Material Weakness Disclosures and Restatement Announcements: The Joint and Order Effects

37 Pages Posted: 20 Feb 2019

See all articles by Li He

Li He

Southwestern University of Finance and Economics (SWUFE) - School of Accountancy

Bharat Sarath

Rutgers, The State University of New Jersey - Accounting

Nader Wans

Memorial University of Newfoundland (MNU) - Faculty of Business Administration

Date Written: January/February 2019

Abstract

We examine differences in stock price, option volatility, and litigation reactions to restatement announcements that are associated with a material weakness (MW) disclosure. Contrasted with restatements that are not associated with any MW disclosure, our analyses reveal that firms that announce both a restatement and an associated MW experience significantly more negative market returns, greater implied volatility, and higher likelihood of class action lawsuits. Separating the restatements into timely reporters, where the MW precedes the restatement, and non‐timely reporters, where the MW is concurrent with or follows the restatement, we find that timely reporters experience more negative returns at the time of the restatement, relative to non‐timely reporters, suggesting that investors perceive the early MW disclosure to signal more pervasive control‐related problems. Interestingly, we find that timely and non‐timely reporters are equally likely to be sued, consistent with the argument that wrongdoing (through either a timely or non‐timely MW disclosure) provides stronger grounds for establishing scienter. However, timely reporters appear to secure more favorable litigation outcomes: they face higher likelihood of lawsuit dismissals and pay much lower settlements, compared to non‐timely reporters. Overall, our evidence provides new insights into how market participants incorporate information about internal control weaknesses into their perceptions regarding the economic implications of financial restatements, and financial reporting quality.

Keywords: class actions, financial reporting quality, market reaction, material weakness disclosure, restatements

Suggested Citation

He, Li and Sarath, Bharat Sarrukai and Wans, Nader, Material Weakness Disclosures and Restatement Announcements: The Joint and Order Effects (January/February 2019). Journal of Business Finance & Accounting, Vol. 46, Issue 1-2, pp. 68-104, 2019. Available at SSRN: https://ssrn.com/abstract=3335342 or http://dx.doi.org/10.1111/jbfa.12363

Li He (Contact Author)

Southwestern University of Finance and Economics (SWUFE) - School of Accountancy ( email )

55 Guanghuacun St
Sichuan, 610072
China

Bharat Sarrukai Sarath

Rutgers, The State University of New Jersey - Accounting ( email )

94 Rockafeller Road
Piscataway, NJ 08854
United States

Nader Wans

Memorial University of Newfoundland (MNU) - Faculty of Business Administration ( email )

St. John's, Newfoundland A1B 3X5
Canada

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