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Is the Outcome of a Securities Class Action a Reliable Signal of Accounting Irregularity? Nana Y. Amoah Old Dominion University Alex P. Tang Morgan State University Feb. 2011

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Motivations Dismissal of several class actions raises questions about the appropriateness of securities litigation as a signal of accounting irregularity. 65.9% (1,396) of 2119 class actions over the period 1996-2005 were dismissed (Simmons and Ryan, 2007). Fich and Shivdasani (2007) note that it cannot be confirmed that fraud has occurred as a result of a securities lawsuit. Effect of PSLRA on securities lawsuit outcome.

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Motivations Proponents of litigation reform argue that only settled lawsuits are a credible signal of accounting irregularity. Critics argue that the litigation process is widely abused and settlements are excessive and do not reflect the wrongdoing. No clear evidence of fraud in settlements. Debate on effectiveness of securities litigation as a governance mechanism (Rogers and Buskirk, 2009).

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TIME Class Certification and Discovery Restatement Triggers Securities Lawsuit (Litig = 1/0) Figure 1: Timeline of Filing and Resolution of Securities Lawsuit Securities Lawsuit is Settled (Settlement=S) Defendants File Motion to Dismiss the Lawsuit (Dismiss=1/0) Restating Firm Announces Irregularity Or Error (Irreg=1/0)

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Accounting Irregularity and Litigation Outcome (Related Research & Hypotheses) Negative association between fraud and restatement announcement returns (Palmrose, Richardson and Scholz, 2004; Lev, Ryan and Wu, 2007). Restatements due to accounting irregularity are more likely to trigger securities lawsuits. Positive association between accounting irregularity and restatement-induced securities lawsuit (Hennes, Leone and Miller, 2008; Amoah and Tang, 2010). Accounting irregularity is defined similarly to Hennes, Leone and Miller (2008).

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Accounting Irregularity and Litigation Outcome (Related Research & Hypotheses) Under the PSLRA, meritorious securities lawsuits are less likely to be dismissed (Choi and Thompson, 2006). Restatement-induced lawsuit centered on accounting irregularity provides an inference of scienter and should be more likely to be settled. Accounting irregularity is associated with greater shareholder losses, thus, settlement amount should be positively associated with accounting irregularity.

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Hypotheses (Accounting Irregularity and Litigation Outcome) H1: Ceteris paribus, settled restatement-induced lawsuits are positively associated with accounting irregularity. H2: Ceteris paribus, the settlement amount of a restatement-induced lawsuit is positively associated with accounting irregularity.

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CEO Turnover and Litigation Outcome (Related Research & Hypotheses) Likelihood of CEO turnover increases with securities litigation (Niehaus and Roth,1999; Collins, et. al, 2008). SEC and DOJ enforcement action positively associated with termination of executive officers implicated in the fraud (Karpoff, Lee and Martin, 2008). CEOs have access to material non-public adverse information and should be culpable when financial statements are false and misleading.

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Hypothesis (CEO Turnover and Litigation Outcome) Thus, when restating firms settle securities lawsuits, it is likely that CEOs are culpable in the alleged fraud. H3: Ceteris paribus, settled restatement-induced securities lawsuit is positively associated with CEO turnover.

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DescriptionNumber Restatements from 1997-2005 in GAO (2002) and GAO (2007) databases2309 Deleting repeated restatements(322) Missing Compustat and CRSP data(860) Technical restatements, income increasing restatements and missing restatement and litigation data(432) Restating sample695 Litigation firms185 Sample Selection Procedure

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Distribution of Restatements by fiscal year Year1997199819992000200120022003 20042005Total Restating firms31263543369396 130205695 Litigation firms18192322204215 1610185 Settlement firms14 17 143111 87133 Dismissed Lawsuits (%) 22%26% 23%30%26%27%50%30%28% Settled Lawsuits (%) 78%74% 77%70%74%73%50%70%72% Year199719981999200020012002200320042005Total Litigation firms152022241940151614185 Settlement firms1314161714311387133 Distribution of Litigations by fiscal year

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VariableMeanMedianStd. Dev. t-stat (p-value) Wilcoxon (p-value) R (-1,1) -0.067-0.0270.155<0.001 Lev0.2410.2040.230<0.001 LnA6.2896.1652.157<0.001 ROA0.0250.0560.179<0.001 VariableNumber of firmsPercentage Chi-Sq (p-value) Irregularity17726% 167.31 (<0.001) Revenue21331% 104.12 (<0.001) Litig18527% 151.98 (<0.001) Dismiss528% 502.56 (<0.001) Settle13319% 264.81 (<0.001) Descriptive Statistics of Continuous Variables (Restating Firms) Frequency of Binary Variables (Restating Firms)

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Variable Pred. Sign Irregularity= 1 Observations (N=177) (percentage) No-Irregularity= 0 Observations (N=518) (percentage) Chi-Square (p-value) Revenue+92 (51.98%) 121 (23.36%) 50.83 a (0.008) Litig+88 (49.72%) 97 (18.73%) 64.87 a (<0.001) Dismiss?13 (7.34%) 39 7.53%) 0.01 (0.936) Settle+75 (42.37%) 58 (11.20%) 82.86 a (<0.001) Binary Variables Continuous Variables Variable Pred. Sign Irregularity= 1 (N=177) Mean No-Irregularity= 0 (N=518) Mean Difference in Mean (p-value) R (-1,1) --0.103 0.249 6.811 0.040 -0.055 0.239 6.086 0.020 -0.048 a (0.001) Lev+/- 0.010 (0.638) LnA+/- 0.725 a (<0.001) ROA +/- 0.020 (0.147) Univariate Results - Irregularity and No-Irregularity Restating Subsamples

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VariableMeanMedianStd. Dev. t-stat p-value Wilcoxon p-value R (-1,1) -0.197-0.1540.204<0.001 LnS16.86416.7301.673<0.001 Lev0.2660.2570.207<0.001 LnA7.6227.4372.020<0.001 ROA0.0750.0820.097<0.001 VariableNumber of firmsPercentage Chi-Sq (p-value) Irregularity8848% 0.27 (0.605) Revenue10356% 2.89 (0.089) Dismiss5228% 35.85 (<0.001) Settle13372% 35.85 (<0.001) Descriptive Statistics of Continuous Variables (Litigation Firms) Frequency of Binary Variables (Litigation Firms)

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Variable Pred. Sign Irregularity= 1 Observations (N=88) (percentage) No-Irregularity= 0 Observations (N=97) (percentage) Chi-Square (p-value) Revenue+54 (61.36%) 49 (51.58%) 1.78 (0.182) Dismiss-13 (14.77%) 38 (40.0%) 14.46 (0.936) Settle+75 (85.23%) 57 (60.0%) 14.46 a (<0.001) Binary Variables Continuous Variables Univariate Results - Irregularity and No-Irregularity Litigation Subsamples Variable Pred. Sign Irregularity= 1 (N=88) Mean No-Irregularity= 0 (N=97) Mean Difference in Mean (p-value) R (-1,1) --0.185 0.251 7.666 -0.207 0.279 7.582 0.022 (0.465) Lev+/--0.028 (0.374) LnA+/-0.084 (0.780) ROA LnS +/-0.0790.072 0.392 (0.599) + 17.09816.4580.640 (0.111)

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Analysis of Accounting Irregularity

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Logistic Regressions of Accounting Irregularity (Restating Sample) Model VariableLogit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Intercept (?) -1.852 a (37.01) --1.873 a (36.98) --1.854 a (36.23) --1.866 a (35.77) --2.278 a (46.38) - R (-1,1) (+)0.177 (0.08) 19.3%0.512 (0.62) 66.9%0.595 (0.80) 81.3% Revenue (+)1.000 a (23.81) 171.9% Litig (+)1.330 a (42.18) 278.2%1.327 a (31.36) 276.9% Dismiss (?) Settle (+) ROA (+/-) Lev (+/-) -0.182 (0.10) -0.132 (0.10) -16.7% -12.3% -0.305 (0.28) -0.031 (0.01) -26.3% -3.1% 0.357 (1.03) 1.675 a (55.28) -0.128 (0.05) -0.143 42.9% 433.9% -12.0% -13.4% 0.334 (0.81) 1.758 a (44.33) -0.257 (0.19) -0.037 (0.01) 39.7% 480% -22.6% -3.7% 0.030 (0.01) 1.381 a (24.75) -0.055 (0.01) -0.003 (0.00) 3.1% 297.7% -5.3% -0.3% LnA (+/-)0.058 (1.36) 5.9%0.060 (1.44) 6.1%0.058 (1.37) 6.0%0.060 (1.40) 6.1%0.083 (2.58) 8.6% ModChiSq (P-value) H-L ChiSq 57.49 a (<0.01) 4.25 54.00 a (<0.01) 9.25 71.84 a (<0.01) 5.18 69.83 a (<0.01) 12.42 93.23 a (<0.01) 12.62 (P-value)(0.83)(0.32)(0.74)(0.13)

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Logistic Regressions of Accounting Irregularity (Litigation Sample) Model VariableLogit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Intercept (?)-1.692 b (5.05) --1.656 b (5.10) --1.392 b (3.85) --1.748 b (5.28) --3.941 c (3.74) - R (-1,1) (+)1.022 (1.64) 178.0%1.022 (1.65) 177.7%1.048 (1.71) 185.3%1.288 (2.15) 262.7% Revenue (+)0.427 (1.66) 53.2%0.343 (1.11) 40.9%0.441 (1.76) 55.4%0.213 (0.28) 23.7% LnS (+)0.278 b (4.88) 32.1% Settle (+) ROA (+/-) Lev (+/-) 1.412 a (13.35) -0.716 (0.68) 310.6% -51.1% 1.292 a (12.00) 1.124 (0.47) -0.913 (1.18) 264.1% 207.6% -59.9% 1.481 a (14.70) 0.841 (0.25) -0.720 (0.70) 339.9% 131.9% -51.3% 1.430 a (13.52) 0.994 (0.35) -0.676 (0.60) 317.9% 170.2% -49.1%-1.277 (1.56) -72.1% LnA (+/-)0.086 (0.99) 9.0%0.073 (0.72) 7.6%0.064 (0.55) 6.6%0.080 (0.84) 8.3% Model ChiSq (P-value) H-L ChiSq 19.56 a (<0.01) 11.71 17.05 a (<0.01) 6.61 18.14 a (<0.01) 4.12 19.90 a (<0.01) 3.91 8.36 c (0.079) 4.05 (P-value)(0.17)(0.58)(0.85)(0.87)(0.85)

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Analysis of CEO Turnover

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Logistic Regressions of CEO Turnover CEO1 CEO2 CEO3 VariableLogit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Intercept (?)-3.104 a (12.90) --2.574 a (8.39) --1.947 a (7.28) --1.541 b (4.37) - R (-1,1) (+)0.965 (0.95) 162.5%1.298 (1.63) 266.2%-0.162 (0.04) -14.9%0.561 (0.45) 75.2% Revenue (+)0.450 (1.44) 56.9%0.243 (0.38) 27.5%0.454 (2.05) 57.4%0.297 (0.87) 34.6% Litig (+)1.642 a (12.22) 416.5% Dismiss (?) Settle (+) ROA (+) Lev (+)0.158 (0.03) 17.1% 0.851 (1.87) 2.173 a (18.25) -3.283 (2.40) 0.061 (0.00) 134.2% 778.3% -96.2% 6.3% 0.155 (0.11) 1.206 a (9.03) -2.600 (2.18) 0.324 (0.19) 16.8% 234.1% -92.6% 38.2% 1.039 b (5.42) 1.844 a (19.58) 0.612 (0.12) 0.189 (0.06) 182.6% 532.4% 84.4% 20.8% LnA (+/-)0.041 (0.14) 4.2%0.011 (0.01) 1.1%0.053 (0.34) 5.4%-0.054 (0.33) -5.2% Model ChiSq (P-value) H-L ChiSq 23.38 a (<0.01) 3.34 33.35 a (<0.01) 10.17 29.68 a (<0.01) 6.59 35.22 a (<0.01) 3.83 (P-value)(0.91)(0.25)(0.58)(0.87)

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Logistic Regressions of SEC Enforcement Action Model VariableLogit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Intercept (?) -3.181 a (39.27) --2.869 a (34.79) --3.114 a (38.97) --12.191 (13.46) --12.186 a (13.47) - R (-1,1) (+)0.725 (0.64) 106.5%0.953 (1.09) 159.5%0.143 (0.02) 15.4%0.190 (0.03) 21.0% Revenue (+) 0.630 b (4.32) 87.7%0.512 c (2.82) 66.9%0.233 (0.18) 26.2% Litig (+)1.284 a (11.81) 261.0% LnS (+)0.590 a (8.11) 80.4%0.575 a (7.54) 77.8% Dismiss (?) Settle (+) ROA (+/-) Lev (+/-) 0.147 (0.02) -0.001 (0.00) 15.8% -0.00% 0.836 (2.63) 1.875 a (24.47) 0.162 (0.02) -0.002 (0.00) 130.6% 552.3% 17.6% -0.2% 0.706 (2.11) 1.391 a (15.16) 0.295 (0.07) -0.00 (0.00) 102.5% 301.9% 34.3% -0.2% -1.786 (0.32) -2.549 c (2.97) -83.2% -92.2% -1.701 (0.30) -2.487 c (2.81) -81.7% -91.7% LnA (+/-)0.059 (0.60) 6.0%0.031 (0.17) 3.2%0.050 (0.44) 5.1%0.212 (1.67) 23.7%0.222 (1.77) 24.9% ModChiSq (P-value) H-L ChiSq 35.28 a (<0.01) 6.61 36.06 a (<0.01) 6.52 37.32 a (<0.01) 5.21 18.96 a (<0.01) 10.58 19.13 a (<0.01) 6.30 (P-value)(0.58)(0.59)(0.73)(0.23)(0.61)

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Results Settled lawsuit positively associated with accounting irregularity consistent with our first hypothesis (H1). Positive association between settled lawsuit and CEO turnover (Supports H3). Weak evidence of a positive association between accounting irregularity and settlement amount. Results for settled lawsuit are robust with SEC enforcement action as the fraud measure. Strong evidence of a positive association between settlement amount and SEC enforcement action.

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Conclusions Settled lawsuit is an appropriate signal of accounting irregularity. CEOs of settlement firms are implicated in the alleged fraud that triggered the lawsuit. Findings are contrary to Beneish (1999) who find that SEC enforcement action is not effective in discouraging management fraud.

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Contributions First study that examines the relation between accounting irregularity and securities litigation outcome. Highlights the importance of distinguishing between dismissed and settled lawsuits in litigation studies. Contributes to the debate on whether securities litigation is an effective governance mechanism. Extends studies linking restatement and restatement-induced securities lawsuit to CEO turnover (such as Desai, Hogan, and Wilkins, 2006 & Collins, Reitenga and Sanchez, 2008).

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