This section discusses the relations between the board and audit committee governance variables, restatement characteristics along with stock returns at the announcement of restatements, and the probability of restatement-induced class action lawsuits as well as stock returns at the announcement of class action lawsuits. Theoretical linkages between the constructs are illustrated in Fig. 1. Proxies used for each construct are listed. Links 1, 2 and 3 have been established in prior literature. Our study including hypotheses developments focuses on links 4, 5, 6 and 7.
Evidence of a negative market reaction to restatement announcement has been documented in (Baber et al., 2007), (Agrawal and Chadha, 2005), (Palmrose et al., 2004) and (Lev et al., 2008). The negative market reaction to a restatement announcement could result in significant shareholder losses and will cause shareholders to initiate a securities class action to recover damages. A restatement-induced securities class action lawsuit follows detection of material accounting errors by a company, auditor, the Securities and Exchange Commission (SEC hereafter) or other third parties and admission of the accounting misstatement through the announcement of a restatement.
Following a firm's restatement announcement, a class action lawsuit alleging securities fraud by the firm, its executive officers and directors may be filed by attorneys on behalf of those who purchased the company's securities during the class period or time frame in which the alleged fraud or securities law violation occurred.5 The securities fraud allegations relate to the defendants having intentionally withheld adverse information or disclosed misleading information in the class action firm's financial statements during the class period (Niehaus & Roth, 1999).
Rule 10b-5 of the SEC requires that firms disclose material information in a candid and timely manner.6 Shareholders may allege that the firm's stock price did not reflect the adverse information during the class period and purchasers of the company's shares during the class period suffered losses (Niehaus & Roth, 1999). Because shareholders initiate restatement-induced class action lawsuits to recover loss of shareholder value, we expect that measures capturing shareholder wealth losses as a result of a restatement will be associated with the likelihood of restatement-induced class action lawsuits. The market reaction to restatement announcements is a measure of not only the materiality and pervasiveness of the accounting misstatement but also the disclosure losses suffered by shareholders and these losses should increase when the market reacts more negatively to the restatement announcement. Consequently, it is expected that the greater the shareholder losses are, the more likely a restatement-induced securities class action will be filed (Link 4). This leads to the following hypothesis:
H1
Probability of restatement-induced securities class action lawsuits is negatively related to market reaction to restatement announcements.
Announcement of a restatement-induced securities class action signals that not only has the restatement resulted in significant shareholder losses but also the firm, and its executive officers and directors could be implicated in the alleged securities fraud in relation to the accounting misstatement. This is especially so following passage of the PSLRA, which has raised pleading standards for the allegations in securities class actions specifically relating to the strength and specificity of the allegations ([Choi and Thompson, 2006] and [Johnson et al., 2007]). Given that the announcement of a restatement-induced securities class action is a negative signal to the market because it contains alleged intentional accounting misstatement and securities fraud as well as possible payment of damages to shareholders, we expect that a restatement-induced class action will be associated with a negative market reaction (Link 5) and our hypothesis is as follows:
H2
The announcements of restatement-induced class lawsuits will induce negative stock returns.
Prior studies provide evidence that some of the restatement materiality and pervasiveness measures are associated with restatement-induced securities class action. Palmrose and Scholz (2004) examine the association between the nature, pervasiveness and materiality of restatements and the incidence of litigation following restatements in the period (1995–1999) before and after passage of the PSLRA. Palmrose and Scholz (2004) hypothesize that measures of materiality and pervasiveness of restatements negatively impact investor valuation of the restating firm and increase the probability of investors initiating a securities class action lawsuit. They provide empirical evidence to support the hypothesis that revenue restatement and the number of accounts restated are positively associated with restatement-induced securities class actions.
However, their result for the restatement materiality measure is inconsistent with their hypothesis. Palmrose and Scholz (2004) find a positive association between percentage change in net income and the probability of restatement-induced litigation, suggesting that restatements that have more negative impact on net income are associated with a lower probability of restatement-induced litigation. Given that the study includes litigation that was filed before the PSLRA, it is possible that some of these lawsuits were frivolous which could explain the inconsistent result.
Lev et al. (2008), on the other hand use a model of restatement-induced litigation that primarily includes variables that capture the restatement's effect on earnings. They examine the relation between restatement-induced litigation and measures of the restatement's effect on the historical pattern of earnings, current earnings and lagged earnings. Based on analysis of a sample covering the period after passage of the PSLRA, they find that the market reaction to the restatement announcement, revenue restatement, and fraud variables are consistently significant to restatement-induced litigation. In addition, Lev et al. (2008), find a positive association between litigation and restatements that undo earnings growth, or undo positive earnings. However, the other measures of restatement materiality, which are restatement effect on current and lagged earnings, are not associated with litigation.
The present study examines the relation between restatement-induced securities class action and restatement materiality and pervasiveness measures similar to Palmrose and Scholz (2004), but this study limits the analysis to the post-PSLRA period.7 Restricting the analysis to the period after passage of the PSLRA provides empirical evidence on whether the intended litigation reforms are achieving the objective of limiting frivolous lawsuits. Given that restatement materiality and pervasiveness measures are directly associated with a more negative market reaction to restatement announcement and therefore greater shareholder losses, it is expected that probability of restatement-induced class action lawsuits will be directly related to restatement of revenues, number of accounts restated, years restated and size of restatement, respectively (Link 6). Further, compared to other types of errors, revenue restatement is associated with a higher probability of restatement-induced class action lawsuits because it has a more adverse effect on restating firm performance and shareholder value. Therefore, our hypothesis is as follows:
H3
Probability of restatement-induced securities class action lawsuits is positively associated with restatement pervasiveness and materiality measures.
In addition to requiring that securities class action allegations provide evidence of shareholders losses as a result of the accounting misstatement, PSLRA requires shareholders to provide facts that support an inference that defendants act with scienter or a state of mind to knowingly or recklessly misreport. The act or omission of the defendants causes the loss for which shareholders seek to recover damages. Following passage of the PSLRA, securities class action allegations that fail to establish scienter are more likely to be dismissed because they lack merit. Accordingly, in the post-PSLRA period, shareholders will be more likely to file a restatement-induced securities class action lawsuit if the circumstances surrounding the restatement support an inference that defendants acted with scienter.
The board and audit committee variables are expected to be associated with restatement-induced litigation because weak boards and audit committees provide an inference of scienter, which strengthens shareholders' class action allegations. Evidence in the literature is consistent with weak boards and audit committees supporting an inference of scienter. Prior studies find that when boards and audit committees exercise less oversight or monitoring of management, there is a greater likelihood of an accounting misstatement. Abbott, Parker, and Peters (2003) report that fully independent audit committee is negatively associated with restatement. They also find a negative relation between audit committee financial expertise and restatement.
Agrawal and Chadha (2005) document a negative association between audit committee financial expertise and restatement. Although results from studies on restatements and board and audit committee variables only suggest that weak boards and audit committees provide opportunity for accounting misstatements, it can also be argued that the more lax the oversight or monitoring, the greater the likelihood or opportunity to intentionally misstate a firm's financial statement. This view is supported by the results from studies such as (Beasley, 1996) and (Zhang et al., 2007). Beasley (1996) finds that the probability of intentional misstatement for restating firms is negatively associated with the percentage of independent directors while Zhang et al. (2007) report that firms with less financial expertise on their audit committees are associated with a greater likelihood of internal control weaknesses and a greater propensity to intentionally misreport their financial statements.8 Collectively, these results support the argument that boards and audit committee governance measures should be associated with restatement-induced securities class actions because they provide evidence that weak boards and audit committees are associated with intentional accounting misstatement, which supports an inference of scienter.
We also establish the link between board and audit committee governance measures and probability of restatement-induced securities class action based on the influence of the governance measures on the perceived merit of the restatement-induced class action. We expect that shareholders' perception of the merit of the restatement-induced class action should influence the probability of restatement-induced securities class actions because PSLRA has raised pleading standards for securities class action lawsuits and increased the likelihood that class action lawsuits that lack merit would be dismissed.9 Because restatement-induced securities class action lawsuits are a result of financial misstatements, the perceived merit of the restatement-induced class action will be directly associated with the likelihood that the financial statement was intentionally misstated.
The board and audit committee are responsible for not only monitoring and disciplining management but also exercising oversight on the financial reporting process. Weak boards and audit committees are perceived by shareholders as increasing the merit of a restatement-induced class action lawsuit because they are associated with lax supervision which provides evidence of an opportunity to intentionally misstate the financial statements. Accordingly, restatement-induced class action allegations that cite weak boards and audit committees to support the inference of scienter are considered more meritorious and are more likely to survive defendants' motion for dismissal and be settled.
From the preceding discussion, we argue that if shareholders' perception of the merit of a restatement-induced class action is higher for a restating firm with weaker board and audit committee governance measures, then they would be more likely to initiate such litigation. Furthermore, restating firms with weak board and audit committee governance measures provide more data for shareholders to plead with greater specificity and strength pursuant to PSLRA. Hence, we expect a negative association between probability of restatement-induced class action lawsuits and the board and audit committee measures of restating firms (Link 7). This leads to the following hypothesis:
H4
Probability of restatement-induced securities class action lawsuits is negatively associated with the board and audit committee governance measures.
Evidence of a negative market reaction to restatement announcement has been documented in (Baber et al., 2007), (Agrawal and Chadha, 2005), (Palmrose et al., 2004) and (Lev et al., 2008). The negative market reaction to a restatement announcement could result in significant shareholder losses and will cause shareholders to initiate a securities class action to recover damages. A restatement-induced securities class action lawsuit follows detection of material accounting errors by a company, auditor, the Securities and Exchange Commission (SEC hereafter) or other third parties and admission of the accounting misstatement through the announcement of a restatement.
Following a firm's restatement announcement, a class action lawsuit alleging securities fraud by the firm, its executive officers and directors may be filed by attorneys on behalf of those who purchased the company's securities during the class period or time frame in which the alleged fraud or securities law violation occurred.5 The securities fraud allegations relate to the defendants having intentionally withheld adverse information or disclosed misleading information in the class action firm's financial statements during the class period (Niehaus & Roth, 1999).
Rule 10b-5 of the SEC requires that firms disclose material information in a candid and timely manner.6 Shareholders may allege that the firm's stock price did not reflect the adverse information during the class period and purchasers of the company's shares during the class period suffered losses (Niehaus & Roth, 1999). Because shareholders initiate restatement-induced class action lawsuits to recover loss of shareholder value, we expect that measures capturing shareholder wealth losses as a result of a restatement will be associated with the likelihood of restatement-induced class action lawsuits. The market reaction to restatement announcements is a measure of not only the materiality and pervasiveness of the accounting misstatement but also the disclosure losses suffered by shareholders and these losses should increase when the market reacts more negatively to the restatement announcement. Consequently, it is expected that the greater the shareholder losses are, the more likely a restatement-induced securities class action will be filed (Link 4). This leads to the following hypothesis:
H1
Probability of restatement-induced securities class action lawsuits is negatively related to market reaction to restatement announcements.
Announcement of a restatement-induced securities class action signals that not only has the restatement resulted in significant shareholder losses but also the firm, and its executive officers and directors could be implicated in the alleged securities fraud in relation to the accounting misstatement. This is especially so following passage of the PSLRA, which has raised pleading standards for the allegations in securities class actions specifically relating to the strength and specificity of the allegations ([Choi and Thompson, 2006] and [Johnson et al., 2007]). Given that the announcement of a restatement-induced securities class action is a negative signal to the market because it contains alleged intentional accounting misstatement and securities fraud as well as possible payment of damages to shareholders, we expect that a restatement-induced class action will be associated with a negative market reaction (Link 5) and our hypothesis is as follows:
H2
The announcements of restatement-induced class lawsuits will induce negative stock returns.
Prior studies provide evidence that some of the restatement materiality and pervasiveness measures are associated with restatement-induced securities class action. Palmrose and Scholz (2004) examine the association between the nature, pervasiveness and materiality of restatements and the incidence of litigation following restatements in the period (1995–1999) before and after passage of the PSLRA. Palmrose and Scholz (2004) hypothesize that measures of materiality and pervasiveness of restatements negatively impact investor valuation of the restating firm and increase the probability of investors initiating a securities class action lawsuit. They provide empirical evidence to support the hypothesis that revenue restatement and the number of accounts restated are positively associated with restatement-induced securities class actions.
However, their result for the restatement materiality measure is inconsistent with their hypothesis. Palmrose and Scholz (2004) find a positive association between percentage change in net income and the probability of restatement-induced litigation, suggesting that restatements that have more negative impact on net income are associated with a lower probability of restatement-induced litigation. Given that the study includes litigation that was filed before the PSLRA, it is possible that some of these lawsuits were frivolous which could explain the inconsistent result.
Lev et al. (2008), on the other hand use a model of restatement-induced litigation that primarily includes variables that capture the restatement's effect on earnings. They examine the relation between restatement-induced litigation and measures of the restatement's effect on the historical pattern of earnings, current earnings and lagged earnings. Based on analysis of a sample covering the period after passage of the PSLRA, they find that the market reaction to the restatement announcement, revenue restatement, and fraud variables are consistently significant to restatement-induced litigation. In addition, Lev et al. (2008), find a positive association between litigation and restatements that undo earnings growth, or undo positive earnings. However, the other measures of restatement materiality, which are restatement effect on current and lagged earnings, are not associated with litigation.
The present study examines the relation between restatement-induced securities class action and restatement materiality and pervasiveness measures similar to Palmrose and Scholz (2004), but this study limits the analysis to the post-PSLRA period.7 Restricting the analysis to the period after passage of the PSLRA provides empirical evidence on whether the intended litigation reforms are achieving the objective of limiting frivolous lawsuits. Given that restatement materiality and pervasiveness measures are directly associated with a more negative market reaction to restatement announcement and therefore greater shareholder losses, it is expected that probability of restatement-induced class action lawsuits will be directly related to restatement of revenues, number of accounts restated, years restated and size of restatement, respectively (Link 6). Further, compared to other types of errors, revenue restatement is associated with a higher probability of restatement-induced class action lawsuits because it has a more adverse effect on restating firm performance and shareholder value. Therefore, our hypothesis is as follows:
H3
Probability of restatement-induced securities class action lawsuits is positively associated with restatement pervasiveness and materiality measures.
In addition to requiring that securities class action allegations provide evidence of shareholders losses as a result of the accounting misstatement, PSLRA requires shareholders to provide facts that support an inference that defendants act with scienter or a state of mind to knowingly or recklessly misreport. The act or omission of the defendants causes the loss for which shareholders seek to recover damages. Following passage of the PSLRA, securities class action allegations that fail to establish scienter are more likely to be dismissed because they lack merit. Accordingly, in the post-PSLRA period, shareholders will be more likely to file a restatement-induced securities class action lawsuit if the circumstances surrounding the restatement support an inference that defendants acted with scienter.
The board and audit committee variables are expected to be associated with restatement-induced litigation because weak boards and audit committees provide an inference of scienter, which strengthens shareholders' class action allegations. Evidence in the literature is consistent with weak boards and audit committees supporting an inference of scienter. Prior studies find that when boards and audit committees exercise less oversight or monitoring of management, there is a greater likelihood of an accounting misstatement. Abbott, Parker, and Peters (2003) report that fully independent audit committee is negatively associated with restatement. They also find a negative relation between audit committee financial expertise and restatement.
Agrawal and Chadha (2005) document a negative association between audit committee financial expertise and restatement. Although results from studies on restatements and board and audit committee variables only suggest that weak boards and audit committees provide opportunity for accounting misstatements, it can also be argued that the more lax the oversight or monitoring, the greater the likelihood or opportunity to intentionally misstate a firm's financial statement. This view is supported by the results from studies such as (Beasley, 1996) and (Zhang et al., 2007). Beasley (1996) finds that the probability of intentional misstatement for restating firms is negatively associated with the percentage of independent directors while Zhang et al. (2007) report that firms with less financial expertise on their audit committees are associated with a greater likelihood of internal control weaknesses and a greater propensity to intentionally misreport their financial statements.8 Collectively, these results support the argument that boards and audit committee governance measures should be associated with restatement-induced securities class actions because they provide evidence that weak boards and audit committees are associated with intentional accounting misstatement, which supports an inference of scienter.
We also establish the link between board and audit committee governance measures and probability of restatement-induced securities class action based on the influence of the governance measures on the perceived merit of the restatement-induced class action. We expect that shareholders' perception of the merit of the restatement-induced class action should influence the probability of restatement-induced securities class actions because PSLRA has raised pleading standards for securities class action lawsuits and increased the likelihood that class action lawsuits that lack merit would be dismissed.9 Because restatement-induced securities class action lawsuits are a result of financial misstatements, the perceived merit of the restatement-induced class action will be directly associated with the likelihood that the financial statement was intentionally misstated.
The board and audit committee are responsible for not only monitoring and disciplining management but also exercising oversight on the financial reporting process. Weak boards and audit committees are perceived by shareholders as increasing the merit of a restatement-induced class action lawsuit because they are associated with lax supervision which provides evidence of an opportunity to intentionally misstate the financial statements. Accordingly, restatement-induced class action allegations that cite weak boards and audit committees to support the inference of scienter are considered more meritorious and are more likely to survive defendants' motion for dismissal and be settled.
From the preceding discussion, we argue that if shareholders' perception of the merit of a restatement-induced class action is higher for a restating firm with weaker board and audit committee governance measures, then they would be more likely to initiate such litigation. Furthermore, restating firms with weak board and audit committee governance measures provide more data for shareholders to plead with greater specificity and strength pursuant to PSLRA. Hence, we expect a negative association between probability of restatement-induced class action lawsuits and the board and audit committee measures of restating firms (Link 7). This leads to the following hypothesis:
H4
Probability of restatement-induced securities class action lawsuits is negatively associated with the board and audit committee governance measures.
