Does the Market Punish the Many for the Sins of the Few? The Contagion Effect of Accounting Restatements for Foreign Firms Listed in the United States

Abstract

In this article, we study the contagion effects of accounting restatements issued by foreign firms traded in the United States. Specifically, we predict and find that accounting restatements that negatively affect the share prices of the restating foreign firms raise investor concerns that nonrestating foreign firms from the same home countries have similar accounting issues, and therefore induce a negative stock market reaction to nonrestating home country peer firms. We refer to this as a restatement-induced home country contagion effect. On average, nonrestating home country peer firms experience a negative stock market return of approximately −0.69% over a 3-day window around the restatement announcement. Moreover, we hypothesize and show that the strength of the home market rule of law (ROL) affects investor assessment of the likelihood that peer firms have similar accounting issues, and therefore affects the magnitude of the contagion. Specifically, nonrestating home country peer firms from countries with weak ROL experience an average stock price decline of approximately −1.32%, whereas peer firms from strong ROL countries experience an average negative return of only −0.26% over the 3-day window around the restatement. These results suggest that restatements filed by weak ROL firms are perceived to be more “contagious” than those filed by strong ROL firms.

The Price of Being Foreign: Stock Market Penalties Associated with Accounting Irregularities for U.S.‐Listed Foreign Firms

“…Assuming the stock returns of the non‐restating firms would be mean zero during a non‐event day, the fact that the returns centered around the irregularity announcement of another firm from the same country are significantly negative suggests there is some country‐specific factor that investors associate with a foreign firm's accounting irregularity. However, contrary to Jia and Zhao (), we do not find that this country‐specific factor is related to a country's rule of law tradition. We do, however, find that, within a given country‐year, the stock price decline is greater for non‐restating firms with lower accruals quality, which suggests the spillover effect is greater for firms whose firm‐specific information risk is higher (as earnings quality is one aspect of information risk).…”

“…We also do not find evidence that the market reaction to irregularity announcements by U.S.‐listed foreign firms represents an overreaction (i.e., we do not observe future price reversals). Finally, similar to Jia and Zhao (), we find that non‐restating firms from the same country experience an average market‐adjusted stock return of −0.589 percent over the six‐day window [0, 5] following an irregularity announcement of a firm from the same country. Assuming the stock returns of the non‐restating firms would be mean zero during a non‐event day, the fact that the returns centered around the irregularity announcement of another firm from the same country are significantly negative suggests there is some country‐specific factor that investors associate with a foreign firm's accounting irregularity.…”

“…A recent study by Jia and Zhao () finds evidence that the negative market reaction to foreign restating firms' U.S.‐listed shares spills over to non‐restating firms from the same country. Thus, we examine whether we find similar evidence of country‐level spillovers in our sample of irregularities…”

“…Similar to Jia and Zhao () and Gleason et al (), we identify a sample of non‐restating foreign firms (that are also listed in the United States) that are from the same country as our irregularity firm. We then calculate stock returns for the non‐restating firms during the announcement window of our irregularity firm.…”

Sins of the Father: The Effect of a Parent Firm's Accounting Misconduct on Current and Former Subsidiaries.

“…Prior studies find evidence of industry or geographic information transfer among peer firms around restatements and bankruptcies (e.g., Lang and Stulz 1992;Gleason et al 2008;Jia and Zhao 2016). Since these studies focus on broad groups of peer firms, they potentially overlook specific cases where information transfer should occur (Hertzel, Li, Officer, and Rodgers (2008) and Boone and Ivanov (2012), discussed later, are notable exceptions but focus only on financial distress).…”