Internal Control Quality and Restatement-Related Litigation: The Importance of Ttimely Material Weakness Disclosures

• In Event: Accounting Errors and Auditor Litigation

Abstract

This study investigates whether the existence and timing of material internal control weakness (MW) disclosures is associated with restatement-related litigation risk. The disclosure of a MW during the misstated time period could either increase litigation risk because it represents the failure of management to maintain effective controls or decrease litigation risk because plaintiffs would be less able to argue that management withheld bad news from investors. Examining MW and restatement disclosures from 2003 – 2011, we find that MW disclosures increase the likelihood that a company will experience restatement-related litigation but only if the company failed to disclose the MW during the misstated time period. In addition, we find that plaintiffs are more likely to argue that management withheld material information from investors if MW disclosures are not timely. Lastly, we find that arguments that management failed to disclose MWs are positively associated with the settlement amount when a settlement does occur. Our results suggest that restatement-related litigation risk increases with undisclosed MWs and may act as a mechanism to deter MW non-disclosure.

Authors

• Chris E Hogan, Michigan State University

• Tamara A Lambert, University of Massachusetts Amherst

• Jaime J Schmidt, The University of Texas at Austin