0.026 0.026 0.032

(0.084) (0.085) (0.044)

n 358 b 358

b 358

b

Adjusted R2 6.58% 6.43% 9.45%

42

Panel B: Model Comparing Short (-1, +1) and Long (-1, +20) Window Returns

CAR = α + β1PROMINENCE INDEX+ β2RESTATEMENT AMT + β3SEC + β4FRAUD + β5REVENUE +

β6RULE CHANGE + β7COUNT + β8SHORT INTEREST + β9MKTCAP + β10TECH + β11FINANCIAL + ε


Variablea Predictions CAR = (-1,+1) CAR = (-1,+20)

Intercept ? 0.065 0.009

(0.122) (0.897)

Press Release

PROMINENCE INDEX ? -0.040 -0.031

(0.000) (0.112)

RESTATEMENT AMT ( + ) 0.004 0.038

(0.390) (0.057)


SEC ( + ) 0.030 -0.010

(0.075) (0.389)

FRAUD ( - ) 0.002 0.055

(0.485) (0.280)

REVENUE ( - ) -0.059 -0.040

(<0.001) (0.047)

RULE CHANGE ( + ) 0.053 0.052

(0.001) (0.039)

COUNT ( - ) -0.004 -0.011

(0.406) (0.349)

SHORT INTEREST ( - ) -0.001 -0.001

(0.274) (0.346)

Controls

MKTCAP ? -0.003 -0.002

(0.331) (0.737)

TECH ( - ) -0.005 -0.012

(0.382) (0.327)

FINANCIAL ( + ) 0.032 0.052

(0.044) (0.056)

n 358 b 353

c

Adjusted R2 9.45% 1.15%

43

The p-values are in parentheses under the regression coefficients. Two-tailed tests are shown for variables without a

signed prediction; one-tailed tests are shown for variables with a signed prediction.

a Variable Definitions: CAR = cumulative abnormal return, calculated as the raw stock return minus the CRSP

equally-weighted market portfolio return measured over various windows [either (-1,+1), (+2, +20), or (-1, +20)] with

day 0 indicating the restatement announcement; PROMINENCE INDEX takes on the value of either 1, 2, or 3.

Disclosure emphasis is coded as 3 (high prominence) for any press release that mentions the earnings restatement in

the headline. Disclosure quality is coded 2 (medium prominence) for press releases that do not mention the

restatement in the headline, but that discuss the restatement in some detail within the body of the report. A code of 1

(low prominence) is assigned to press releases that only mention the restatement in the footnotes of the report;

RESTATEMENT AMT = 1 if the press release includes information on the amount of the restatement and 0 otherwise;

SEC = 1 if the press release indicates an SEC inquiry and 0 otherwise; FRAUD = 1 if the press release mentions an

allegation of fraud and 0 otherwise; REVENUE = 1 if any part of the restatement is due to revenue recognition

problems and 0 otherwise; RULE CHANGE = 1 if a change in accounting rules was mentioned in the press release as

the reason for the restatement and 0 otherwise; COUNT = the number of different accounting issues, as reported in the

GAO database; SHORT INTEREST = the percent of short interest [100*(number of shares sold short)/(total shares

outstanding)] as of the month prior to the restatement announcement; MKTCAP = natural log of market capitalization

(closing stock price * common shares outstanding) of the firm measured as of the end of the fiscal year prior to t;

TECH = 1 if the firm is classified as a technology firm and 0 otherwise; FINANCIAL= 1 if the firm operates in the

financial services sector (SIC codes 6000-6999) and 0 otherwise.

b 23 firms were excluded from the regression due to missing market capitalization information.

c 5 additional firms are excluded from the (-1,+20) regression due to missing abnormal return data. Both regressions

were also run using a common sample of 353 firms for which all data are available. The results are qualitatively

unchanged from those reported in the table.

44

TABLE 6

Extension of Main Analysis to Replace Prominence Index with Indicator Variables

Panel A: Multivariate Model

CAR = α + β1HIGH_NOAMT + β2MEDIUM_AMT + β3MEDIUM_NOAMT + β4LOW_AMT +

β5LOW_NOAMT + β6-14 [CONTROLS] + ε

OLS Regression Coefficients

(p-value in parentheses)

Variablea Predictions CAR = (-1,+1) CAR = (-1,+20)

Intercept ? -0.046 -0.037

(0.124) (0.474)

Disclosure Variable Interactions Compared to

Baseline Group of High Prominence with Amount

High Prominence without Restatement Amount ? -0.043 -0.088

(0.064) (0.026)

Medium Prominence with Amount Reported ? 0.020 -0.001

(0.237) (0.981)

Medium Prominence without Restatement

Amount ? 0.041 -0.007

(0.025) (0.823)

Low Prominence with Amount Reported ? 0.066 0.055

(0.194) (0.533)

Low Prominence without Restatement Amount ? 0.067 0.019

(0.017) (0.690)

Misstatement Severity and Controls

Omitted for space—Sign and significance for all

variables are the same as in Table 5.

n 358 b 353

c

Adj. R2 9.88% 1.06%

Panel B: Short-window CAR – Multivariate Coefficient Sums

High Prominence Medium Prominence Low Prominence

Obs. CAR (-1,+1) Obs. CAR (-1,+1) Obs. CAR (-1,+1)

Restatement

Amt

Disclosed?

YES 109 -4.6% 92 -2.6% 6 2.0%

NO 37 -8.9%** 86 -0.5% 28 2.1%

Panel C: Long-window CAR – Multivariate Coefficient Sums

High Prominence Medium Prominence Low Prominence

Obs. CAR (-1,+20) Obs. CAR (-1,+20) Obs. CAR (-1,+20)

Restatement

Amt

Disclosed?

YES 107 -3.7% 92 -3.8% 6 1.8%

NO 37 -12.5%** 83 -4.4% 28 -1.8%

45

The p-values are in parentheses under the regression coefficients. Two-tailed tests are shown for variables without

a signed prediction; one-tailed tests are shown for variables with a signed prediction.

*** Significantly greater than zero at the p = 0.01 level or better (two-tailed).

** Significantly greater than zero at the p = 0.05 level or better (two-tailed).

* Significantly greater than zero at the p = 0.10 level or better (two-tailed).


equally-weighted market portfolio return measured over various windows [either (-1,+1) or (-1, +20)] with day 0

indicating the restatement announcement; Disclosure emphasis is coded as 3 (high prominence) for any press

release that mentions the earnings restatement in the headline. Disclosure quality is coded 2 (medium prominence)

for press releases that do not mention the restatement in the headline, but that discuss the restatement in some detail

within the body of the report. A code of 1 (low prominence) is assigned to press releases that only mention the

restatement in the footnotes of the report; RESTATEMENT AMT = 1 if the press release includes information on the

amount of the restatement and 0 otherwise; HIGH_NOAMT, MEDIUM_AMT, MEDIUM_NOAMT, LOW_AMT, and

LOW_NOAMT are a series of dummy variables set equal to 1if both statements are true. For example,

HIGH_NOAMT equals one if the restatement had high prominence within the press release and the press release did

not include information on the amount of the restatement.

b 23 firms were excluded from the regression due to missing market capitalization information.

c 5 additional firms were excluded from the regression due to missing abnormal return data

46

TABLE 7

Abnormal Returns around Restatement Announcement with Controls for Earnings Surprise

CAR = α + β1PROMINENCE INDEX+ β2RESTATEMENT AMT + β3SEC + β4REVENUE + β5RULE

CHANGE + β6COUNT + β7SHORT INTEREST + β8MKTCAP + β9TECH + β10FINANCIAL +

β11SURPRISE + β12BEAT + ε


Variablea Predictions CAR = (-1,+1) CAR = (-1, +20)

Intercept ? 0.020 0.083

(0.822) (0.560)

Disclosure Variables

PROMINENCE INDEX ? -0.055 -0.023

(0.007) (0.468)

RESTATEMENT AMT ( + ) 0.005 0.019

(0.424) (0.323)


SEC ( + ) 0.054 0.007

(0.082) (0.227)

REVENUE ( - ) -0.070 -0.035

(0.002) (0.178)

RULE CHANGE ( + ) 0.046 0.014

(0.039) (0.368)

COUNT ( - ) 0.016 -0.039

(0.335) (0.260)

SHORT INTEREST ( - ) -0.001 -0.002

(0.389) (0.328)

Controls

MKTCAP ? 0.001 -0.011

(0.457) (0.321)

TECH ( - ) -0.007 -0.080

(0.385) (0.022)

FINANCIAL ( + ) 0.100 0.060

(0.011) (0.193)

SURPRISE ? 4.184 3.714

(0.037) (0.244)

BEAT ? 0.060 0.077

(0.032) (0.089)

n 113b 111

c

Adjusted R2 26.65% 5.21%

47

The p-values are in parentheses under the regression coefficients. Two-tailed tests are shown for variables

without a signed prediction; one-tailed tests are shown for variables with a signed prediction.


equally-weighted market portfolio return measured over various windows [either (-1,+1) or (-1, +20)] with day

0 indicating the restatement announcement; PROMINENCE INDEX takes on the value of either 1, 2, or 3.

Disclosure emphasis is coded as 3 (high prominence) for any press release that mentions the earnings

restatement in the title. Disclosure quality is coded 2 (medium prominence) for press releases that do not

mention the restatement in the title, but that discuss the restatement in some detail within the body of the

report. A code of 1 (low prominence) is assigned to press releases that only mention the restatement in the

footnotes of the report; RESTATEMENT AMT = 1 if the press release includes information on the amount of

the restatement and 0 otherwise; SEC = 1 if the press release indicates an SEC inquiry and 0 otherwise;

REVENUE = 1 if any part of the restatement is due to revenue recognition problems and 0 otherwise; RULE

CHANGE = 1 if a change in accounting rules was mentioned in the press release as the reason for the

restatement and 0 otherwise; COUNT = the number of different accounting issues, as reported in the GAO

database; SHORT INTEREST = the percent of short interest [100*(number of shares sold short)/(total shares

outstanding)] as of the month prior to the restatement announcement; MKTCAP = natural log of market

capitalization (closing stock price * common shares outstanding) of the firm measured as of the end of the

fiscal year prior to t; TECH = 1 if the firm is classified as a technology firm and 0 otherwise; FINANCIAL= 1

if the firm operates in the financial services sector (SIC codes 6000-6999) and 0 otherwise; SURPRISE =

difference between actual quarterly earnings per share and the most recent consensus analyst earnings forecast

prior to the earnings announcement, both reported by I/B/E/S, scaled by stock price measured just prior to the

date of the forecast; BEAT = 1 if the firm beat analyst expectations (i.e. Surprise >0) and 0 otherwise.

b This sample includes only those firms who announced earnings and a restatement during the same three-day

window. Additional observations were deleted due to missing analyst or stock price information and likely

outliers were deleted on the basis of news magnitude. 7 firms were excluded from the regression due to

missing market capitalization information.

c 2 additional firms are excluded from the (-1,+20) regression due to missing abnormal return data.

48

TABLE 8

Distribution of Class Action Lawsuits by Disclosure Prominence

High

Prominence

Medium

Prominence

Low

Prominence Total

Class Action Lawsuit Filed 42 31 0 73

No Class Action Lawsuit Filed 115 158 35 308

Total 157 189 35 381

Percentage of Observations

with Litigation 27% 16% 0% 19%

Chi-square (difference in lawsuit

initiation among prominence

levels)

15.065

(p = 0.001)

Litigation information is from the Securities Class Action Clearinghouse website.

49

TABLE 9

Likelihood of Class Action Lawsuits following an Accounting Irregularity

LITIGATION = α + β1PROMINENCE INDEX + β2RESTATEMENT AMT + β3SEC + β4FRAUD +

β5REVENUE + β6RULE CHANGE + β7COUNT+ β8SHORT INTEREST + β9CONCURRENT RETURN

+ β10PRIOR STOCK RETURN + β11POST STOCK RETURN + β12SHARE TURNOVER +

β13MKTCAP + β14TECH + β15FINANCIAL+ ε

Logit Regression with Dependent Variable = LITIGATION

Variablea

Predictions

Coefficient

Estimates

Chi-square

p-value*

Odds Ratio

Intercept ? -8.427 <0.001

Press Release

PROMINENCE INDEX ? 0.830 0.009 2.292

RESTATEMENT AMT ? 0.048 0.898 1.049


SEC ( + ) 0.978 0.017 2.660

FRAUD ( + ) 3.035 0.003 20.799

REVENUE ( + ) 0.196 0.303 1.217

RULE CHANGE ( - ) -1.19 0.026 0.304

COUNT ( + ) 0.556 0.075 1.744

SHORT INTERST ( + ) 0.062 0.041 1.064

CONCURRENT RETURN (-1,+1) ( - ) -4.890 <0.001 0.008

General Controls

PRIOR STOCK RETURN (-252,-2) ? -0.487 0.023 0.615

POST STOCK RETURN (+2,+20) ( - ) 0.257 0. 378 1.293

SHARE TURNOVER ( + ) 3.402 <0.001 30.022

MKTCAP ? 0.161 0.082 1.175

TECH ( + ) 0.097 0.404 1.102

FINANCIAL ? 0.649 0.267 1.914

n 347 b

- 2 log likelihood 229.93

Model Chi-square 110.60

p-value <0.001

Pseudo R-square 28%

Correctly Classified

[baseline of no litigation is 81%] 87.4%

50

* Two-tailed tests are shown for variables without a signed prediction; one-tailed tests are shown for variables

with a signed prediction.

a Variable Definitions: LITIGATION = 1 if a class action lawsuit was filed against the firm as a response to the

restatement of their financial statements and 0 otherwise; PROMINENCE INDEX takes on the value of either 1,

2, or 3. Disclosure emphasis is coded as 3 (high prominence) for any press release that mentions the earnings

restatement in the headline. Disclosure quality is coded 2 (medium prominence) for press releases that do not

mention the restatement in the headline, but that discuss the restatement in some detail within the body of the

report. A code of 1 (low prominence) is assigned to press releases that only mention the restatement in the

footnotes of the report; RESTATEMENT AMT = 1 if the press release includes information on the amount of the

restatement and 0 otherwise; SEC = 1 if the press release indicates an SEC inquiry and 0 otherwise; FRAUD =

1 if the press release mentions an allegation of fraud and 0 otherwise; REVENUE = 1 if any part of the

restatement is due to revenue recognition problems and 0 otherwise; RULE CHANGE = 1 if a change in

accounting rules was mentioned in the press release as the reason for the restatement and 0 otherwise; COUNT

is the number of different accounting issues, as reported in the GAO database; SHORT INTEREST is the percent

of short interest [100*(number of shares sold short)/(total shares outstanding)] as of the month prior to the

restatement announcement; CONCURRENT RETURN is the compounded raw return over the (+1, -1) interval

with 0 being the date of the restatement announcement; PRIOR STOCK RETURN is the compounded raw returns

over one year, ending on the second day before the restatement announcement (-252, -2); POST STOCK

RETURN is the compounded raw return over the (+2, +20) interval with day 0 being the date of the restatement

announcement; SHARE TURNOVER = [1-Π(1-volume tradedt/total sharest)], accumulated over the 1-year period

ending on the second day prior to the restatement announcement date; MKTCAP = natural log of market

capitalization (closing stock price * common shares outstanding) of the firm measured as of the end of the fiscal

year prior to t; TECH = 1 if the firm is classified as a technology firm and 0 otherwise; FINANCIAL = 1 if the

firm operates in the financial services sector (SIC codes 6000-6999) and 0 otherwise.

b 23 firms were excluded from the regression due to missing market capitalization information and 11

observations were excluded due to missing PRIOR STOCK RETURN and POST STOCK RETURN data.

51

TABLE 10

Likelihood of Surviving (non-Dismissed) Class Action Lawsuits following an Accounting

Irregularity

Panel A: Distribution of Dismissed Lawsuitsa

High

Prominence

Medium

Prominence

Low

Prominence Total

Dismissed Lawsuits 10 7 0 17

Surviving Lawsuits 32 24 0 56

Total 42 31 0 73

Dismissal Rate 24% 23% 0% 23%

Chi-square (difference in dismissal

rates among prominence levels)

0.032

(p = 0.858)

52

Panel B: Multivariate Tests Excluding Dismissed Lawsuits

Logit Regression with Dependent Variable = LITIGATION

Variableb

Predictions

Coefficient

Estimates

Chi-square

p-value*

Odds Ratio

Intercept -8.475 <0.001

Press Release

PROMINENCE INDEX ? 0.728 0.036 2.071

RESTATEMENT AMT ? -0.061 0.880 0.941


SEC ( + ) 0.893 0.040 2.441

FRAUD ( + ) 2.700 0.015 14.886

REVENUE ( + ) 0.271 0.260 1.311

RULE CHANGE ( - ) -1.359 0.025 0.257

COUNT ( + ) 0.378 0.198 1.459

SHORT INTEREST ( + ) 0.066 0.042 1.069

CONCURRENT RETURN (-1,+1) ( - ) -4.713 <0.001 0.009

Controls

PRIOR STOCK RETURN (-252 -2) ? -0.612 0.012 0.542

POST STOCK RETURN (+2,+20) ( - ) 0.564 0.281 1.757

SHARE TURNOVER ( + ) 3.659 <0.001 38.805

MKTCAP ? 0.153 0.138 1.166

TECH ( + ) 0.331 0.227 1.393

FINANCIAL ? 1.164 0.061 3.202

n 332 c

- 2 log likelihood 288.20

Model Chi-square 95.91

p-value <0.001

Pseudo R-square 25%

Correctly Classified

[baseline (no litigation) is 81%] 88.3%

53

* Two-tailed tests are shown for variables without a signed prediction; one-tailed tests are shown for variables

with a signed prediction.

a Dismissed lawsuits are identified by reading about the court cases for each of our litigation firms (available

on the Stanford Securities Class Action Clearinghouse website).

b Variable Definitions: LITIGATION = 1 if a class action lawsuit was filed against the firm as a response to the

restatement of their financial statements and 0 otherwise; PROMINENCE INDEX takes on the value of either

1, 2, or 3. Disclosure emphasis is coded as 3 (high prominence) for any press release that mentions the

earnings restatement in the headline. Disclosure quality is coded 2 (medium prominence) for press releases

that do not mention the restatement in the headline, but that discuss the restatement in some detail within the

body of the report. A code of 1 (low prominence) is assigned to press releases that only mention the

restatement in the footnotes of the report; RESTATEMENT AMT = 1 if the press release includes information

on the amount of the restatement and 0 otherwise; SEC = 1 if the press release indicates an SEC inquiry and 0

otherwise; FRAUD = 1 if the press release mentions an allegation of fraud and 0 otherwise; REVENUE = 1 if

any part of the restatement is due to revenue recognition problems and 0 otherwise; RULE CHANGE = 1 if a

change in accounting rules was mentioned in the press release as the reason for the restatement and 0

otherwise; COUNT = the number of different accounting issues, as reported in the GAO database; SHORT

INTEREST = the percent of short interest [100*(number of shares sold short)/(total shares outstanding)] as of

the month prior to the restatement announcement; CONCURRENT RETURN is the compounded raw return

over the (+1, -1) interval with 0 being the date of the restatement announcement; PRIOR STOCK RETURN is

the compounded raw returns over one year, ending on the second day before the restatement announcement (-

252, -2); POST STOCK RETURN is the compounded raw return over the (+2, +20) interval with day 0 being

the date of the restatement announcement; SHARE TURNOVER = [1-Π(1-volume tradedt/total sharest)],

accumulated over the 1-year period ending on the second day prior to the restatement announcement date;

MKTCAP = natural log of market capitalization (closing stock price * common shares outstanding) of the firm

measured as of the end of the fiscal year prior to t; TECH = 1 if the firm is classified as a technology firm and

0 otherwise; FINANCIAL = 1 if the firm operates in the financial services sector (SIC codes 6000-6999) and 0

otherwise.

c A total of 49 firms were excluded from this regression: 17 dismissed lawsuit firms and an additional 34 with

missing MKTCAP, PRIOR STOCK RETURN, or POST STOCK RETURN data.

Stealth Disclosure of Accounting Irregularities: Is...

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