Do Restatements Really Increase Substantially after the Sox? How Does the Stock Market React to Them?

Abstract

We investigate the U.S. stock market's reactions to companies' restatements before and after SOX during a period from 1997 to 2005. This paper is motivated by the inconsistency between the targeted goal of SOX to improve financial reporting quality (proxied by the occurrence of restatements) and the ever-increasing trend in restatements after the passage of SOX. We focus on companies' voluntary restatements because they are more susceptible to the numerous provisions imposed by SOX on top management's misconducts, audit committees, and internal controls over financial reporting. We propose that, in examining the impacts of SOX on the association between restatements and stock prices, it is the years being restated that are of particular importance to the market participants rather than the announcement dates. We base our argument on a game's perspective that, if SOX is effective, taking as a package, in motivating high-quality financial reporting, companies shall be less willing to restate financial statements issued after SOX because market participants may consider such restatements as signals of non-compliance with SOX. In contrast, companies may be more willing to restate financial statements issued before SOX because market participants may regard such restatements as signals of enhanced internal controls and improved corporate governance. Using the years being restated to classify restatements into pre-SOX and post-SOX periods, we find that the well-documented increase in restatements after SOX (which are classified using the announcement dates) disappears. Instead, we observe a sharp decrease in restatements that are announced after SOX restating financial reports issued after SOX. Notably, we find that most of the restatements announced after SOX are made mainly to restate quarterly financials issued before SOX. After controlling for the self-selection bias resulting from voluntary restatements, we further show that market participants can distinguish between post-SOX restatements that restate financial statements issued before and after SOX, and react differently by focusing on different restatement characteristics. Overall, the empirical results support our conjecture that companies and market participants interact strategically toward restatements announced after SOX.