Merits and Consequences of GAAP-based Securities Litigation

without Prior Restatement

C.S. Agnes Cheng

School of Accounting & Finance

The Hong Kong Polytechnic University

Kowloon, Hong Kong

Tel: (852) 2766-7772, E-mail: afagnes@polyu.edu.hk

Henry He Huang

SySyms School of Business

Yeshiva University

New York, NY 10033

Tel: (832) 276-3834, E-mail: henry.huang@yu.edu

Haitian Lu

School of Accounting & Finance

The Hong Kong Polytechnic University

Kowloon, Hong Kong

Tel: (852) 2766-7065, E-mail: haitian.lu@polyu.edu.hk

January 2016

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Merits and Consequences of GAAP-based Securities Litigation

Without Prior Restatement

ABSTRACT

This paper studies the merit of securities lawsuits with alleged GAAP violation during 1989

to 2010. We compare the allegations with and without a preceding accounting restatement,

with the objective to find whether suits without a preceding restatement have merits, and if

yes, what types of firm choose not to restate their accounting mistakes. We find suits against

many non-restated firms have merits. We also find firms with higher institutional ownership,

worse performance, larger potential investor loss, and insider trading tend not to make

restatement, consistent with a “litigation induction (as opposed to reduction)” hypothesis. The

market appears to penalize this dishonesty, as we document that the 3-day negative

cumulative abnormal return is 4.84% lower for firms that did not restate but was alleged of

GAAP violation in the filing of securities lawsuit. Further, on average, the settlement amount

for these non-restatement firms is $1.61 million higher than that of the restatement firms. Our

study highlights the role of meritorious securities lawsuits as safeguards and partial

substitutes for public enforcement of GAAP violations.

Keywords: GAAP violation, private securities lawsuit, restatement, insider trading,

institutional ownership

JEL Classification: M41; K22; G39

Data Availability: Data are available from sources identified in the text.

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I. INTRODUCTION

This study examines the merits and consequences of allegations of Generally Accepted

Accounting Principles (GAAP) violations in private securities class actions. Since the Private

Securities Litigation Reform Act (PSLRA) of 1995 with legislative intent to reduce frivolous

lawsuits (Choi, Nelson and Pritchard, 2009), majority of the fraud allegations began to focus

on accounting misrepresentations (Thompson and Sale 2003).In our sample period (1989-

2010), there were 1,159 securities lawsuits with alleged GAAP violations, of which 518 suits

are preceded by an accounting restatement, and 641 suits without preceding accounting

restatement. To the extent that a restatement is the company’s public admittance of its prior

accounting errors or irregularities, suits with preceding accounting restatements must have

merit. However, it is less clear whether the (majority) suits without preceding restatement

have merit. Since litigations are costly to shareholders and the company and may have

deadweight losses on the society, it is important that such suits have merits. On the other

hand, if some suits without preceding restatement indeed have merit, why do these firms’

managers choose NOT to restate? Do firms / managers that withhold restatements get

penalized by the market compared to restated firms?

To answer these questions, we gather data on a sample of securities lawsuits with

preceding restatement, and a matched sample of lawsuits without preceding restatement but

“deemed to have merits”. Our screening of frivolous suits (illustrated in details below) relies

on the company’s own subsequent restatement and a number of firm and suit characteristics

that prior literature has proven to be highly correlated with the restatement likelihood. This

exercise generates 325 suits with alleged GAAP violation, of which 182 have prior

restatement, and 143 with no prior restatement but “deemed to have merits”.

4

Of our interest is if these 143 cases without prior restatement do have merit, what types

of firms choose not to make restatement? What are their causes and consequences? Prior

work on has spotted the “litigation risk” as a primary motive for firm’s voluntary disclosure

(or non-disclosure) of bad news (Ball 2001). The “litigation induction view” argues that

voluntary bad news disclosure, such as restatement, can inflict catastrophic financial and

indirect damages to a firm (Hribar and Jenkins, 2004). This includes significantly negative

market responses (Palmrose et al. 2004), management turnover (Collins et al. 2009) and the

resultant securities lawsuits (Francis et al. 1994)1. Follow this view managers have incentives

not to make a restatement, or to make restatements in a less prominent manner. Consistent

with this hypothesis, Files (2009) and Myer et al. (2008) find less prominent disclosure of

restatement reduce negative market reactions and the likelihood of class action lawsuits.2

Srinivasan, Wahid, and Yu (2011) document that firms have incentives to make less visible

restatement disclosures and firms from less stringent legal regime can avoid reporting

restatements.

In contrast, the “litigation reduction view” argues that timely disclosure of bad news

may reduce rather than trigger the likelihood of litigation, for it weakens the plaintiff’s claim

that managers withheld bad news to keep the share price inflated (Skinner 1994), and reduces

damages by shortening the class period (Field et al. 2005). It may also mitigate the large

negative stock price reactions once such fraud is detected, which often triggers securities

lawsuits (Donelson et al. 2012). Skinner (1997) finds some evidence that timelier disclosure

is associated with lower settlement amounts. Using a simultaneous equation approach to

overcome endogeneity between disclosure and expected litigation risk Field et al. (2005) find

no significant relation between earnings warnings and litigation risk when examining all suits,

1For example, Kinney and McDaniel (1989), Wu (2002), and Palmrose and Scholz (2004) report shareholder

litigation rate of 14%, 22%, and 38%, respectively, for restatements. 2 Specifically, Files et al. (2009) find less visible disclosure in press release would reduce negative market

response and litigation risk. Myers et al. (2008) indicate that disclosing restatements in regular SEC filing,

instead of press release or 8-K filing, leads to less negative market response.

5

and after excluding dismissed suits, earnings warnings are found negatively related to the

incidence of litigation. Thus if the litigation reduction hypothesis is correct, firms with ex

ante high litigation risk shall have more incentives to make restatement.

We conjecture that managers act strategically in their disclosure policy, and the cost and

benefit analysis for voluntarily bad news disclosure can vary on the nature of bad news (e.g.

earnings disappointments or accounting irregularities), the firm’s characters, the firm’s

litigation environment, as well as its governance strength, etc. This paper shed light on this

debate by providing empirical evidence in the settings of restatements. More specifically, we

looked at a group of GAAP violation lawsuits with preceding restatements, and contrasting it

with a group of suits without preceding restatements but deem to have merits. Our evidence

appears to support the “litigation induction view” (Francis et al. 1994), as we show firms that

“ought-to-restate” but choose-not-to are, on average bigger, with poorer performance, higher

beta, higher leverage, and larger potential investor loss than the restatement group.

Under our multivariate regression analysis, two pieces of evidence suggest the

withholding of restatements reflect the deliberate choice of the management. The first is

evidence that firms with higher institutional ownership tend not to restate, suggesting that

managers under higher institutional investor scrutiny and discipline are more unwilling to

reveal their mistakes. This is consistent with the litigation induction view, for Cheng et al.

(2010) find securities class actions with institutional owners as lead plaintiffs are less likely

to be dismissed, and have larger monetary settlement than lawsuits with individual lead

plaintiffs. Second, we find that firms with managerial insider trading have higher tendency to

withhold restatement. Because insider trading before a restatement can infer the scienter of

defendant and increase the success of securities litigation (Rogers, 2008; Cheng et al. 2015),

managers have incentives not to make restatements that will expose themselves to litigation

risk (Huddart et al. 2007; Files et al. 2009).

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We also investigate the consequences of not making restatement from the perspective of

(1) market reaction to the filing of securities class actions; and (2) monetary settlement of the

suit. Consistent with our conjecture that the market penalizes dishonest firms / managers, we

find firms choosing not to make statements experience significantly more negative market

reactions (-4.84% cumulative 3-day abnormal return) when shareholders file lawsuits, and

have a larger settlement amount (on average, $1.61 million larger) compared with the

restatement group.

Taken together, our results suggest that managers behave opportunistically in their

decisions to not make restatements. This tendency to hide accounting mistakes is exacerbated

by institutional owner’s pressure and managers’ own insider trading. However, if their

coverings are caught by shareholders through private securities litigations, the market tends

to impose “dishonesty penalty” compared with their peers that make restatements.It shows

the private penalties for GAAP violations are severe and highlights the role of meritorious

securities lawsuits as partial substitutes for public enforcement of GAAP violations.

Our work is related to the vast literature on the merit of private securities lawsuits. The

social utility of these suits rests on compensating victims and deterring future violations.

However, frivolous lawsuits often extract legal fees from the value of shareholders

(Alexander 1991). Ideally the only criteria to determine their merits should be the judgment

after trial. However trials in this area are extremely rare and cases that are not dismissed are

settled. Prior work infers the merit of these suits from whether the case pass the motion to

dismiss (Dyck, Morse and Zingales 2010), the dollar value of settlement amount (Choi 2007;

Choi, Nelson, and Pritchard 2008), and whether the suit has institutional owners as lead

plaintiff (Cheng et al. 2010). This paper focuses on the accounting properties by examining

alleged GAAP violations cases. We assume suits with prior accounting restatements have

merits, and our investigation on suits without prior restatements is novel. In this respect, one

7

study close to ours is Donelson et al. (2012), who find that accounting standards alleged in

non-restatement lawsuits tend to be less rules-based, and this could be attributed to plaintiffs’

inability to observe detailed violations. We specifically examine the firm, accounting, and

suit characteristics of this group of cases. Our findings help regulators in monitoring financial

irregularity and assessing the effect of current securities class action laws in constraining

frivolous lawsuits.

This article also shed light on the debate in accounting literature on the causes and

consequences of voluntary bad news disclosure, dated back to Skinner (1994) and Francis et

al. (1994). Prior work find that managers face an asymmetric loss function when choosing

voluntary disclosure policies: They are not rewarded as much when good news are disclosed

but bear a large cost when bad news are disclosed. Two reasons are given: litigation risks and

reputational penalties. However, empirical evidence are mixed on whether earlier disclosure

triggers or deters litigation (Healy and Palepu 2001), and whether managers face turnovers or

lose outside opportunities (Helland 2006; Desai, Hogan and Wilkins 2006). Using alleged

GAAP violations with and without prior restatements, we find managers of higher litigation

risk firms tend to avoid making a restatement especially when the manager is under

institutional investor scrutiny, and when they themselves are involved in insider trading,

consistent with the litigation induction hypothesis (Francis et al. 1994).

Finally we contribute to the literature on restatements. The incidence of restatements in

the United States has steadily increased, which is directly attributed to the passage of

Sarbanes-Oxley Act and the implementation of its mandates.3 Prior work on restatement

focuses on the market reaction to earnings restatements (Palmrose et al. 2004), restatements

and the cost of capital (Hribar and Jenkins 2004), restatements and executive turnover (Desai

et al. 2006; Jayaraman et al. 2004; Collins et al. 2005; Land 2006; Burks 2007), the

3 These mandates include, for example, the review of a public company’s internal controls over financial

reporting required by Section 404; the certifications by the company’s CEO and CFO required by Sections 302

and 906; and the increased staffing of, and scrutiny by, the SEC required by Sections 408 and 601.

8

information content of earnings after restatements (Wilson 2008), executive compensation

and incentives to restate (Bums and Kedia 2006; Efendi et al. 2007), and restatements and

audit committee consequences (Srinivasan 2005). We also look at the causes and

consequences of restatements, but our angel based on allegations of GAAP violation lawsuits

and their outcome is novel. We find firms that “ought-to-restate but did not” face more

severe penalty compared with those made restatements. Hopefully this has a deterrent effect

on future managers to make earlier disclosures, as suggested by Skinner (1994) and Field et

al. (2005).

The rest of the paper proceeds as follows. Section 2 illustrates our sample selection, data

and descriptive statistics. Section 3 presents empirical results. Section 4 concludes.

II. SAMPLE SELECTION, DATA SOURCE, AND DESCRIPTIVE STATISTICS

Sample and Data Source

The sample of Section 10b-5 federal private securities class actions from 1989 to

2010 is obtained from the Securities Class Action Services (SCAS) of Institutional

Shareholder Services (ISS).4 We collect information on GAAP allegation, restatement, class

period, lead plaintiff type (institutional or individual), defendants, and litigation outcomes

(whether the lawsuit is settled or dismissed, and settlement amounts if the case is settled)

from the SCAS.

In addition to lawsuit data, we obtain the required financial statement data from

Compustat, institutional ownership data from Thomson’s 13F database, and daily stock return

data from CRSP. The Appendix provides detailed definitions of each variable used in our

empirical analysis.

4 Given PSLRA’s substantial impact on private securities litigation (e.g., Johnson et al., 2007), we also restrict

the sample to lawsuits filed after 1995 to reduce the heterogeneity in the litigation environment. In our final

sample, 320 (or 98.5%) of 325 observations are post-1995 litigations. Excluding the pre-PSLRA observations do

not change our results quantitatively.

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Identifying Non-restatement GAAP Allegation with Merits

We start with examining whether allegations of GAAP violations without

restatements prior to filing of lawsuit have merits. We infer the merits of these allegations

through three methods: (1) levels of earnings management, (2) whether the firm made

accounting restatement after the lawsuit filing, and (3) whether the lead plaintiff is an

institutional investor, and whether the CFO and/or the auditor are named as defendants.

High levels of earnings management

Following Richardson et al. (2002) and Srinivasan et al. (2011), we use earnings

management measures to infer whether a firm has accounting misstatements that require

accounting restatements. We use discretionary accruals from the performance-adjusted

modified Jones model (Cohen et al., 2008) to proxy for earnings management. Then we

compare the discretionary accruals between these accounting allegation firms with and

without prior accounting restatements. We deem these non-restatement allegation firms with

adjusted discretionary accruals higher than the top quartile of that of restatement firms as

having merits.

Making restatement after lawsuit filing

If a non-restatement accounting allegation firms made restatement after the lawsuit

filing, it indicates that they admit their misstatements. We thus deem these allegations with

restatements after lawsuit filing as having merits. We limit the time period to 12 months after

the lawsuit filing to ensure that the restatement filing is related to the GAAP violation alleged

in the lawsuit.

Having an institutional lead plaintiff and CFO / auditor named as defendant.

Cheng et al. (2010) show that having an institutional lead plaintiff indicates the merit

of a lawsuit. Following Cheng et al. (2010), another proxy for merit of accounting allegation

10

is whether CFO and/or auditor are named as a defendant. We thus deem these non-

restatement accounting allegations, with an institutional lead plaintiff and having the CFO

and/or the auditor as defendants, as having merits.

There are 518 and 641 lawsuits (for a total of 1,159 lawsuits) in SCAS database that

have allegations of GAAP violations and with and without prior restatements, respectively,

and have the required data to compute the performance-adjusted modified Jones model

(Cohen et al., 2008). The mean (median) discretionary accruals for the samples with and

without prior restatements are 0.1655 (-0.0143) and 0.1692 (-0.0196), respectively; and the

differences in means and medians between these two samples are not significant. The fact

that these two samples have similar levels of adjusted discretionary accruals is suggestive that

these non-restatement allegations on average have merits. Furthermore, we find that 149 of

these 641 non-restatement firms have discretionary accruals that are higher than the top

quartile of that of the restatement firms.

For other indicators of lawsuit merits, we find that 33 non-restatement firms made

restatements within 12 months after the lawsuits. In addition, 511, 452, and 220 of the 1,159

total lawsuits have institutional lead plaintiffs, the CFOs as defendants, and the auditors as

defendants, respectively.5

We classify a non-restatement lawsuit as having merit if it meets at least one of the

following three criteria: (1) discretionary accruals higher than the top quartile of that of

restatement firms, (2) making restatement within 12 months of the lawsuit filing, and (3)

having institutional lead plaintiff and CFO and/or auditor as defendants.

Our final sample consists of 182 and 143 lawsuits (a total of 325 lawsuits) with and

without prior restatements, respectively, that have all the required data available for

regression analysis.

5 Out of the 641 non-restatement lawsuits, there are 249, 96, and 242 for institutional lead plaintiffs, CFOs as

defendants, and auditor as defendants, respectively.

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Descriptive Statistics

Table 1 shows the descriptive statistics on our regression sample of these 325 lawsuits.

For governance monitoring strength, about 90% of our sample firms are audited by big 4

auditor firms, and the average institutional ownership is 61%. These firms appear to perform

poorly as indicated by the negative mean ROA of -0.0473 and negative mean lagged return of

-0.1289. The mean sales growth of 0.3611 seems to indicate that these firms are experiencing

rapid sales growth. For lawsuit characteristics, the mean natural log of class period is 6.1865

(implying an average class period of about 486 days), the average three-day return after the

lawsuit filings is -0.1465, and 22% of lawsuits involve allegations of insider trading. Finally,

for firm characteristics, the average leverage is 0.2353, the mean natural log of total assets is

7.3466 (implying an average total assets of about $1,550 million), the mean natural log of

firm age is 2.6 (implying an average firm age of about 14 years), and the mean book-to-

market ratio is 0.5987.

Table 2 compares the descriptive statistics for the two groups: (1) 182 lawsuits with

allegations of GAAP violation and prior accounting restatements, and (2) 143 lawsuits with

allegations of GAAP violation and no prior accounting restatements, but are deemed as

having merits. We find that these 143 meritorious lawsuits without restatements have higher

institutional ownership (Instown), higher beta (Beta), larger potential investor loss (LogPIL),

higher leverage (Lev), larger firm size (Lnat), higher firm age (Firmage), lower likelihood of

being in a litigious industry (Fps), and lower stock turnovers (Turnover). However, the results

from this univariate analysis are subject to further multivariate analysis after controlling for

compounding factors.

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III. EMPIRICAL RESULTS

Determinants of Not Making Restatement

If allegations of GAAP violations but with no prior accounting restatements have

merits, what type of firms did not restate their financial statements? We thus use the

following Equation (1) to test the determinants of whether to make a restatement. Sample

includes: (1) 182 lawsuits with allegations of GAAP violation and prior accounting

restatement, and (2) 143 lawsuits with allegations of GAAP violation and no prior accounting

restatement, but are deemed as having merits.

Non_Restate_Merit= β0 + β1Au + β2Instown + β3FPS + β4Beta

+ β5Retvol +β6Turnover+ β7Skewness+ β8ROA+ β9Lagret

+ β10Salesgr + β11Loglclass+ β12LogPIL+ β13IT+ β14LEV + β15Lnat

+ β16Firmage+ β17BM + Industry +εi,t, (1)

where Non_Restate_Meritequals to one if it is one of these 143 lawsuits with allegations of

GAAP violation and no prior accounting restatement, but are deemed as having merits; and

zero otherwise.

We examine the determinants of whether to make a restatement from five perspectives:

(1) the strength of governance monitoring, (2) litigation risk, (3) firm performance, (4)

lawsuit characteristics, and (5) firm characteristics. Strength of governance and monitoring

system includes whether a firm’s auditor is a Big 4 auditor (AU) and the proportion of

institutional ownership (Instown). Litigation risk includes whether the firm is in a litigious

industry (FPS), beta (Beta), return volatility (Retvol), daily trading turnover (turnover), and

return skewness (Skewness) (Kim and Skinner, 2012). Firm performance is measured by

return on assets (ROA), lagged returns (Lagret), and sales growth (Salesgr). Lawsuit

characteristics include the class period (Loglclass), the potential investor loss (LogPIL), and

whether the lawsuit involves allegation of insider trading (IT). Firm characteristics include

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leverage (Lev), firm size (Lnat), firm age (Firmage), and book-to-market ratio (BM). Finally,

we control for the industry by including an industry dummy variable. The appendix provides

detailed variable definitions. We expect managers make the decision on whether to make

restatements based on the trade-off of benefits and costs associated with making such

restatements.

Table 3 reports the estimation results for Equation (1). For governance monitoring

strength, we find a significantly positive coefficient on institutional ownership (Instown).

This indicates that firms with higher levels of institutional ownerships are more likely to

choose not to make the restatements. Even though institutional ownership improves a firm’s

monitoring strength, the results is consistent with institutional ownership providing managers

with incentives not to make restatements out of fear of institutional discipline. For litigation

risk, we find a significantly negative coefficient on stock turnover (Turnover). Because stock

turnover tends to be positively associated with the likelihood of a lawsuit (Files et al., 2009;

Kim and Skinner, 2012), this result suggests that these firms choosing not to make

restatements have a lower likelihood of securities litigation. Therefore, the marginal costs for

these firms to make restatements are higher because such restatements can lead to securities

litigation. In other words, firms with low litigation risk stand to lose more if they make

restatements that can trigger lawsuits. For firm performance, we find a significantly negative

coefficient on ROA, indicating that poor-performing firms are more likely not to make

restatements. Because restatements can reduce a firm’s performance further, the result

suggests that the managers withhold restatements to avoid further worsening or scrutiny of

poor firm performance.

For lawsuit characteristics, we find significantly positive coefficients on potential

investor loss (LogPIL) and having allegation of insider trading (It). This indicates that facing

large potential investor claim provides managers with incentives not to make restatement,

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which likely will trigger a lawsuit. This also indicates that managers in these firms choosing

not to make restatements engage in opportunistic insider trading activities. Because insider

trading can infer the scienter of defendant and increase the success of securities litigation

(Rogers, 2008; Cheng et al. 2015), managers have incentives not to make restatements that

will likely trigger a securities lawsuit (Files et al. 2009). In other words, managers have

incentives not to make bad news after insider trading out of fear that their insider trading will

be used as evidence against them (Huddart et al. 2007). For firm characteristics, we find a

significantly positive coefficient on firm size (Lnat). This suggests that larger firms are more

inclined to not make restatements. This is consistent with larger firms having more agency

costs.

In summary, Table 3 shows that firms choosing not to make restatements tend to be

larger, perform poorly, and have higher institutional ownership, lower stock turnovers, larger

potential investor loss, and allegations of insider trading. The evidence suggests that

managers behave opportunistically in their decisions to not make restatements. Specifically,

managers have incentives not to make restatements in order to avoid litigation and public

scrutiny of their performance.

Consequences of Not Making Restatement

Next, we examine the financial consequences of not making restatements from the

perspective of market reactions to the revelation news that led to the lawsuits. On one hand,

the markets may punish the firms for not making disclosure. For example, not making a

restatement may indicate a greater level of information asymmetry between managers and the

shareholders and the markets thus assess a higher cost of equity capital on the firm (Chava et

al., 2010). Furthermore, not making a restatement brings the uncertainty on the severity of the

misstatement and thus may lead to market speculations and more negative reactions. On the

other hand, there is mixed evidence on whether disclosures of bad news (e.g., restatements)

15

would reduce litigation risk (e.g., Francis et al. 1994; Ball 2001). Recent evidence also

indicates that firms engage in less visible restatement disclosures (or no restatement at all) in

order to reduce subsequent negative effects (e.g., Files et al. 2009; Srinivasan 2011). We thus

make no directional hypothesis on whether not making restatements will have more or less

penalty as indicated by the market reaction.

We use the following multivariate regression to examine whether there is any penalty

(indicated by the market reaction) for not making a restatement. The sample is the same as for

the Equation (1).

CAR3= β0 + β1Non_Restate_Merit + β2Au + β3Instown + β4FPS + β5Beta

+ β6Retvol+β7Turnover+ β8Skewness+ β9ROA+ β10Lagret + β11Salesgr

+ β12Loglclass+ β13LogPIL+ β14IT+ β15LEV + β16Lnat+ β17Firmage

+ β18BM + Industry +εi,t, (2)

where CAR3 is the 3-day [t+1, t+3] cumulative abnormal return after the end of the class

period, where [t-375, t-10] is used as estimation window. The variable of interest is

Non_Restate_Merit, which equals to one if it is one of these 143 lawsuits with allegations of

GAAP violation and no prior accounting restatement, but are deemed as having merits; and

zero otherwise.

Table 4 presents the results of estimating Equation (2). We find a significantly

negative coefficient on Non_Restate_Merit (coefficient=-0.0484). This indicates that firms

choosing not to make statements experience non-trivial more negative market reactions (-4.84%

cumulative 3-day abnormal return) when the information that leads to the litigation is

revealed. This suggests that either the revelation news by non-restatement firms contain more

negative information than restatement firms, or these firms were punished by the markets for

not being honest, or both.

Furthermore, to examine whether there is any penalty (for not making a restatement)

in the form of the settlement amount, we replace the dependent variable of the Equation (2)

by LNTOTALAMOUNT, the natural logarithm of the total settlement amount. This results in

16

the following Equation (3). The sample is the same as for the Equation (2).

LNTOTALAMOUNT = β0 + β1Non_Restate_Merit + β2Au + β3Instown + β4FPS

+ β5Beta + β6Retvol +β7Turnover+ β8Skewness+ β9ROA+ β10Lagret

+ β11Salesgr + β12Loglclass+ β13LogPIL+ β14IT+ β15LEV + β16Lnat

+ β17Firmage+ β18BM + Industry +εi,t, (3)

Table 5 presents the results of estimating Equation (3). We find a significantly positive

coefficient on LNTOTALAMOUNT (coefficient=0.4736), which indicates that on average the

settlement amount is $1.61 million higher for firms choosing not to make statements even

after controlling for other determinants of settlement amount. This result is economically

significant and suggests that not making a restatement is associated with greater shareholder

punishment in the form of larger settlements. Alternatively, these non-restatement lawsuits

may have more merits and thus are associated with larger settlement amounts.

Overall, the results in Tables 4 and 5 indicate that these non-restatement lawsuits have

merits as they have more negative market reactions and higher settlement amount than

restatement sample. The results are also consistent with the markets punishing these firms for

withholding information from the public. Prior studies show that firms benefit from less

visible restatement disclosures (e.g., Files et al. 2009). However, our results suggest that not

making a restatement at all may lead to significant market punishment. Our results suggest

that firms may be better off being straight forward with the public about the truthfulness of

their financial reporting.

IV. Conclusion

Using GAAP-based securities litigation with and without prior restatement as our setting,

this paper provides new empirical evidence on several controversial questions in law,

economics and accounting: Do GAAP-based securities lawsuits have merit? If they do have

merit, why certain types of firms choose to withhold their restatement decision? Do firms that

17

act opportunistically by not making restatement penalized by the market? Based on firms’

accounting properties, subsequent restatements, and suit characteristics, we find suits against

many non-restated firms have merits. We also find firms with higher institutional ownership

and managerial insider trading tend not to make restatement, suggesting opportunistic

managerial discretions do exist. The market appears to penalize this dishonesty, as we

document that the 3-day negative cumulative abnormal return is4.84% lower for firms that

did not restate but was alleged of GAAP violation in the filing of securities lawsuit.

Furthermore, we find that non-restatement firms’ settlement is on average $1.61 million more

than the restatement firms.

Absent of the actual trial outcomes, the true merit of each GAAP-based securities

lawsuitis unobservable. It is possible that our classification of non-restatement firms but

deem to have merit may not completely filter out frivolous lawsuits. On the other hand, given

our sample is drawn from alleged GAAP-violations that trigger shareholder lawsuits. It is

possible that some managers still benefit from their non-disclosure strategy by evading

lawsuits. Despite this, we find that meritorious securities lawsuits do help to discipline

opportunistic managers, and impose additional “dishonesty penalties”. This, in turn, will

deter managers to reveal bad news in a timelier manner.

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Table 1: Descriptive statistics

Variable N Mean StdDev Median Minimum Maximum

NON_RESTATE_MERIT1 325 0.4400 0.4972 0.0000 0.0000 1.0000

CAR3 325 -0.1465 0.2057 -0.1052 -1.0858 0.5442

LNTOTALAMOUNT 196 16.1155 1.8718 16.1181 0.0000 20.6458

Governance strength

AU 325 0.9046 0.2942 1.0000 0.0000 1.0000

INSTOWN 325 0.6107 0.2832 0.6456 0.0074 1.6766

Litigation risk

FPS 325 0.2615 0.4402 0.0000 0.0000 1.0000

BETA 325 1.2055 0.6277 1.1568 -0.5508 3.3561

RETVOL 325 0.0429 0.0246 0.0372 0.0104 0.1896

TURNOVER 325 0.8420 0.1972 0.9275 0.0604 1.0000

SKEWNESS 325 -0.3321 1.6063 0.0207 -8.3234 6.0752

Firm performance

ROA 325 -0.0473 0.202 0.0062 -1.2115 0.3571

LAGRET 325 -0.1289 0.7506 -0.2630 -0.9814 5.4353

SALEGR 325 0.3611 1.2201 0.1286 -1.0000 16.9667

Lawsuit characteristics

LOGLCLASS 325 6.1865 1.0652 6.2461 0.0000 8.0317

LOGPIL 325 -0.0296 1.0635 -0.1010 -5.4953 3.9493

IT 325 0.2215 0.4159 0.0000 0.0000 1.0000

Firm characteristics

LEV 325 0.2353 0.2323 0.1876 0.0000 1.0450

LNAT 325 7.3466 2.4170 6.9457 2.4418 14.9357

FIRMAGE 325 2.6000 0.7332 2.4849 1.0986 4.0775

BM 325 0.5987 0.7287 0.4347 -1.4537 6.7163

19

Table 2: Restatement Firms and Non-restatement but-with-merit Firms Compared

This table reports the mean, median, and standard deviation for the restatement firms, and

non-restated firms with merit. The accounting data are taken from the fiscal year end

immediately following the Federal Filing date. The variables definition can be found in

appendix. *, **, *** indicates significance at the 10%, 5%, and 1% levels (two-tailed).

Restatement firms

Non-restatement firms with

merits

(Non_Restate_Merit = 1)

N=182

N=143

Mean Median Std

Mean Median Std T-stat

CAR3 -0.13 -0.09 0.18 -0.16 -0.12 0.21 1.18

LNTOTALAMOUNT6

15.66 15.88 2.01 16.63 16.40 1.56 -3.74***

AU 0.88 1.00 0.32

0.93 1.00 0.26 -1.38

INSTOWN 0.57 0.59 0.28

0.66 0.69 0.27 -2.98***

FPS 0.32 0.00 0.47

0.19 0.00 0.39 2.67***

BETA 1.15 1.09 0.63

1.28 1.24 0.60 -1.92*

RETVOL 0.04 0.04 0.02

0.04 0.04 0.02 -0.10

TURNOVER 0.86 0.93 0.17

0.82 0.92 0.22 1.95*

SKEWNESS -0.37 -0.10 1.41

-0.30 0.09 1.70 -0.38

ROA -0.04 0.01 0.19

-0.06 0.01 0.22 0.82

LAGRET -0.09 -0.24 0.76

-0.20 -0.31 0.62 1.36

SALEGR 0.31 0.13 0.71

0.31 0.13 0.77 -0.05

LOGLCLASS 6.17 6.29 1.09

6.21 6.19 1.04 -0.35

LOGPIL -0.11 -0.11 0.93

0.13 -0.09 0.96 -2.30***

IT 0.19 0.00 0.40

0.26 0.00 0.44 -1.43

LEV 0.22 0.16 0.23

0.26 0.22 0.23 -1.76*

LNAT 6.88 6.46 2.27

7.94 7.62 2.44 -4.03***

FIRMAGE 2.48 2.40 0.68

2.76 2.71 0.77 -3.51***

BM 0.56 0.41 0.55

0.61 0.48 0.70 -0.73

6 Number of observations of LNTOTALAMOUNT for non_restate_merit = 0 and non_restate_merit = 1 are 104

and 92 respectively.

20

Table 3: Logit model to test the determinants of making no restatement with merit

This table presents estimates from a logit regression of the probability of firms that making

no restatement with merit and firm level variables. The t-statistics (in parentheses) are robust

to heteroskedasticity.*, **, *** indicates significance at the 10%, 5%, and 1% levels (two-

tailed).

VARIABLES Non_Restate_Merit

AU -0.6747

(-1.21)

INSTOWN 1.3688**

(2.39)

FPS -0.1614

(-0.25)

BETA 0.3926

(1.53)

VOLRET 0.9804

(0.14)

TURNOVER -1.3772**

(-2.04)

SKEWNESS 0.0897

(0.87)

ROA -2.6149***

(-3.05)

LAGRET -0.2064

(-1.14)

SALEGR 0.1031

(1.04)

LOGLCLASS 0.0358

(0.25)

LOGPIL 0.3277**

(2.14)

IT 0.7637**

(2.09)

LEV -0.0215

(-0.03)

LNAT 0.2297**

(2.26)

FIRMAGE 0.2566

(1.04)

BM 0.0713

(0.28)

Constant -3.4101**

(-2.16)

Observations 325

Pseudo-R-squared 0.176

Chi-sq 62.89

Prob> Chi-sq 0.0200

21

22

Table 4 Effect of Making No Restatement on Market Reactions to Litigation News

This table presents estimates from a regression model of the effect of making no restatement

but with merit on market reactions to the litigation news.The t-statistics (in parentheses) are

robust to heteroskedasticity.*, **, *** indicates significance at the 10%, 5%, and 1% levels (two-

tailed).

VARIABLES CAR3

NON_RESTATE_MERIT -0.0484*

(-1.85)

AU -0.1175***

(-2.98)

INSTOWN 0.0231

(0.54)

FPS -0.0401

(-0.62)

BETA 0.0110

(0.49)

RETVOL -0.1165

(-0.20)

TURNOVER -0.0086

(-0.12)

SKEWNESS -0.0056

(-0.73)

ROA -0.0173

(-0.23)

LAGRET -0.0095

(-0.58)

SALEGR 0.0118*

(1.65)

LOGLCLASS -0.0108

(-0.92)

LOGPIL -0.0041

(-0.28)

IT 0.0612**

(2.13)

LEV 0.1116*

(1.85)

LNAT -0.0067

(-0.91)

FIRMAGE 0.0426

(1.63)

BM 0.0241

(1.13)

Constant -0.0804

(-0.64)

Industries included

Observations 325

R-squared 0.227

Adj. R-squared 0.0621

F test 1.764

Prob> F 0.0297

23

Table 5 Effect of making no restatement on total settlement amount to the litigation

news

This table presents estimates from a regression model of the effect of making no restatement

but with merit on total settlement to the litigation news. The t-statistics (in parentheses) are

robust to heteroskedasticity.*, **, *** indicates significance at the 10%, 5%, and 1% levels

(two-tailed).

VARIABLES LNTOTALAMOUNT

NON_RESTATE_MERIT 0.4736*

(1.82)

AU -0.8648

(-1.10)

INSTOWN 1.1610

(1.60)

FPS 0.6805

(1.27)

BETA -0.4559

(-1.56)

RETVOL -2.2892

(-0.37)

TURNOVER 0.8997*

(1.84)

SKEWNESS 0.0206

(0.36)

ROA -0.3435

(-0.77)

LAGRET 0.0200

(0.14)

SALEGR 0.1372

(1.12)

LOGLCLASS -0.1030

(-1.18)

LOGPIL 0.0738

(1.08)

IT 0.0811

(0.29)

LEV -0.2530

(-0.36)

LNAT 0.4133***

(5.61)

FIRMAGE 0.1145

(0.58)

BM 0.0724

(0.49)

Constant 12.9769***

(11.74)

Industries included

Observations 196

R-squared 0.588

Adj. R-squared 0.426

F test 6.889

Prob> F 0

24

Appendix I: Variables definition

NON_RESTATE_MERIT = 1 if firms that meet at least one of the following three

criteria: high discretionary accruals that is higher than the

top quartile of restatement firms, making restatement within

12 months of the lawsuit filing, and have institutional lead

plaintiff and CFO and/or auditor as defendants.

CAR3 = 3-day [t+1, t+3] cumulative abnormal return after the end of

the class period, where [t-375, t-10] is used as estimation

window

LNTOTALAMOUNT = Natural Logarithm of the total settlement amount

Governance Stength

AU = indicator variable, equals to 1 if the firm is audited by big 4, 0

otherwise

INSTOWN = proportion of institutional ownership, number of shares held by the

institutional divided by the number of outstanding

Litigation risk

FPS = 1 ifir biotech firms (sic: 2833-2836 and 8731-8734), computer firms

(3570-3577 and 7370-7374), electronics firms (3600-3674) and

retail firms (5200-5961), 0 otherwise.

BETA = beta from CAPM model

RETVOL = return volatility, standard deviation of the daily return within the

fiscal year.

TURNOVER = 1-(1-TURN)n, where turn is average daily trading volume divided

by the number of shares outstanding and n is the number of trading

days in the one-year calendar-day window [-375, -10] relative to

the class period end date

SKEWNESS = the third moment of the return distribution over the one-year

calendar day window [-375, -10] relative to the class period end

date

Firm performance

ROA = return on assets, net income scaled by total assets (ni/at)

LAGRET = compounded raw return over one-year calendar-day [-375, -10]

relative to the class period end date

SALESGR = the different between sales in current year sales and pervious year

divided by the sales in pervious year

Lawsuit characteristics

LOGLCLASS = natural logarithm of (the length of the class period in days + 1)

LOGPIL = natural logarithm of PIL (potential investor loss), where PIL is

measured by the difference between the highest value of the market

capitalization during the class period and the market capitalization

on the day after the end of the class period, scaled by the market

value at the last fiscal year-end prior to the end to the class period

IT = the lawsuit involves allegation of insider trading

Firm characteristics

25

LEV = leverage, total debt scaled by total assets (dltt+dlc)/at

LNAT = firm size, natural logarithm of the total assets

FIRMAGE = firm age, natural logarithm of the number of years of available

accounting data

BM = the book value of equity (CEQ) plus book value of deferred taxes

(TXDB) divided by market value (PRCC_F*CSHO), measured at

the last fiscal year-end prior to the end of the class period

26

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