Financial Restatements, Litigation, and Implied Cost of Equity

Abstract

We reexamine the effect of financial restatements on the cost of equity vis-a-vis litigation risk. Specifically, we study the effect of litigation on post-restatement financing costs and whether market anticipates litigation before restatement announcement as evident from its effect on financing costs. While we find that the cost of equity increases subsequent to a financial restatement for all restating firms, the increase is substantially greater for firms facing litigation as a result of the restatement. We also find that investors do not adjust for the cost of equity prior to the announcement of a financial restatement for firms facing post-restatement litigation. Overall, our findings suggest that most of the increase in the cost of equity after restatement is concentrated in sued sub-sample and that the cost of equity is an important channel through, which litigation associated with financial restatement is priced. The economic effect of post-restatement litigation is approximately 259 basis points increase in the firm’s cost of equity.

Keywords: Cost of Equity, Litigation, Financial Restatements, Earnings Forecasts, Analyst Forecasts

JEL Classification: G14, G12, K22, M41