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Abstract:
We examine the market reaction to a sample of 403 restatements announced from 1995 to 1999. We document an average abnormal return of about -9 percent over a two-day announcement window. We find that more negative returns are associated with restatements involving fraud, affecting more accounts, decreasing reported income and attributed to auditors or management (but not the SEC). There appears to be an additional penalty for announcements that do not quantify the restatement. Finally, we provide evidence on the relation between restatement announcements and analyst earnings forecast dispersion, bid-ask spreads and subsequent revisions in analyst earnings forecasts.

misstatements, fraud, auditor

Abstract:
We examine the market reaction to a sample of 403 restatement announcements made from 1995 to 1999. We find significantly negative average abnormal returns of about 9 percent over a two-day announcement window. We also document substantial variance in the abnormal returns. Our analysis indicates that more severe reactions are related to indications of management fraud, more material dollar effects and restatements that are attributed to auditors. We hypothesize that the negative signal associated with fraud and auditor-initiated restatements is associated with an increase in investors' expected monitoring costs, while higher materiality is associated with greater revisions of future performance expectations.

Restatement; Stock market reaction; Fraud; Audit; Auditor; SEC

Abstract:
This study provides evidence on the restatement circumstances associated with lawsuits against auditors. We examine restatements of financial statements previously issued to the public and filed with the SEC by 416 US companies that announced restatements from 1995 to mid-1999. Our examination focuses on the accounting issues giving rise to restatements. We classify these issues as either economic or technical. Economic restatements involve transactions and accounts related to core (recurring) earnings; all other restatements are technical. We find that auditors are significantly more likely to be sued over economic restatements than technical ones. Additionally, we find that revenue restatements, one type of economic restatement and overall the most frequent, primarily contribute to this result. While economic restatements are associated with more severe circumstances as measured by fraud, materiality, bankruptcy/delisting, and security price reaction, our multivariate model includes these as control variables.

Restatements, Auditor Litigation, Securities Class Actions, Audit and Reporting Quality

Abstract:
Two alternative approaches are used in audit practice to make quantitative materiality assessments about proposed audit adjustments: the cumulative approach compares to net income the total amount of misstatement existing at the end of the current period, while the current-period approach compares to net income the amount of misstatement added in the current period. The Panel on Audit Effectiveness and the SEC have expressed concern that these alternative materiality approaches could affect auditor judgments, but no research has investigated this question. We report the results of an experiment in which 234 audit managers and partners from one Big 4 firm completed eight cases that required them to determine whether the final outcome of an audit would be to book or waive a proposed adjusting journal entry. We manipulated materiality approach between auditors by providing auditors with either the current-period or cumulative formats used at their firm, and also manipulated whether auditors were provided with a prompt to consider their clients' quality of earnings. Results indicate waived adjustments for all cases, and a robust and often unintentional effect of materiality approach on auditors' adjustment decisions, but no effect of the quality of earnings prompt. Results also indicate that auditors' adjustment decisions are affected by misstatement size, subjectivity, current-period income effect, and precision.

Materiality, auditing, adjusting entries, iron curtain, rollover, earnings management.

Abstract:
Research finds independent audit committees are generally effective in monitoring the financial reporting and auditing processes. However, not all audit committees that appear in form to be independent are in fact actually independent. CEO involvement in the board selection process can affect whether an audit committee substantively functions as an independent one. We use financial statement restatements to examine whether the benefits of having an independent audit committee are diminished, or even eliminated, when the CEO is involved in the selection of board members. Our results indicate that the monitoring benefits of having an independent audit committee are only maintained when the CEO is not formally involved in selecting board members. Further, we find that these results appear to be driven by the more severe restatements, including misstatements in conjunction with fraudulent financial reporting. Thus, our evidence suggests that the diminishment in audit committee effectiveness with CEO involvement in selecting directors is associated with real economic costs to the firm. Finally, or results provide support for various post-SOX changes, which enhanced audit and nominating committee independence.

Audit Committees, Nominating Committees, Corporate Governance

Abstract:
Two alternative approaches are used in audit practice to provide quantitative materiality assessments about proposed audit adjustments. The cumulative approach compares to net income the total amount of misstatement existing at the end of the current period, while the current-period approach compares to net income the amount of misstatement added in the current period. Depending on the relation between total misstatement and current-period misstatement, either the cumulative approach or the current-period approach can calculate higher quantitative materiality. This paper reports an experiment that varies materiality approach between auditors by providing auditors with either the current-period or cumulative formats used by their firm to summarize proposed audit adjustments. Results indicate that, across a variety of experimental contexts (varying misstatement size, subjectivity, precision and income effect, and varying whether auditors document effects on their client's quality of earnings), auditors are more likely to require their client to book the misstatement under the approach that makes the misstatement appear more material. These results suggest that standard setters mandate that auditors require adjustment whenever a misstatement is material under either approach.

Materiality, auditing, adjusting entries, iron curtain, rollover, earnings management

Abstract:
Our study examines the circumstances of non-GAAP financial reporting by 492 U.S. companies that announced restatements from 1995 to 1999. We analyze the occurrence and resolution of litigation over restatements; and, we explore the role of accounting items in bringing and resolving this litigation. To do so, we focus on the income statement. We provide evidence on the nature and pervasiveness of accounting misstatements and how, if at all, they affect litigation. We assess the nature of restatements by whether normal, recurring earnings from primary perations (core) or other components of earnings (non-core) are misstated and their pervasiveness by estimating the number of primary accounts misstated.

In our sample, companies with core restatements have higher frequencies for intentional misstatements (fraud) and subsequent bankruptcy or delisting. They likewise have, on average, more material misstatements, more negative security price reactions to restatement announcements, and more negative security price changes over the six months preceding and following restatement announcements. However, controlling for these and other factors, we find a significant association between accounting items and litigation, whether occurrences or resolutions. Specifically, core restatements - driven primarily by revenue misstatements, a component of core earnings - and more pervasive restatements each play a role, while misstatements of non-core earnings alone do not.

Litigation, Core Earnings, Earnings Quality

Abstract:
Studies in Accounting Research #33 provides guidance for conducting empirical research on auditor litigation and for using data on auditor litigation in teaching. To facilitate research and teaching, the monograph includes a CD with a Database. The Database has over 1,000 client observations with audit litigation involving the Big Five and their legacy firms. Non-Big Five firms are included on joint litigation. The Database includes litigation over allegations of audit failure on audits from 1960 through 1995, as long as legal actions were filed by end of 1995.

The Database contains an extensive amount of information. For example, it has information on clients and auditors, accounting and auditing issues, legal characteristics and issues, regulatory actions, and litigation resolutions. All information is from public sources available through early 1999.

The Database should be easily usable by academics, practitioners, and students alike. It is designed for use with Microsoft Access (the CD has three versions for Access 2.0, 97, and 2000). While the Database as published provides a rich source of litigation-related information, it is also designed so that users can customize it to meet their particular needs. For example, the Database can be updated with further information about the observations or with additional observations, such as audit litigation filed after 1995.

The monograph makes a number of suggestions for using the Database in a variety of research settings. The Database is designed for stand-alone use or it can be used in combination with data from other sources. The discussion of research considerations and applications encompasses both the usefulness and limitations of the Database.

Further, the Database can be used in teaching a variety of graduate and undergraduate courses, including courses on financial accounting, financial statement analysis, auditing, securities litigation, accountant's liability, governance, and professional regulation and institutions. The discussion of teaching applications includes suggestions on opportunities for bringing litigation-related topics into the classroom through supplementing lecture materials, promoting active learning, developing new teaching cases, extending and enriching existing case materials, and designing student projects, assignments, and other educational activities.

Auditor litigation; Securities class actions

Abstract:
This study examines whether certain types of financial reporting fraud result in a higher likelihood of litigation against independent auditors. We expect that auditors are more likely to be judged responsible for failing to detect commonly occurring frauds or those that stem from fictitious transactions. We examine companies with SEC Accounting and Auditing Enforcement Releases and designate whether each fraud present in their financial statements is common and/or arises from fictitious transactions. We then examine whether these types of fraud are related to auditor litigation in analyses that control for various client, auditor and case characteristics. Our results provide some support for our two primary hypotheses-auditors are more likely to be sued when the financial statement frauds are of a common variety or when the frauds arise from fictitious transactions.

Abstract:
This study examines whether frequent and fictitious financial statement frauds increase the likelihood of litigation against independent auditors. We expect that auditors are more likely to be judged responsible for failing to detect frauds with these characteristics. We use companies with SEC Accounting and Auditing Enforcement Releases for our fraud sample, then designate whether the types of fraud present in their financial statements are frequent and fictitious. We examine whether these fraud characteristics are related to auditor litigation in analyses that control for various client, auditor, and case characteristics. Our results provide some support for our two primary hypotheses -- auditors are more likely to be sued when financial statement frauds are frequent and fictitious.