Litigation Risk and Market Reaction to Restatements

Abstract

A large negative stock price reaction to a restatement announcement could imply a particularly significant accounting error, or one made by a firm that has a relatively high probability of being sued. This paper investigates the extent to which market reactions to restatement announcements are explained by litigation risk. We model the simultaneous relationship between restatement announcement abnormal returns and litigation risk and find that about half of the -9.2 percent average restatement announcement effect is due to expected litigation costs. We also find that the significance of the accounting error does not directly affect the magnitude of the abnormal return; it only affects abnormal return indirectly because it increases the probability of being sued.