THE ACCOUNTING REVIEW

Vol. 83, No. 1

2008
pp. 83–110

The Contagion Effects

of Accounting Restatements
Cristi A. Gleason
The University of Iowa
Nicole Thorne Jenkins
Vanderbilt University
W. Bruce Johnson
The University of Iowa
ABSTRACT: We predict and find that accounting restatements that adversely affect
shareholder wealth at the restating firm also induce share price declines among non-
restating firms in the same industry. These share price declines are unrelated to
changes in analysts’ earnings forecasts, but instead seem to reflect investors’ account-
ing quality concerns. Peer firms with high industry-adjusted accruals experience a more
pronounced share price decline than do low-accrual firms. This accounting contagion
effect is concentrated among revenue restatements by relatively large firms in the in-
dustry. We also find that investors impose a larger penalty on the stock prices of peer
firms with high earnings and high accruals when peer and restating firms use the same
external auditor. Our results are consistent with the notion that some accounting re-
statements cause investors to reassess the financial statement information previously
released by non-restating firms.
Keywords: accounting quality; contagion; earnings quality; information transfer.
JEL Classification: G34; D80.
Data Availability: Data are available from public sources.

I. INTRODUCTION

T
his paper investigates whether and how announced accounting restatements that in-
duce a shareholder loss at the correcting firm affect the share prices of non-restating
firms. Our study is motivated by two streams of empirical research. One research

We appreciate the helpful comments from Patricia Dechow, Dan Dhaliwal (editor), Lillian Mills, Gyung Paik, two
anonymous reviewers, and participants at the Brigham Young University Accounting Research Symposium, the
2005 Midyear Meeting of the Financial Accounting and Reporting Section of the American Accounting Association,
and workshops held at the University of Arkansas and The University of Iowa. We gratefully acknowledge the
contribution of I / B / E / S for providing analyst and earnings per share forecast data available through the Institu-
tional Brokers Estimates System. These data have been provided as part of a broad academic program to encourage
earnings expectations research.
Editor’s note: This paper was accepted by Dan Dhaliwal.
Submitted June 2006
Accepted July 2007

83
84 Gleason, Jenkins, and Johnson

stream documents the shareholder losses suffered when accounting misstatements are dis-
covered and prompt financial statement corrections (Anderson and Yohn 2002; Palmrose et
al. 2004), enforcement actions by the SEC (Feroz et al. 1991; Dechow et al. 1996), or
lawsuits by shareholders (Kellogg 1984; Francis et al. 1994). A second research stream
documents the information transfer effects associated with sales and earnings announce-
ments, management forecasts of earnings, and bankruptcy announcements (e.g., Foster
1981; Pyo and Lustgarten 1990; Freeman and Tse 1992; Lang and Stulz 1992; and Ramnath
2002).
Building on these research streams, we provide evidence on whether accounting mis-
statements discovered at one firm cause investors to reassess the content and credibility of
financial statements issued by other firms in the same industry. Specifically, we predict and
find that restatements that induce a shareholder loss at the correcting firm also induce a
statistically reliable share price decline among non-restating firms in the same industry.
This share price decline does not just reflect investors’ expectations of diminished economic
prospects for the industry or peer firm because it is unrelated to changes in analysts’ earn-
ings per share (EPS) forecasts coincident with the restatement. Instead, we find that the
share price decline is larger for peer firms with low accounting quality (i.e., high industry-
adjusted accruals). Accounting contagion is concentrated among revenue restatements by
relatively large firms in the industry. We also find that investors impose a larger penalty on
the stock prices of peer firms with high earnings and high accruals when peer and restating
firms use the same external auditor.
Our paper makes an important contribution to the literature on accounting quality and
investor behavior. One strand of that literature finds evidence of a higher cost of equity
capital for firms with low financial disclosure quality (Botosan 1997; Botosan and
Plumlee 2002), low earnings quality, and low accruals quality (Francis et al. 2004, 2005).
These findings confirm that investors routinely price accounting and disclosure quality,
although little is known about when and how they do so. Accounting quality concerns may
arise from financial press commentaries that target a particular firm or accounting contro-
versy (Foster 1979), from analysts’ research reports (Fairfield and Whisenant 2000), or
from firm-initiated announcements about a discovered accounting misstatement or the onset
of an accounting probe (Anderson and Yohn 2002; Palmrose et al. 2004). Informational
events of this sort help shape investors’ accounting quality assessments by highlighting the
firm’s questionable accounting practices. This paper shows that restatements also serve
as a catalyst for investors to reassess the past financial statements of other, similar
firms.
The remainder of the paper is organized as follows. Section II summarizes prior re-
search and develops testable implications about the contagion effects of restatements. Sec-
tion III describes sample selection procedures and provides descriptive information about
the restatement events that are the focus of our contagion tests. Section IV presents our
empirical results and Section V contains concluding remarks.

II. ACCOUNTING RESTATEMENTS AND INFORMATION CONTAGION

Articles in the financial press suggest that an accounting restatement by one firm may
cause investors to alter their assessments of financial statement information issued by other
firms in the industry. Consider, for example, Great Atlantic & Pacific Tea Company’s
(A&P) $36.8 million restatement in 2002. The restatement was prompted by an internal

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The Contagion Effects of Accounting Restatements 85

investigation into the company’s accounting for vendor allowances.1 A&P’s stock price fell
16 percent the day the restatement was announced.
A Wall Street Journal article on the A&P restatement quoted one industry analyst who
said that vendor allowances are ‘‘a very complicated area of accounting that’s only now
getting a lot of [investor] attention’’ (Covert 2002b). Few (if any) grocery companies dis-
closed details of their vendor allowance accounting practices in financial statement foot-
notes. The article concluded by noting that two of A&P’s competitors (Kroger Co. and
Winn-Dixie Stores) quickly confirmed their continuing use of the more conservative ac-
counting approach just adopted by A&P. Public confirmation was presumably meant to
dispel investor concern about aggressive accounting.
Two other grocery companies (Safeway and Albertson’s) ‘‘didn’t immediately respond
to requests for comment’’ (Covert 2002a), leaving investors and analysts in doubt as to
whether these firms’ previously reported financial results were tainted. One industry analyst
predicted that other (unnamed) grocery retailers would eventually restate earnings because
of improper accounting for vendor allowances. Two grocery firms (Flemmings Cos. and
U.S. Foodservices) did so during the ensuring nine months.2

Prior Research on Accounting Restatements

Management has a duty to correct inaccurate, incomplete, or misleading financial state-
ment disclosures in Securities and Exchange Commission (SEC) filings if the statements
are ‘‘discovered to have been false and misleading from the outset, and the issuer knows
or should know that persons are continuing to rely on all or any material portion of the
statements’’ (Sec. Act Rel. 6084, 17 SEC Dock. 1048, 1054 1979).3 Once identified, the
nature of the accounting misstatement and its financial statement effect must be disclosed.4
Correcting an accounting misstatement constitutes de facto admission that previously
issued financial statements contain misrepresentations, and may entail legal liability for
management and external auditors (Kellogg 1984; Francis et al. 1994; Karpoff et al. 2006b).
Correction of the misstatement may alter investors’ perception of the firm’s past perform-
ance or future prospects. Financial statement credibility may also be diminished if the
circumstances of the misstatement raise questions about management integrity, internal
control adequacy, audit committee oversight, or external auditor independence. It is there-
fore not surprising that restatement announcements convey unfavorable information to in-
vestors in restating firms.
Prior research shows that the stock prices of restating firms fall, on average, by some-
where between ⫺6 percent (Dechow et al. 1996) and ⫺10 percent (U.S. General Accounting
Office [GAO] 2003; Palmrose et al. 2004) when the restatement is first made public. The

1
The restatement also corrected comparatively small mistakes in the accounting for perishable inventory, self-
insurance reserves, and closed store subleases.
2
Safeway and Albertson’s both changed their accounting for vendor allowances in 2003, but neither firm issued
a formal restatement. Instead, they opted for prospective application of Emerging Issues Task Force Issue (EITF)
No. 02-16, Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,
which became effective in the first quarter of 2003.
3
Our operational definition of an accounting restatement does not include changes in accounting principle that
requires retroactive treatment, the use of the ‘‘pooling-of-interests’’ method for business combinations and dis-
continued operations or correction of prior interim financial reports when there is an adjustment (or settlement)
of litigation or similar claims provided that certain GAAP criteria are met.
4
Some restatements in our sample were first reported in press releases, others in Form 8-K filings, and still others
became known only when the final amended financials statements were filed. SEC rules adopted in August 2004
now require companies to file a Form 8-K within four days of discovering a misstatement in previously issued
financial statements. These rules also greatly expand the scope of information required to be disclosed about
the misstatement.

The Accounting Review, January 2008

86 Gleason, Jenkins, and Johnson

price decline is most pronounced when the restatement involves egregious accounting ir-
regularities or fraud, and culminates in enforcement action by the SEC or Department of
Justice (Karpoff et al. 2006a). Harsh legal penalties and regulatory sanctions are imposed
on executives and auditors who knowingly participate in the preparation of fraudulent or
misleading financial statements (Karpoff et al. 2006b). More generally, restatements often
precipitate top executive turnover (Desai et al. 2006) and are followed by shareholder
litigation against the company, its management, board of directors, and external auditors
(Griffin 2003; Palmrose and Scholz 2004), by a decline in sell-side analysts’ consensus
annual EPS forecasts and an increase in forecast dispersion (Palmrose et al. 2004; Hribar
and Jenkins 2004), and by an increase in the implied cost of equity capital (Hribar and
Jenkins 2004).
Some restatements correct unintentional accounting errors involving minor—but none-
theless material—clerical mistakes, financial software malfunctions, or inadvertent misap-
plications of accounting policies.5 Restatements of this sort tend to have minimal financial
statement impact and little or no discernable effect on the share prices of restating firms
(Anderson and Yohn 2002; GAO 2003; Richardson et al. 2003). Kinney and McDaniel
(1989) find that shareholder losses are negligible when the correction involves only one or
two prior quarterly filings and thus likely stems from an accounting error. Palmrose et al.
(2004) find that 29 percent of the restatement announcements in their sample do not ad-
versely affect shareholder wealth.6
In summary, the central message from prior research is that some (but not all) restate-
ments adversely affect shareholder wealth. Two forces may be responsible for the share
price decline observed for restating firms. First, a restatement makes clear that the firm’s
previously issued financial statements were tainted, thus causing investors to alter their
perceptions about the content and credibility of the restating firm’s financial statements.
Second, a restatement may also convey unfavorable information about the restating firm’s
economic prospects. Prior research has not attempted to disentangle the two effects, and
evidence consistent with both can be found in the literature.

Prior Research on Accounting Information Transfers

An intra-industry information transfer occurs when news released by one firm affects
the stock prices of other firms in the industry.7 The typical information transfer study
proceeds in three steps. First, the stock return behavior of announcing firms is examined
to isolate any share price movements that accompany the news event of interest (e.g., a
bank failure). Next, stock returns coincident to the news announcement are computed for

5
The distinction between a financial statement error and an irregularity centers on intent, which is often difficult
to determine in practice. Accounting ‘‘fraud’’ involves a high level of what lawyers call scienter—that is,
knowing and willful conduct—with actions intended to violate the law, misapply accounting standards, and
affect financial reporting.
6
Palmrose et al. (2004) offer three explanations for non-negative stock returns to announced restatements: (1)
some restatements involve minor corrections and thus have very little impact on investor perceptions; (2) other
information in the press release dampens or offsets the impact of the restatement; or (3) investors anticipate
some restatements, perhaps because of industry clustering around specific accounting issues. This last possibility
is consistent with our notion of contagion.
7
Accounting information transfers have been documented for earnings announcements (Foster 1981; Clinch and
Sinclair 1987; Pownall and Waymire 1989; Han and Wild 1990; Freeman and Tse 1992; Ramnath 2002), bank
loan-loss reserves (Docking et al. 1997) and retailers’ monthly sales reports (Olsen and Dietrich 1985). Infor-
mation transfers are also present for bank failures (Aharony and Swary 1983), bankruptcy filings (Lang and
Stulz 1992; Ferris et al. 1997), dividend initiations (Firth 1996), Internet hacker attacks (Ettredge and Richardson
2003), and nuclear accidents (Bowen et al. 1983).

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The Contagion Effects of Accounting Restatements 87

a sample of non-announcing firms (e.g., other banks). Information transfer effects are
presumed present when the mean event-period stock return for non-announcing firms is
reliably different from zero. Finally, corroborating evidence is sought indicating that cross-
sectional differences in the stock returns of non-announcing firms can be traced to event-
related differences in firm characteristics. In the case of adverse events like bank failures,
this step is designed to separate unfavorable ‘‘contagion’’ effects from favorable ‘‘compet-
itive’’ effects and to confirm that contagion stock returns are correlated with firm charac-
teristics that portend bank financial distress.8 Our empirical procedures are guided by this
same approach.

Restatement Contagion Hypotheses

Prior research is silent about whether restatements convey information useful to inves-
tors in pricing the common shares of other, similar firms. One possibility is that restatements
are extremely idiosyncratic and thus alter investors’ expectations about restatement firm
value, but leave non-restatement peer firm share prices unchanged. A second possibility is
that restatements influence peer firm share prices simply because they provide information
about deteriorating economic prospects for the industry. Under this scenario, restatements
are predicted to induce a downward revision in analysts’ earnings forecasts for peer firms
and those forecast revisions should explain the contagion stock returns experienced by peer
firms. Of course, our primary interest lies in a third possibility—namely that restatements
function as a catalyst for altering investors’ perceptions about the financial statements issued
by other (non-restating) firms in the industry. In this case, contagion stock returns will be
positively correlated with variables that proxy for differences in the quality of peer firms’
reported financial information.
Accounting restatements are likely candidates for information contagion related to ei-
ther changing industry prospects or to accounting quality concerns. As prior research has
demonstrated, some (but not all) restatements produce an immediate and economically large
share price decline at the announcing firm. We conjecture that this unfavorable information
will spill over to non-restating firms in the same industry; firms that are presumably engaged
in similar business transactions, face similar industry prospects, and use similar accounting
practices. Consequently, our first hypothesis predicts a contagion effect:

H1: The share prices of non-restating firms in the same industry will decline in response
to accounting restatements that produce large share price declines at the announc-
ing firm.

Prior research suggests that a restatement-induced contagion share price effect, if pres-
ent, is likely to be small in magnitude and thus difficult to detect in broad samples of peer
firms. In studies of contagion effects due to bankruptcy filings (Lang and Stulz 1992) and
loan-loss reserve increases (Docking et al. 1997), the contagion share price effects are only
about 4 percent as large as the mean share price decline experienced by announcing firms.
Consequently, we suspect that the average restatement-induced contagion share price effect

8
Contagion effects are present when an adverse event at one firm also conveys negative information about the
valuation of other firms, for example, when the failure of one bank portends financial distress at other banks
that have similar clientele, lending practices, and geographical concentration. Competitive effects are present
when the adverse informational event conveys favorable information about related firms, for example, when the
failure of one bank is expected to induce predatory responses by competitors that yield increased market share
and profitability.

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88 Gleason, Jenkins, and Johnson

will also be small in magnitude. In our setting, differences in accounting quality among
peer firms presumably result in small contagion effects for some firms and large contagion
effects for others.
Our second research hypothesis tests this conjecture by examining whether the conta-
gion stock returns of peer firms are correlated with differences in accrual measures of
accounting quality. Anecdotal evidence in financial press articles lends credence to this
hypothesis. Some restatements apparently cause analysts and investors to scrutinize the
accounting practices and financial disclosures of other firms in the industry to determine
whether non-restating firms employ dubious accounting practices or otherwise misrepresent
their financial performance in a manner similar to that of the restating firm. The share prices
of suspect firms then decline as investors alter their perceptions about the content and
credibility of firms’ past financial statements. Evidence of a positive association between
contagion stock returns and accounting quality differences would provide support for the
notion that restatements trigger heightened financial statement skepticism by investors.9
Accordingly, our second research hypothesis is:
H2: Restatement-induced contagion share price effects will be positively associated
with cross-sectional differences in accounting quality as measured by accrual-
related financial statement characteristics.
Our tests include controls for concurrent information about changes in firms’ economic
prospects (Palmrose et al. 2004), capital market pressures confronting management
(Richardson et al. 2003), and the severity of the restatement.
Our final hypothesis predicts that restatement contagion will be most pronounced
among peer firms that subsequently issue an accounting restatement. We conjecture that
investors respond to restatements involving commonly used accounting practices (e.g., ven-
dor allowances at A&P) by correctly altering their assessment of the probability that other
firms in the industry will subsequently disclose and correct misstatements similar to those
uncovered at the restating firm. Our third research hypothesis is:
H3: Peer firms that later announce their own restatement will exhibit larger contagion
share price declines than non-restating peer firms.
The intuition underlying this partial anticipation hypothesis also implies that investors will
be less surprised than they otherwise would have been by subsequent restatements in the
industry when those restatements involve similar accounting and reporting issues.
III. SAMPLE SELECTION AND RESTATEMENT FIRMS’
SHARE PRICE BEHAVIOR
Stock Return Measurement and Restatement Events
Size-adjusted daily common stock returns are used to document the share price response
to announced accounting restatements. Size-decile returns constructed from NYSE, AMEX,

9
There are two ways in which increased investor skepticism can induce a contagion stock price decline among
peer firms. Investors who fear that a peer firm’s financial statements are tainted might lower their expectations
for future earnings and cash flows. This response recognizes that past levels of tainted earnings and cash flow
are less persistent than previously thought. Alternatively, investors might just increase the discount rate applied
in an equity valuation model to expected (but unadjusted) future earnings or cash flows to reflect information
risk. Substantial disagreement exists about whether information risk is priced (Core et al. 2007; Francis et al.
2005; Lambert et al. 2006). We acknowledge the debate but remain agnostic about its implication for our
research. Moreover, our cross-sectional accruals tests are not intended to disentangle the two potential expla-
nations for a contagion price reaction.

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The Contagion Effects of Accounting Restatements 89

and NASDAQ listed firms are from CRSP. Announcement buy-and-hold abnormal stock
returns are cumulated over a three-day window (day ⫺1 to day ⫹1) that spans the day of
the first press release describing the accounting misstatement (day 0). CRSP delisting re-
turns are included if available.
Our initial sample of 919 restatement events is from the GAO (2003) and comprises
nearly all public company restatements from January 1, 1997 to June 30, 2002. We augment
this sample with 185 restatements identified in Wall Street Journal articles published be-
tween January 1, 1990 and December 31, 1996.10 Restatement announcement dates (denoted
day 0) are from the GAO (for events after January 1, 1997) or are hand-collected from
Wall Street Journal articles (for events before January 1, 1997).11 Restatements are dis-
carded if CRSP announcement period common stock returns are unavailable (154 events),
or the restating firm lacks an industry peer group comprised of at least five firms (62 events).
This yields a preliminary sample of 888 restatements involving 807 firms.
Figure 1 depicts the frequency of announced restatements by calendar quarter and GAO
focus category (e.g., ‘‘revenue recognition’’ as defined in the Appendix) for the preliminary
sample. Each event is assigned to one of the nine GAO categories that best reflects the
primary (but not exclusive) accounting misstatement uncovered at the firm. Restatements
involving most GAO focus categories occur throughout the sample period and become more
frequent through time. A notable exception to this pattern is ‘‘in-process research and
development’’ (IPR&D) restatements, which are predominantly clustered in a single cal-
endar quarter. Even though the preliminary sample exhibits calendar quarter clustering,
there is minimal event date clustering of restatement announcements involving the same
accounting focus and industry.12
To enhance our ability to detect restatement-induced stock price contagion, we eliminate
338 events (38.1 percent of the preliminary sample) where restatement is initially announced
as part of the firm’s routine quarterly earnings press releases. These events tend to involve
minor misstatements in past quarterly (but not annual) filings. Their inclusion in the sample
presents a problem because information transfer effects are known to be associated with
quarterly earnings releases.
We also discard restatements that fail to convey unfavorable information about the
restatement firm’s value. Specifically, events are discarded if the announcement period ab-
normal stock return is either positive (135 events) or lies between zero and ⫺1.0 percent
(24 events) because inclusion of these events would add noise to the analysis.13 We also

10
The Dow Jones Interactive娃 database was searched electronically for Wall Street Journal articles containing the
text strings CORRECTION, ERROR, REVISION, or RESTATEMENT in conjunction with ACCOUNTING,
EARNINGS, FINANCIAL STATEMENTS, or RESULTS. Approximately 2,200 articles were identified. Each
article was then read and discarded from further consideration if the restatement: (1) failed to satisfy the GAO
selection criteria for inclusion (U.S. GAO 2003) or (2) involved a U.S. firm not listed on the CRSP database or
a foreign firm.
11
We confirm GAO announcement dates against company press releases and 8-K filings, and uncover 24 cases
where the restatement is first disclosed earlier than the GAO date. We use the earlier confirmed press release
or 8-K date where there is a conflict.
12
Only about 3 percent of the restatements in our preliminary sample of 888 events occur within three trading
days of one another, and less than 6 percent occur within 10 trading days, when clustering is assessed by
industry and accounting focus category.
13
Press releases for the 20 events with the largest positive three-day abnormal return (mean return of 28.2 percent,
range from 17.3 percent to 53.4 percent) were examined to identify the likely source of positive restatement
announcement stock return. Nineteen press releases describe accounting errors in quarterly (but not annual)
financial statements that were quickly discovered and corrected by management. These releases also contain
information about favorable earnings pre-announcements, confirmation of a bankruptcy reorganization plan, or
board approval of a stock repurchase plan and rights offering. The final press release announces discovery and
correction of a computer error that had understated earnings for the prior nine months.

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The Accounting Review, January 2008

90
FIGURE 1
Frequency of Restatements by GAO Accounting Focus Category and Calendar Quarter from January 1990 through June 2002

Gleason, Jenkins, and Johnson

The vertical axis of each graph ranges from zero to 40. Each segment of the horizontal axis denotes a calendar quarter. Accounting focus categories are from the U.S.
GAO (2003) study and are described in the Appendix.
The Contagion Effects of Accounting Restatements 91

eliminate 11 remaining IPR&D restatements because they are transaction-specific and clus-
tered in calendar time. Moreover, they have no discernable average impact on the share
prices of restating firms nor do they produce contagion stock price effects among peer firms
(Banyi 2006).
Our final sample is comprised of 380 restatements that adversely affect shareholder
wealth at the restating firm. These restatements involve firms in every economic sector but
are more prevalent among information technology firms (roughly 30 percent of the sample)
and consumer discretionary firms (18 percent of the sample). There is almost no time-series
clustering of restatement announcements by industry and GAO focus category evident in
the final sample.14

Non-Restating Peer Firms

Non-restating peer firms are identified from Compustat’s active and research data files
using historical eight-digit Global Industry Classifications Standard (GICS) codes.15 Indus-
try peer firms are retained if: (1) announcement period (day ⫺1 to day ⫹1) stock returns
are available on CRSP; (2) analysts’ consensus annual earnings per share (EPS) fore-
casts are available from I/B/E/S for one month before and one month after the restatement
announcement; (3) the pre-announcement stock price is at least $5; and (4) the peer firm
has not announced an accounting restatement within the preceding 24 months. Changes in
analysts’ EPS forecasts are used to control for the possibility that restatement announce-
ments also convey information about the economic prospects for the industry as a whole
or for individual peer firms.16 Firms with stock prices below $5 are excluded to mitigate
potential trading liquidity problems that might add noise to the analysis. We retain peer
firms that issue a restatement at a later date as long as they meet the other sample selection
criteria.
This process produces a peer group sample comprised of 22,510 firms or about 59 peer
firms for each restatement event. Each peer group is comprised of at least five firms to
diversify the impact of any idiosyncratic price movements that might otherwise confound
our contagion tests.

Stock Price Behavior of Restating Firms

Table 1 reports descriptive statistics on the stock return behavior of restating firms.
Size-adjusted abnormal returns are calculated for the announcement period (days ⫺1 to
⫹1), the pre-announcement window (days ⫺10 to ⫺2) and two post-announcement win-
dows (days ⫹2 to ⫹10 and days ⫹2 to ⫹60) to capture information about share price
behavior around the restatement announcement. The data in Panel A confirm that the re-
statements in our sample are accompanied by a reliably negative mean three-day announce-
ment period abnormal return of ⫺19.8 percent.

14
The final sample contains one industry-by-focus event that occurs within three trading days of another event,
and just four events that occur within 10 trading days of each other. Our results are not altered when these
clustered events are excluded from the sample.
15
Bhojraj et al. (2003) show that GICS classifications are better at explaining stock return co-movements, valuation
multiples, forecasted and realized earnings growth rates, R&D expenditures, and various financial ratios (e.g.,
ROE) than are Standard Industrial Classification (SIC) codes or Fama and French (1997) industry groups. An
alternative approach for identifying peer firms is based on common coverage among sell-side analysts (Ramnath
2002). Despite its intuitive appeal, this approach does not yield a unique set of peer firms in all instances and
is not used here.
16
Requiring peer firms to be in the I / B / E / S data file allows us to control for changes in analysts’ EPS expectations
but tilts the non-restatement sample away from small, low-growth firms in each GICS industry.

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92 Gleason, Jenkins, and Johnson

TABLE 1
Abnormal Daily Stock Returns for 380 U.S. Firms That Announced Accounting Restatements
from January 1990 through June 2002 and Their Non-Restatement Industry Peer Firms

Restatement Firms Peer Firms

n Mean Median n Mean Median
Panel A: Restatement Returns
Announcement (day ⫺1 to ⫹1) 380 ⫺19.8%t ⫺14.6% 22,510 ⫺0.5%*** ⫺0.5%
Pre-announcement (day ⫺10 to ⫺2) 380 ⫺4.6%t ⫺3.8% 22,510 ⫺0.8%*** ⫺0.8%
Post-announcement (day ⫹2 to ⫹10) 380 ⫺2.1%t ⫺0.7% 22,510 ⫺0.7%*** ⫺0.7%
Post-announcement (day ⫹2 to ⫹60) 380 ⫺10.3%t ⫺10.9% 22,510 0.2% ⫺0.1%

Panel B: Announcement Returns by Accounting Focus

Revenue recognition 148 ⫺21.5%t ⫺17.1% 7,615 ⫺0.5%*** ⫺0.9%
Cost or expense 45 ⫺19.9%t ⫺16.9% 2,407 ⫺0.4%*** ⫺0.3%
Restructurings and write-downs 49 ⫺19.7%t ⫺13.4% 1,583 ⫺0.4%** ⫺0.6%
Acquisitions and mergers 26 ⫺16.1%t ⫺7.4% 1,763 ⫺0.3%* ⫺0.6%
Securities 22 ⫺11.7%t ⫺5.1% 1,936 ⫺1.5%*** ⫺0.7%
Other 90 ⫺20.1%t ⫺13.5% 7,206 ⫺0.3%*** ⫺0.4%
380 22,510
*, **, *** Denotes a statistically significant two-tailed t-test of the null hypothesis that the mean cumulative
abnormal return is different from zero at the 0.10, 0.05, and 0.01 levels, respectively.
Restatements announced concurrently with quarterly or annual earnings are excluded from the sample as are
those where the three-day announcement period abnormal stock return for the restating firms is equal to or
greater than ⫺1.0 percent. Restating firms’ announcement period stock returns are therefore different from zero
by construction (denoted by ‘‘t’’ in the table) because the sample is restricted to restatements that adversely
affect shareholder wealth at the restating firm. Non-restating peer group firms are identified from Compustat
using the eight-digit Global Industry Classifications Standard (GICS) of the corresponding restating firm. Non-
restating firms are discarded if: (1) CRSP stock returns for the announcement period plus the following 240
trading days are not available on the CRSP data files; (2) analysts’ consensus earnings per share forecasts issued
immediately before and after the restatement announcement are not available on the I / B / E / S data files; (3) the
pre-announcement stock price is less than $5; or (4) the peer firm restated its own financial statements within
the preceding two years.
Daily stock returns are size adjusted using CRSP NYSE / AMEX / NASDAQ market capitalization decile returns
and are then compounded over time to reflect a ‘‘buy and hold’’ return. Day 0 is the trading date of the first
restatement-related press release issued by the restating firm. Accounting focus categories correspond to the
GAO (2003) groupings as described in the Appendix.

Restating firms also exhibit a reliably negative mean abnormal return of ⫺4.6 percent
over the nine trading days preceding the announcement. This pre-announcement share price
decline could reflect bad news unrelated to the restatement, information leakage related to
the restatement, or partial anticipation triggered by other restatements. The mean abnormal
return for restating firms is ⫺2.1 percent over the nine trading days following the press
release announcement, and ⫺10.3 percent over the entire 59-day post-announcement period.
This post-announcement share price decline has been documented elsewhere and likely
reflects the resolution of investor uncertainty about the circumstances, magnitude, and scope
of the misstatement and other related bad news.
Panel B of Table 1 reports the three-day abnormal stock returns of restating firms by
accounting focus using the five broad GAO (2003) categories in the Appendix. The mean
three-day abnormal return for restating firms varies from ⫺21.5 percent for ‘‘revenue rec-
ognition’’ misstatements to ⫺11.7 percent for ‘‘securities’’ misstatements. In summary, the

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The Contagion Effects of Accounting Restatements 93

restatements that form the basis for our contagion tests involve a range of accounting issues
and (by construction) are associated with substantial share price declines among restating
firms.

IV. STOCK PRICE REACTION OF NON-RESTATING PEER FIRMS

Share Price Behavior of Non-Restating Firms
Descriptive statistics summarizing the abnormal stock returns of peer firms are reported
in Table 1. Non-restating peer firms experience a reliably (p ⬍ 0.01) negative mean three-
day abnormal return of ⫺0.5 percent when an accounting misstatement is first announced
by another firm in the industry. This result is consistent with the notion that announcement
of a discovered accounting misstatement by one firm in the industry triggers information
contagion among peer firms. The mean price decline for peer firms in our sample is small
but comparable in magnitude to earlier contagion studies (i.e., Lang and Stulz 1992;
Docking et al. 1997).
Non-restating peer firms experience a reliably negative ⫺0.8 percent average share price
decline over the pre-announcement period. This pre-announcement share price decline mir-
rors that experienced by restating firms and could reflect bad news unrelated to the discov-
ered misstatement, information leakage related to the announced misstatement, or partial
anticipation effects triggered by other recently announced restatements. Peer firms’ share
prices continue to drift downward until about day ⫹10 (⫺0.7 percent mean abnormal re-
turn).17 Some degree of post-announcement drift might be expected in this setting because
it is a time-consuming task for investors to gather and evaluate information about the
circumstances of the misstatement and the specific accounting issues involved, determine
whether the accounting practices of other firms in the industry are likely to be tainted, and
then assess the share price implications of this accounting quality concern.
Panel B of Table 1 reports the mean three-day announcement period abnormal stock
return for non-restating peer firms by accounting focus. A reliably negative share price
decline is present for each GAO accounting focus category, with the largest decline occur-
ring for ‘‘securities’’ restatements (⫺1.5 percent). ‘‘Securities’’ restatements involve finan-
cial services firms and the distinctly homogeneous nature of GICS industries in this eco-
nomic sector may partially explain why the contagion share price decline is so large relative
to that for restating firms (⫺11.7 percent).

Contagion Stock Returns and Analysts’ Earnings Forecast Revisions

In this section, we investigate whether a restatement by one firm in the industry affects
analysts’ EPS forecasts for peer firms and, if so, whether these forecast revisions then
explain the share price behavior of peer firms. Palmrose et al. (2004) find that restatements
are accompanied by a statistically significant ⫺6.7 percent decline in the sell-side analysts’
consensus (scaled) annual EPS forecasts. Moreover, this EPS forecast revision exhibits a
positive cross-sectional association with restatement firms’ announcement period share price
declines. These forecast revisions may simply reflect the mechanical consequences of cor-
recting the misstatement as, for example, when costs improperly capitalized in the past are
now to be expensed as incurred. Alternatively, restatement firms’ forecast revisions may
arise because restatements alert analysts and investors to the deteriorating economic pros-
pects of the announcing firm and, perhaps, its industry.

17
There is a very small, but statistically reliable, positive correlation between the announcement period stock
returns of peer firms’ and both their pre-announcement returns (␳ ⫽ 0.02) and their post-announcement returns
over days ⫹2 through ⫹10 (␳ ⫽ 0.01). This pattern is also present among restating firms.

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94 Gleason, Jenkins, and Johnson

To distinguish between these two possibilities, we investigate whether peer firms also
experience downward earnings forecast revisions when the restatement is announced. We
measure the change in analysts’ annual EPS forecasts over a 60-day period that begins with
the I/B/E/S consensus forecast issued immediately prior to the restatement announcement.
Our composite forecast revision measure is the average dollar change in the consensus one-
year- and two-year-ahead EPS estimates for a given peer firm, scaled by pre-announcement
share price.
Peer firms exhibit a statistically significant but small ⫺0.6 percent decline in analysts’
(scaled) annual EPS forecasts after a restatement announcement by another firm in the
industry. This result is consistent with the notion that restatements convey some new in-
formation about deteriorating economic conditions in the industry or, alternatively, that they
tend to occur when the industry’s prospects are otherwise declining. However, EPS forecast
revisions are statistically unrelated to the three-day abnormal stock returns of peer firms.18
This finding indicates that changes in analysts’ expectations about future economic per-
formance, as captured by their EPS forecast revisions, do not explain the contagion stock
returns of non-restating firms.

Contagion Stock Returns, Accounting Quality, and Capital Market Pressure

This section investigates whether restatement-induced contagion stock returns are cor-
related with measures of accounting quality (AQ) and capital market pressure for aggressive
accounting (PRESS); i.e., constructs that prior research has shown predict the likelihood of
restatement (Richardson et al. 2003). If the share price declines of peer firms do indeed
reflect investors’ heightened concern about tainted financial statements, then contagion stock
returns should exhibit a positive association with contemporaneous measures of accounting
quality and a negative association with capital market pressures for aggressive accounting.
On the other hand, finding no association between contagion stock returns and account-
ing quality or capital market pressure would cast doubt on our conjecture that a restatement
by one firm triggers a reassessment by investors of the financial statements of other firms
in the industry.
Our cross-sectional regression analysis of size-adjusted three-day stock returns (CARi)
has the following general form:

冘 ␤ Control
9
CARi ⫽ ␣0 ⫹ ␤1AQi ⫹ ␤2PRESSi ⫹ k ki ⫹ εi (1)
k⫽3

where the variables of interest capture information about peer firm accounting quality (AQ)
and capital market pressure (PRESS). The model specification includes several control var-
iables (described below) and year fixed-effect indicators to partially mitigate the influence
(if any) of restatement announcement calendar year.
Our proxy measures for accounting quality follow from earlier studies showing that
large accounting accruals predict restatements (Richardson et al. 2003) and SEC enforce-
ment actions (Dechow et al. 1996). As a baseline, we first estimate the cross-sectional
regression of contagion stock returns using industry-mean-adjusted annualized quarterly

18
The coefficient estimates and t-statistics from our untabulated regression of scaled EPS forecast revisions on
peer firms’ three-day stock returns for the 22,510 non-restatement firms in Table 1 are: intercept of ⫺0.00561
(t ⫽ ⫺16.78) and EPS forecast revision coefficient of ⫹0.00071 (t ⫽ 0.34). The regression F-statistic is 0.12
(p ⫽ 0.73). For estimation purposes, we eliminate influential outlying observations with leverage values ex-
ceeding 2 (Belsley et al. 1980).

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The Contagion Effects of Accounting Restatements 95

earnings (EARN) as the accounting quality measure. The baseline model establishes whether
contagion stock returns are associated with differences in the relative profitability of peer
firms. We then decompose industry-adjusted EARN into operating cash flow and total ac-
cruals (CFO and TACC, respectively) to isolate accounting accruals and thus capture in-
formation about potential differences in the quality of earnings reported by peer firms.19
TACC reflects both operating and investing accruals for the period and thus serves as a
comprehensive measure of accrual behavior that incorporates all nonfinancing accrual
transactions. Finally, TACC is decomposed into its operating and investing components
(OPER ACC and INV ACC) so that the incremental contribution of each type of accrual
can be assessed. Contagion stock returns (CAR) are predicted to be negatively associated with
industry-adjusted total accruals, operating accruals, and investing accruals consistent with the
notion that restatement-induced contagion share price declines are larger among peer firms
with relatively low-quality earnings.
To capture information about capital market pressures for aggressive accounting choices
and thus about the ex ante likelihood of restatement, we rely on prior evidence from
Richardson et al. (2003). They find that investors’ perceptions of future earnings growth,
as measured by book-to-market (BM) and earnings-to-price (EP) ratios, are negatively re-
lated to the probability of restatement. Peer firms that trade at substantial multiples of book
value and earnings (i.e., low BM and EP) presumably face greater pressure to adopt ag-
gressive accounting practices to deliver the anticipated earnings growth. Richardson et al.
(2003) also find that firm SIZE (measured as the natural logarithm of equity market value)
is positively related to the probability of restatement. Larger firms are subject to closer
scrutiny by the investment and analyst community, and this heightened scrutiny contributes
to increased capital market pressure for aggressive accounting choices. Two other variables
shown to be predictive of future restatements are EPS GROWTH firms with increases in
year-over-year quarterly EPS in each of the four quarters prior to restatement, and STRING
firms with small positive forecast errors in each of the prior four quarters.20 Richardson et
al. (2003) find that EPS GROWTH is positively related to the probability of restatement,
while STRING is negatively related.
Although we limit the sample to restatements that adversely affect shareholder wealth
at the restating firm, we include the restating firm’s three-day abnormal stock return
(RESTRET) to control for differences in investor perceptions of the severity and importance
of the restatement and related information in the announcement. Events that investors deem
to be relatively inconsequential will have RESTRET values closer to zero and are less likely

19
Earnings, cash flow, and accrual variables are ‘‘annualized’’ by accumulating quarterly amounts over the four
fiscal quarters preceding the restatement announcement. Annualized amounts are then industry-mean adjusted
using sample means for all non-restating peer firms available on Compustat so that the resulting variables
measure abnormal levels of profitability, cash flow, and accruals. Earnings (EARN) is income before extraordinary
items, scaled by average assets; total accrual (TACC) is EARN minus the sum of operating cash flow (CFO)
and investing cash flow, scaled by average assets; operating accruals (OPER ACC) is EARN minus CFO,
whereas investing accruals (INV ACC) is TACC minus OPER ACC. Variable definitions correspond to those
in Richardson et al. (2003). Other accrual-based measures of accounting quality are considered in robustness
tests.
20
As in Richardson et al. (2003), we define a ‘‘small positive forecast error’’ to be cases where the I / B / E / S
actual EPS exceeds the last available I / B / E / S consensus EPS forecast by no more than three cents per share.
Unadjusted I / B / E / S consensus data are used to mitigate the rounding problems encountered with split-adjusted
earnings estimates and actual earnings (Baber and Kang 2002). Richardson et al. (2003) also document a positive
association between the probability of restatement and salary mix, defined as the fraction of top executives’ total
compensation that is equity based. We omit this variable because of data availability constraints. We also omit
variables that measure ‘‘financing raised’’ and ‘‘ex ante financing need’’ because neither variable is shown to
predict future restatements in Richardson et al. (2003).

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96 Gleason, Jenkins, and Johnson

to provoke peer firm contagion. REST SIZE is the restating firm’s equity market value
decile rank on CRSP. Restatements by relatively large firms in an industry are likely to
provoke greater contagion than are those at small firms. REVISION is the scaled composite
change in analysts’ consensus one-year- and two-year-ahead EPS forecasts for the peer firm
(see the ‘‘Contagion Stock Returns and Analysts’ Earnings Forecast Revisions’’ section),
and controls for changes in expectations about future performance. LEV is measured as
total debt-to-equity ratio and controls for the well-known influence of leverage on observed
stock price reactions to informational events.
Three variables (DAYS F, DAYS L, and FIRST) capture information about the chron-
ological sequence of restatements in an industry and their time-series proximity. The in-
dicator variable FIRST denotes the initial restatement announcement in a series of related
restatements (or ‘‘episode’’) involving different firms but the same focus category and
industry. DAYS F counts the cumulative number of trading days that have elapsed since
the episode’s first restatement. DAYS L counts the number of trading days that have elapsed
since the last restatement by any firm and regardless of focus category.21 These variables
allow us to establish whether contagion becomes more or less pronounced as more firms
in the industry announce similar accounting restatements. We use the completion date of
the most recent annual audit (approximated by the fiscal fourth quarter earnings release
date plus 20 trading days) to reset the episode counter. This approach presumes that each
peer firm’s outside auditor responds to a restatement made by another firm in the industry
by assessing their client’s exposure to the same sort of misstatement and, if a misstatement
is discovered, requiring an immediate correction. Episodes are constructed from the original
sample of 888 events.
Earnings-based variables use the most recently available quarterly data as of the re-
statement announcement. We require the data collection quarter to end at least 30 days (45
days for the fourth quarter) prior to the restatement announcement so that investors have
timely access to peer firms’ quarterly financial statements. Quarterly cash flow data are not
readily available on Compustat for financial services firms and utilities, so both economic
sectors are deleted from the regression tests even though the results in Table 1 suggests
that restatement contagion is present in each sector.
Table 2 reports descriptive statistics for the 13,594 peer firms with available data for
our cross-sectional regression tests.22 The industry-adjusted accounting quality variables
(EARN, CFO, TACC, OPER ACC, and INV ACC) exhibit mean values greater than zero,
indicating that the peer firms in our sample are more profitable than the average for the
GICS industry group. The capital market pressure variables are not industry-adjusted and
exhibit mean values comparable to those reported by Richardson et al. (2003). Panel C
describes the distributional characteristics of the control variables. The announcement pe-
riod average abnormal stock return for restating firms (RESTRET) is ⫺21.4 percent, and
roughly 65 percent of the sample is comprised of initial restatement events (FIRST). Peer

21
To illustrate, consider three restatements that comprise a single episode. Each restatement is associated with a
unique vector of the form (FIRST, DAYS F, DAYS L). For example, (1, 0, 67) denotes the first restatement in
a focus category / industry episode where some other firm in the industry announced 67 days earlier a restatement
involving a different focus category; (0, 25, 25) denotes a second restatement in the same episode that occurs
25 trading days later, and (0, 65, 40) denotes a third restatement that occurs 40 days after the second restatement.
22
This reduced sample includes 367 (96.6 percent) of the restatement events described in Table 1, and the mean
restatement and contagion stock return associated with these events are qualitatively indistinguishable from the
mean returns reported in Table 1.

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The Contagion Effects of Accounting Restatements 97

TABLE 2
Descriptive Statistics for 13,594 Non-Restating Peer Firms Included in the Cross-Sectional
Regression Analysis of Contagion Stock Returns on Accounting Quality, Capital Market
Pressure, and Control Variables

25th 75th Standard

Variable Mean Median Percentile Percentile Deviation
Panel A: Accounting Quality
EARN 0.060 0.067 0.000 0.165 0.402
CFO 0.044 0.047 ⫺0.024 0.137 0.181
TACC 0.053 0.027 ⫺0.068 0.156 0.422
OPER ACC 0.015 0.020 ⫺0.034 0.080 0.365
INV ACC 0.038 ⫺0.002 ⫺0.071 0.104 0.221
Panel B: Capital Market Pressure
EP ⫺0.022 0.027 ⫺0.015 0.058 0.386
BM 0.460 0.360 0.192 0.606 0.470
SIZE 5.996 5.849 4.763 6.960 1.656
EPS GROWTH 0.237 0.000 0.000 0.000 0.425
STRING 0.144 0.000 0.000 0.000 0.351
Panel C: Control Variables
RESTRET ⫺0.214 ⫺0.175 ⫺0.303 ⫺0.063 0.183
REVISION ⫺0.010 0.000 ⫺0.003 0.000 0.218
REST SIZE 6.375 7.000 4.000 9.000 2.645
FIRST 0.651 1.000 0.000 1.000 0.477
DAYS F 37.374 0.000 0.000 38.000 79.325
DAYS L 221.463 61.000 2.000 299.000 348.034
LEV 0.576 0.101 0.000 0.608 4.939
EARN is income before extraordinary items; CFO is cash flow from operations; total accruals (TACC) is EARN
minus the sum of CFO plus cash flow from investing activities; operating accruals (OPER ACC) is EARN
minus CFO; and investing accruals (INV ACC) is TACC minus operating accruals. Earnings, cash flow, and
accrual variables are ‘‘annualized’’ by accumulating quarterly amounts over the four fiscal quarters before the
restatement announcement. Annualized amounts are then scaled by average assets for the same time period, and
industry mean-adjusted using sample means for all Compustat firms in the same GICS industry group. The
tabulated mean values for these variables are approximately equal to 0 by construction. Earnings-to-price (EP) is
‘‘annualized’’ income from continuing operations divided by equity market value, book-to-market (BM) is book
value of equity divided by equity market value, and SIZE is the natural logarithm of equity market value, all
measured at the end of the fiscal quarter preceding the restatement announcement. EPS-GROWTH equals 1 if the
firm reports consecutive increases in year-over-year quarterly EPS for each of the prior four quarters, and 0
otherwise. STRING equals 1 if the firm reports a small positive EPS forecast error (less than 4 cents per share)
in each of the prior four quarters, and 0 otherwise. RESTRET is the restating firm’s three-day abnormal stock
return. REVISION is the composite change in analysts’ consensus one- and two-year-ahead earnings per share
forecasts, scaled by share price and measured from the month before the restatement announcement to the month
following. REST SIZE is the restating firm’s CRSP size decile rank as of the beginning of the calendar year in
which the restatement is announced. FIRST is an indicator variable that equals 1 for the initial restatement event
(as defined in the ‘‘Contagion Stock Returns, Accounting Quality, and Capital Market Pressure’’ sub-section in
section IV) in a sequence of restatements involving different firms but the same focus category and industry, and
0 otherwise. DAY F counts the number of trading days that have elapsed since the episode’s first restatement.
DAY L counts the number of trading days that have elapsed since the last restatement in the industry regardless
of focus category. Leverage (LEV) is total debt divided by equity book value measured at the end of the fiscal
quarter preceding the restatement announcement.
The sample selection procedures used to identify peer (non-restatement) firms are described in Table 1. The
number of peer firms in this table is less than that in Table 1 because of data availability limitations and the
exclusion of financial services and utility firms from the sample.

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98 Gleason, Jenkins, and Johnson

firms again exhibit a small decline in analysts’ (scaled) annual EPS forecasts after a re-
statement announcement by another firm in the industry.23
The results of our cross-sectional regression tests of the influence of accounting quality
and capital market pressure on contagion stock returns are reported in Table 3. Coefficient

TABLE 3
Regression Tests for the Influence of Accounting Quality, Capital Market Pressure, and
Control Variables on Contagion Stock Returns

Model 1 Model 2 Model 3

Intercept ⫺1.168*** ⫺0.918** ⫺0.916**
Accounting quality:
EARN ? 0.189
CFO ? 1.639*** 1.624***
TACC ⫺ ⫺0.532***
OPER ACC ⫺ ⫺0.569**
INVST ACC ⫺ ⫺0.499*
Capital market pressure:
EP ⫹ 0.702*** 1.055*** 1.080***
BM ⫹ 0.319** 0.314** 0.317**
SIZE ⫺ 0.066* 0.023 0.023
EPS GROWTH ⫺ 0.219* 0.180 0.180
STRING ⫺ 0.626*** 0.590*** 0.590***
Control variables:
RESTRET ⫹ ⫺0.224 ⫺0.203 ⫺0.203
REVISION ⫹ 0.355 0.150 0.146
REST SIZE ⫺ ⫺0.079*** ⫺0.077*** ⫺0.077***
FIRST ⫺ 0.224 0.248 0.247
DAYS F ⫺ ⫺0.003*** ⫺0.003*** ⫺0.003***
DAYS L ⫺ ⫺0.001*** ⫺0.001*** ⫺0.001***
LEV ? ⫺0.046*** ⫺0.044*** ⫺0.044***
YEAR FIXED EFFECTS Not reported Not reported Not reported
2
Adj. R 2.43% 2.70% 2.69%
F-statistic 13.85*** 14.76*** 14.21***
Sample size 12,890 12,886 12,886
*, **, *** Denotes a statistically significant two-tailed t-test of the null hypothesis that the coefficient estimate is
different from zero at the 0.10, 0.05, and 0.01 levels, respectively.
The dependent variable is the size-adjusted buy-and-hold stock return for each non-restating peer firm cumulated
over the three trading days centered on the restatement announcement date.
The sample selection procedures used to identify peer (non-restatement) firms are described in Table 1. Variable
definitions appear in Table 2. Coefficient estimates for year fixed-effect variables are omitted for brevity.
Influential observations with leverage values exceeding 2.0 are eliminated to facilitate estimation of robust
regression coefficients (Belsley et al. 1980). Coefficient estimates are multiplied by 100 in the table.

23
Untabulated results show statistically significant pair-wise correlations for several explanatory variables. In par-
ticular, the accounting quality variables are highly collinear by construction. Cash flow from operations (CFO),
total accruals (TACC), and operating accruals (OPER ACC) are each positively correlated with earnings (EARN),
while OPER ACC and investing accruals (INV ACC) are both positively correlated with TACC. The extent of
collinearity present among capital market pressure and control variables is modest in most cases. A notable
exception is the large negative Pearson correlation (⫺0.64) between FIRST and DAYS F that occurs because
the distribution of DAYS F is censored with values equal to 0 when FIRST equals 1.

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The Contagion Effects of Accounting Restatements 99

estimates for the year fixed-effect variables are suppressed for brevity. Influential obser-
vations with leverage values exceeding two are deleted to facilitate robust estimation
(Belsley et al. 1980).
The data in Table 3 reveal that contagion stock returns are statistically unrelated to the
relative profitability of peer firms (EARN in Model 1). Contagion stock returns do exhibit
a reliably positive association with operating cash flows (CFO in Model 2) and a reliably
negative association with total accruals (TACC in Model 2). As predicted, peer firms with
high industry-adjusted total accruals experience a more pronounced contagion stock price
decline than do low-accrual firms. On the other hand, peer firms with high industry-adjusted
operating cash flows experience a less pronounced contagion stock price decline than do
low operating cash flow firms. This means that contagion stock returns reflect investor
concern about the relative contribution of operating cash flow and total accruals to reported
earnings rather than just a concern about earnings levels. When TACC is decomposed into
its operating and investing components (Model 3), the resulting coefficient estimates are
again reliably negative.
Contagion stock returns exhibit a positive and significant association with three capital
market pressure variables: EP, BM, and STRING. This means that peer firms with higher
growth expectations (price-to-earnings and book-to-market ratios) and those with a track
record for continuous quarterly EPS growth experience a larger contagion share price de-
cline than do peer firms with low growth expectations and no track record. The coefficient
estimates for SIZE and EPS GROWTH are insignificant except in Model 1.
Table 3 also shows that the coefficient estimates for REST SIZE, DAYS F, DAYS L,
and LEV are reliably negative. This means that peer firms experience larger contagion stock
price declines when a dominant firm in the industry restates, when a substantial amount of
time has elapsed since the last restatement in the industry, and when the peer firm is highly
leveraged. Peer firms’ EPS forecast revisions (REVISION), the restating firm’s own stock
return (RESTRET), and whether the restatement is the first in a series of related restatements
(FIRST) are statistically unrelated to cross-sectional differences in contagion stock returns.24
To summarize, the evidence in Table 3 is consistent with the notion that accounting
restatements trigger stock price declines among peer firms that in part reflect investors’
accounting quality concerns. This conclusion follows from the observation that contagion
stock returns are decidedly more negative for peer firms with high accounting accruals and
low operating cash flows (i.e., low accounting quality), and high capital market pressure
for aggressive accounting choices.25

Revenue Restatements versus Expense Restatements

To gain further insight about the circumstances under which accounting quality con-
siderations influence contagion stock returns, Table 4 reports regression results for two
restatement groups formed from the GAO focus categories. One group contains 147 revenue
recognition restatements and 6,542 peer firms, while the second group is comprised of 174

24
The absence of a significant positive RESTRET coefficient in Table 3 does not contradict our claim of a contagion
price effect. RESTRET captures information about both common effects (i.e., those that trigger contagion) and
idiosyncratic effects unique to the restatement firm. Our other variables provide a direct measure of the predicted
contagion effects and this presumably diminishes the explanatory power of RESTRET.
25
In supplemental tests, we augment the accrual measures in Richardson et al. (2003) using variables that proxy
for balance sheet ‘‘bloat’’ (Barton and Simko 2002) and for book-tax differences in accounting practices (Mills
and Newberry 2001; Phillips et al. 2003). We find little support for these measures.

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100
TABLE 4
Accounting Focus Category Regression Tests for the Influence of Accounting Quality, Capital Market Pressure,
and Control Variables on Contagion Stock Returns

Revenue Recognition Restatements (147 Events) Expense Restatements (174 Events)

Model 1 Model 2 Model 3 Model 1 Model 2 Model 3
Intercept ⫺1.326** ⫺0.886 ⫺0.883 ⫺0.451 ⫺0.490 ⫺0.438
Accounting quality:
EARN ? 0.965** 0.756*
CFO ? 2.300*** 2.262*** 1.050** 1.005**
TACC ⫺ ⫺0.966*** 0.497
OPER ACC ⫺ ⫺1.044*** 0.346
INVST ACC ⫺ ⫺0.896*** 0.457
Capital market pressure:
EP ⫹ 0.647 1.538*** 1.606*** 2.518*** 2.496*** 2.557***
BM ⫹ ⫺0.005 ⫺0.022 ⫺0.010 0.282 0.303* 0.307*
SIZE ⫺ 0.007 ⫺0.041 ⫺0.041 0.089 0.087* 0.081
EPS GROWTH ⫺ ⫺0.009 ⫺0.028 ⫺0.028 0.129 0.119 0.128
STRING ⫺ 0.557** 0.551** 0.551** 0.383* 0.381* 0.360
Control variables:
RESTRET ⫹ 0.002 0.033 0.036 ⫺0.489 ⫺0.472 ⫺0.479
REVISION ⫹ 0.814** 0.862** 0.851** 0.581 0.598 0.622
REST SIZE ⫺ ⫺0.154*** ⫺0.154*** ⫺0.153*** ⫺0.064** ⫺0.063** ⫺0.064**
FIRST ⫺ 0.868*** 0.862*** 0.862*** ⫺0.621 ⫺0.613 ⫺0.607

Gleason, Jenkins, and Johnson

DAYS F ⫺ ⫺0.002** ⫺0.002* ⫺0.002* ⫺0.009* ⫺0.009* ⫺0.009*
DAYS L ⫺ 0.000 0.000 0.000 0.000 0.000 0.000
LEV ? ⫺0.040** ⫺0.040** ⫺0.040** ⫺0.041*** ⫺0.041*** ⫺0.041***
YEAR FIXED EFFECTS Not reported Not reported Not reported Not reported Not reported Not reported
2
Adj. R 3.73% 4.41% 4.40% 2.98% 3.08% 3.00%
F-statistic 11.01*** 12.44*** 11.97*** 7.13*** 7.09*** 6.72***
Sample size 6,197 6,200 6,200 4,991 4,991 4,991
(continued on next page)
 The Contagion Effects of Accounting Restatements
TABLE 4 (continued)

*, **, *** Denotes a statistically significant two-tailed t-test of the null hypothesis that the coefficient estimate is different from zero at the 0.10, 0.05, 0.01 levels,
respectively.
Accounting focus categories follow the groupings used in the GAO (2003) study and are described in the Appendix. Expense restatements are those assigned to the
GAO categories ‘‘Cost and Expense,’’ ‘‘Other,’’ and ‘‘Restructuring.’’
The sample selection procedures used to identify peer (non-restatement) firms are described in Table 1. Variable definitions appear in Table 2. Coefficient estimates for
year fixed-effect variables are omitted for brevity. Influential observations with leverage values exceeding 2.0 are eliminated to facilitate estimation of robust regression
coefficients (Belsley et al. 1980). Coefficient estimates are multiplied by 100 in the table.
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101
102 Gleason, Jenkins, and Johnson

expense restatements and 5,249 peer firms.26 We expect accounting quality contagion to be
more pronounced for revenue restatements because the underlying business transactions,
accounting practices, and affected financial statement items are more heterogeneous for the
expense group.
The key insight from Table 4 is that the accounting quality results in Table 3 are driven
by revenue-restating peer firms. Contagion stock returns for these peer firms exhibit a
reliably positive association with industry-adjusted profitability (EARN) and with operating
cash flows (CFO), but a reliably negative association with total accruals (TACC) and its
two components (OPER ACC and INVST ACC).27 EARN and CFO coefficients are reliably
positive when the sample is restricted to expense restatements, but none of the accrual
coefficient estimates are negative and the coefficient on TACC is reliably positive.28
The results in Table 4 provide contradictory evidence on the influence of capital market
pressure variables on contagion stock returns. For example, the EP coefficients are statis-
tically significant and in the direction predicted for both revenue and expense restatements.
On the other hand, STRING remains significant in the opposite direction predicted by
Richardson et al. (2003) and none of the other capital market pressure variables exert a
detectable influence on contagion stock returns for revenue recognition restatements. The
coefficients for SIZE and BM are reliably positive when the sample is restricted to expense
restatements. We have no compelling explanation for differences in capital market pressure
across restatement categories.
Several features of the control variable results in Table 4 are noteworthy. Contagion
stock returns are statistically more negative when a large firm in the industry restates
(REST SIZE) and when other firms in the industry have also announced similar restatements
(DAYS F). Third, the coefficients for EPS forecast REVISION are reliably positive among
revenue restatements but indistinguishable from zero for expense restatements. Revenue
restatements may be a more important source of information about declining industry pros-
pects than expense restatements, and thus induce larger and more value relevant EPS fore-
cast revisions among peer firms. Finally, FIRST restatements are associated with a less
negative contagion stock return in the revenue restatement sample, but have no incremental
effect on peer firms’ stock returns in the expense restatement sample.29

26
Expense restatements include those assigned to ‘‘Cost and expense,’’ ‘‘Restructuring,’’ and ‘‘Other’’ GAO cate-
gories. Expense restatements involve corrections to one or more of a myriad of balance sheet items including
bad debt or product warranty reserves, inventory, fixed assets, capitalized marketing costs or other intangibles,
and operations liabilities as well as off-balance sheet items such as operations leases and pensions. We omit
‘‘Merger and acquisition’’ and ‘‘Securities’’ restatements because they are transaction driven events for which
peer firm data about the relevant prior transaction is not readily available in electronic form.
27
Thirty-eight of the 888 restatements involve accounting mistakes made when implementing the revenue recog-
nition requirements proscribed in Staff Accounting Bulletin (SAB) No. 101 issued by the SEC in 2000. Excluding
SAB No. 101 restatements from the regression sample has no discernable impact on the revenue restatement
results in Table 4 nor does it alter the results in Table 3.
28
Rajgopal and Venkatachalam (2005) find that idiosyncratic stock price volatility is statistically associated with
abnormal accrual measures. Volatility may function as a correlated omitted variable in the Table 3 and Table 4
regressions. We repeat the analysis including stock price volatility, measured as the standard deviation of peer
firm-specific raw returns over a one-year period ending 30 days before the restatement announcement. As
expected, the coefficient estimate for volatility is reliably negative in all regressions. Including volatility elimi-
nates the association between contagion stock returns and our measures of accounting quality except when the
sample is restricted to revenue restatements by large firms in the industry. For this subsample, the coefficient
estimates for TACC and OPER ACC remain reliably negative.
29
We re-estimated our regressions using a Huber-White correction to mitigate the effect of within-firm autocor-
relation on our test statistics (Huber 1967; White 1980). As expected, control variables measured at the restate-
ment event level (e.g., REST SIZE or RESTRET) become statistically insignificant because the common variance
component is large relative to the individual variance component. Some capital market pressure variables lose
significance, but our findings about accounting quality are unchanged.

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The Contagion Effects of Accounting Restatements 103

Supplemental Tests
This section describes briefly how the results in Tables 3 and 4 change when: (1) the
restating firm and its peers use the same external auditor; (2) the return measurement
window is expanded, and (3) the sample is limited to restatements by large firms in the
industry.

External Auditor Effects

To investigate whether contagion share price effects are more pronounced when re-
stating and peer firms use the same external auditor, we identify the restating firm’s auditor
for the fiscal year before the restatement is announced. Approximately 18 percent of the
peer firms in our sample use the restating firm’s auditor. We augment the regression by
inserting a common-auditor indicator variable and also interact it with the accounting qual-
ity variables.
We find that contagion stock returns are negatively related to the incremental effects
of CFO and OPER ACC when peer and restating firms use the same auditor. The negative
incremental ‘‘same auditor’’ coefficient for OPER ACC is concentrated in revenue restate-
ments by relatively large firms, while the negative incremental coefficient for CFO is con-
centrated in expense restatements by small firms. The incremental coefficient for EARN is
also reliably negative in both sample partitions. Investors thus appear to impose an incre-
mental contagion penalty on peer firms with high earnings and high accruals when the peer
and restating firm share the same external auditor.

Expanded Returns Window

Restating firms and their peers both experience a pre-announcement stock price decline
and post-announcement drift (Table 1). To investigate the possibility that our three-day
announcement period returns tests may not capture the full extent of accounting quality
contagion, we expand the returns window to 21 trading days (⫺10 to ⫹10) and repeat the
Table 4 regression tests.
Three insights emerge from this analysis. First, the coefficients for accruals (TACC,
OPER ACC, and INV ACC) remain reliably negative for revenue restatements and the
coefficient for operating cash flows (CFO) is reliably positive. Second, the coefficient es-
timates for EARN, TACC, OPER ACC, and INV ACC become reliably negative for ex-
pense restatements. Third, the coefficient estimate for EPS forecast REVISION is reliably
positive for restatements involving either revenues or expenses. The pattern of results for
the remaining variables is largely unchanged. These long-window results thus suggest that
accounting quality contagion is present among both revenue and expense restatements.

Dominant Restating Firm

Restatements by large firms induce a greater contagion stock price decline than do
restatements by small firms; i.e., the REST SIZE coefficient is reliably negative in Tables
3 and 4. This result suggests that restatements by large firms may also cause investors to
become more skeptical about peer firm accounting quality. To investigate this question, we
partition the sample according to the restating firm’s SIZE relative to all restatement and
peer firms in the same GICS industry group. Restatements by firms in the bottom tercile
are assigned to the ‘‘Small Firm’’ group, while those in the middle and top terciles are
assigned to the ‘‘Large Firm’’ group.
The accounting quality coefficient estimates (TACC, OPER ACC, and INV ACC) are
reliably negative when the sample is restricted to revenue restatements by large firms in
the industry. However, these variables are unrelated to contagion stock returns when the

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104 Gleason, Jenkins, and Johnson

sample is restricted to revenue restatements by small firms or expense restatements by small

or large firms.

Investor Anticipation of Subsequent Accounting Restatements

This section investigates whether investors respond to the first restatement in an industry
by penalizing the share prices of peer firms that later disclose and correct similar accounting
misstatements. Evidence that investors partially anticipate later restatements in the same
industry would support the joint hypothesis that (1) initial restatements serve as a catalyst
for reassessing the accounting quality of peer firms, and (2) investors can correctly predict
which peer firms are likely to later restate.
The partial anticipation tests exploit the time-series clustering of restatements by in-
dustry and GAO focus category illustrated in Figure 1. We identify the first restatement in
each industry/focus category episode using our original sample of 888 restatements. This
process yields 643 restatement episodes of one or more restatements involving the same
focus category and by firms in the same industry.30 Of these, 530 episodes (82.4 percent)
contain only the one restatement. The other 113 episodes (17.6 percent) contain both an
initial and at least one later (‘‘follow-on’’) restatement.
Industry peer firms are assigned to one of two mutually exclusive groups: peer firms
that later restate during the episode (denoted ‘‘Restate later’’), and those that do not (denoted
‘‘Do not restate’’). For each group, we compute the three-day mean abnormal stock return
associated with the first restatement in the episode. If investors partially anticipate future
restatements when the first restatement is announced, then we should observe a larger stock
price decline for ‘‘Restate later’’ peer firms than for non-restating peer firms.31 We also
compute the three-day mean return for the restatements announced subsequently by ‘‘Re-
state later’’ firms.
Table 5 reports the results of the partial anticipation for 340 revenue restatement epi-
sodes constructed from our original sample (Panel A) and 148 episodes from the final
sample that is the basis for our cross-sectional regression tests (Panel B). The data in both
panels show that average share price reaction of ‘‘Restate later’’ peer firms to initial revenue
restatements is negative but statistically indistinguishable from zero. Nor do the data suggest
that ‘‘Restate later’’ firms experience a smaller share price decline when they subsequently
announce their own restatements. Untabulated results for expense restatements are quali-
tatively similar to those reported in Table 5.
The central message from Table 5 is that we do not find support for the partial antic-
ipation hypothesis.32 The share prices of firms that subsequently uncover and correct similar
accounting misstatements are statistically unaffected, on average, when other firms in the
industry first announce a restatement. The apparent failure on the part of investors to cor-
rectly anticipate subsequent accounting restatements does not imply market inefficiency
because restatements are admittedly difficult to predict (Richardson et al. 2003).

30
Consistent with the approach used in constructing the variable FIRST, the completion date of the most recent
annual audit (approximated by the fiscal fourth quarter earnings release date plus 20 trading days) is used to
reset the episode counter.
31
The test lacks power for detecting contagion-related partial anticipation if relatively innocuous restatements tend
to surface first or if the task of forming correct assessments about the likelihood of restatement by an individual
firm is exceedingly difficult.
32
This finding is confirmed by regression test results where we restrict the sample to events with FIRST equals 1
and repeat the analysis in Tables 3 and 4.

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The Contagion Effects of Accounting Restatements 105

TABLE 5
Tests for Partial Anticipation Following Revenue Recognition Restatements

Three-Day Announcement Period Abnormal Stock

Returns (%)
Restatement Firms Peer Firms (n)
(n) Restate Later Do Not Restate
Panel A: All Revenue Restatments
First in the episode ⫺9.89%*** ⫺1.31% ⫺0.24%***
(190) (83) (6,893)
Without a follow-on restatement ⫺9.53%*** ⫺0.20%*
(129) (3,791)
With a follow-on restatement ⫺10.64%*** ⫺1.31% ⫺0.30%**
(61) (83) (3,102)
Subsequent restatements ⫺11.99%*** ⫺0.91%***
(150) (10,174)

Panel B: Final Revenue Restatement Sample

First in the episode ⫺19.95%t ⫺3.03% 0.01%
(88) (36) (3,168)
Without a follow-on restatement ⫺18.63%t ⫺0.34%**
(60) (1,588)
With a follow-on restatement ⫺22.79%t ⫺3.03% 0.36%*
(28) (36) (1,580)
Subsequent restatements ⫺23.70%t ⫺0.77%***
(60) (4,337)
*, **, *** Denotes a statistically significant two-tailed t-test of the null hypothesis that the coefficient estimate is
different from zero at the 0.10, 0.05, and 0.01 levels, respectively.
An episode is series of one or more revenue restatements by firms in the same industry. First restatements are
those where no earlier revenue restatement has occurred in the industry since completion of firms’ most recent
annual audit (approximated by the fiscal year end plus 30 trading days). All other restatements are classified as
follow-on events because they occur in close proximity to an earlier revenue restatement by a firm in the same
industry. A restating firm is classified as ‘‘relatively large’’ if it falls in the top two-thirds of the industry peer
firm size distribution based on market capitalization; otherwise, the restating firm is considered ‘‘relatively
small.’’ The ‘‘final’’ restatement sample is limited to revenue restatements that are not announced as part of a
quarterly or annual earnings press release and that give rise to a stock price decline of at least 1.0 percent. The
average abnormal stock returns of ‘‘final’’ restating firms are different from zero by construction and denoted
with a ‘‘t’’ in the table. Non-restating peer firms are identified using the procedures described in Table 1. Daily
abnormal stock returns are size-adjusted using CRSP NYSE / AMEX / NASDAQ market capitalization decile
returns. The announcement period is a three-trading-day window centered on the date of the initial restatement-
related press release.

V. CONCLUSION
This paper examines whether accounting misstatements discovered at one firm cause
capital market participants to reassess the content and quality of financial statements pre-
viously issued by other firms in the same industry. We predict and find that accounting
restatements that adversely affect shareholder wealth at the restating firm also induce a
small but statistically reliable share price decline among non-restating peer firms. This price
decline is unrelated to changes in analysts’ EPS forecasts, our proxy for restatement-induced
changes in investors’ expectations about peer firms’ future economic prospects. We also

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106 Gleason, Jenkins, and Johnson

predict and find that non-restating firms with high industry-adjusted accruals experience a
more pronounced share price decline than do low-accrual peer firms. This accounting con-
tagion effect is concentrated among revenue restatements by relatively large firms in the
industry. For these restatements, investors impose a larger contagion penalty on the stock
prices of peer firms with high earnings and high accruals when peer and restating firms
use the same external auditor. We also find evidence of accrual-related contagion for ex-
pense restatements, but only when the stock return event window is expanded to 21 days.
The data provide mixed support for the influence of capital market pressures on peer firms’
stock returns.
Our results are consistent with the predicted contagion effects of accounting restate-
ments, although not all restatements induce contagion. One recurring message in the data
is that revenue restatements by relatively large firms cause investors to reassess the past
financial statements of other firms in the industry. This reassessment induces a share price
decline among low-quality (i.e., high-accrual) peer firms. However, our data also suggest
that this process is noisy because we find no evidence to indicate that investors partially
anticipate subsequent restatements by these firms.
There are several caveats to our interpretation of the results. First, the overall explan-
atory power of the regression model is quite modest. This may reflect noise in our measure
of contagion stock returns, limitations of the accounting quality variables, or our reliance
on a broad sample of industry peer firms. For example, we have not attempted to control
for the possibility that peer firms issue ‘‘good’’ or ‘‘bad news’’ press releases in close
proximity to the restatement announcement. Moreover, our accounting quality measures
capture information about current (or lagged) accruals in general, rather than accruals spe-
cific to the accounting item that is the focus of the restatement.
A second caveat is that we cannot rule out the possibility that the contagion stock
returns documented here just reflect restatement-induced changes in expectations about the
future economic performance of peer firms. Our tests control for this possibility using
analysts’ EPS forecast revisions, but the control may be incomplete. Consequently, it is
possible that our accrual results are driven by reduced expectations of peer firms’ future
performance that coincidentally is more pronounced among firms with high industry-
adjusted accruals than among low-accrual firms.33
A final caveat concerns the out-of-sample generalizability of the study’s findings. Our
results show clearly that accounting quality contagion is not ubiquitous. Many restatements
have no discernable negative impact on restating firms’ share prices, a necessary condition
for contagion among peer firms. Out-of-sample generalizability is also limited by the chang-
ing nature of restatements themselves. Implementation of Sarbanes-Oxley Section 404 in-
ternal control evaluations prompted a flood of restatements in 2005 and 2006, many of
which corrected classification mistakes or errors in the application of complex GAAP rules.
Restatements of this sort have little (if any) impact on the share prices of restating firms,
and thus do not induce peer firm contagion.
One intriguing aspect of our results is that financial statement contagion effects are
concentrated among revenue recognition restatements. The reason why contagion effects
are less prevalent among expense restatement is not entirely clear, although we suspect it

33
In a recent working paper, Durnev and Mangen (2007) also find that the share price decline of competitor firms
is larger in industries where competitors have made more inefficient investments in the past, as measured by
the marginal Tobin’s Q for the industry. Neither their hypotheses nor tests are intended to explain the share
price declines of individual peer firms in an industry.

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The Contagion Effects of Accounting Restatements 107

is partially due to expense item heterogeneity. A more detailed examination of the revenue
and expense restatements, and of the underlying business transactions and accounting prac-
tices of peer firms, may shed further light on the circumstances under which contagion
occurs. Another avenue for future research is the possibility that some restatements induce
‘‘competitive’’ share price effects of the sort described in footnote 6. Our tests do not
examine this possibility.

APPENDIX
ACCOUNTING RESTATEMENT CATEGORIES AS DESCRIBED
IN THE GAO STUDY

Category Description
Acquisitions and Restatements of acquisitions or mergers that were improperly accounted
mergers for or not accounted for at all. These include instances in which the
wrong accounting method was used or losses or gains related to the
acquisition were understated or overstated. This category does not
include in-process research and development or restatements for
mergers, acquisitions, and discontinued operations when appropriate
accounting methods were employed.
Cost or expense Restatements due to improper cost accounting. This category includes
instances of improperly recognizing costs or expenses, improperly
capitalizing expenditures, or any other number of mistakes or
improprieties that led to misreported costs. It also includes
restatements due to improper treatment of tax liabilities, income tax
reserves, and other tax-related items.
In-process research Restatements resulting from instances in which improper accounting
and development methodologies were used to value in-process research and
development at the time of an acquisition.
Other Any restatement not covered by the listed categories. Cases included in
this category include restatements due to inadequate loan-loss reserves,
delinquent loans, loan write-offs, improper accounting for bad loans
and restatements due to fraud, and accounting irregularities that were
left unspecified.
Reclassifications Restatements due to improperly classified accounting items. These
include restatements due to improprieties such as debt payments being
classified as investments.
Related-party Restatements due to inadequate disclosure or improper accounting of
transactions revenues, expenses, debts, or assets involving transactions or
relationships with related parties. This category includes those
involving special-purpose entities.
Restructuring, Restatements due to asset impairment, errors relating to accounting
assets, or treatment of investments, timing of asset write-downs, goodwill,
inventory restructuring activity and inventory valuation, and inventory quantity
issues.
Revenue recognition Restatements due to improper revenue accounting. This category includes
instances in which revenue was improperly recognized, questionable
revenues were recognized, or any other number of mistakes or
improprieties were made [sic] that led to misreported revenue.
Securities-related Restatements due to improper accounting for derivatives, warrants, stock
options, and other convertible securities.
Source: U.S. GAO (2003, 6).

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108 Gleason, Jenkins, and Johnson

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