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.