Market Reaction to Restatements after Sarbanes-Oxley

INTRODUCTION This paper examines differences in the market response to accounting restatements after the passage of the Sarbanes-Oxley Act (SOX). Our focus is on whether the market responded differently to restatements during the initial implementation of SOX than it did subsequently. As a result of past financial frauds, SOX was designed to boost investor confidence in corporate reporting. Restatements increased after the passage of SOX, and it has been suggested that this is evidence of the effectiveness of the Act, since this was the first time companies were systematically evaluating and being held accountable for the effectiveness of internal controls. Because this was a change for all companies, it was believed that the disclosure of material weaknesses and restatements would be common during the initial implementation of SOX. Therefore, we posit that companies were not penalized as strongly by the stock market for restatements occurring immediately after the required implementation of SOX. This study contrasts the market reaction to restatements during the implementation period with the market reaction after SOX became entrenched in corporate reporting. MOTIVATION The Sarbanes-Oxley Act was intended to improve investor's confidence in financial reporting. A side-effect of the Act was a dramatic increase in the number of accounting restatements (Turner & Weirich, 2006). Accounting restatements occur when a company releases incorrect financial statements and then must correct the reported numbers. At best, these arise because managers are not scrutinizing the financial statements diligently. At worst, managers were caught unethically manipulating earnings. The fact that corrections almost always reduce income (GAO, 2002; Wilson, 2008) gives some credence to the latter explanation. Therefore, restatements are generally considered evidence that executives were not acting in the best interest of the stockholders. Krishnan, Rama & Zhang (2008) documented a significant cost to implementing SOX, so several studies have tested the benefits received. Chang, Fernando & Liao (2009) established that the market believes earnings are of higher quality subsequent to SOX. Lobo and Zhou (2006) found that management is more conservative subsequent to SOX, tending to recognize losses earlier than before. Cohen, Dey & Lys (2008) corroborated this finding. In their sample, management manipulated income less after SOX, but modified operating decisions to opportunistically manage earnings. Bartov and Cohen (2009) combined these studies with analysts' forecasts and found that fewer companies just met or exceeded earnings forecasts after SOX. Therefore, managers appear to still manipulate earnings, but are using different methods to accomplish that goal. Koh, Matsumoto & Rajgopal (2008) confirmed less direct earnings management in the post-SOX period. In addition, they determined that the stock market reacted less to meeting analysts' expectations. Finally, Wilson (2008) investigated restatements prior to SOX and found that investors are dubious of earnings reported subsequent to a restatement, but lose their skepticism after about a year. In addition, researchers have examined whether SOX improved the credibility and clarity of financial reporting by testing for differences in the relationship between restatements and market returns before and after its implementation (e.g., Hirschey et al, 2010; Burks, 2011). They demonstrated that SOX has improved credibility, or at least, not increased investor confusion. Burks (2011) examined the earnings drift related to restatements before and after the passage of SOX. Hirschey, Smith & Wilson (2010) also contrasted the market response to restatements before and after SOX implementation. In general, all the studies find a negative market reaction to restatements, but the reaction is less severe post-SOX. Our contribution is to demonstrate whether the market effects of restatements documented in the literature are confounded by the uncertainty surrounding initial implementation of SOX. …