Does Accounting Information Affect Investor Uncertainty

about Firm Value around Restatements?

Yuri Loktionov
Leventhal School of Accounting
Marshall School of Business
University of Southern California

Kara Wells*
Leventhal School of Accounting
Marshall School of Business
University of Southern California

May 2012

*Corresponding Author. Contact email: karawell@usc.edu.

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

ABSTRACT

This paper investigates how the quality of accounting information (measured as the inverse of
the Dechow-Dichev accrual quality measure) impacts investors reaction to announcements of
financial accounting restatements. We measure investors reaction (change in investor
uncertainty about firm value) as the change in implied volatility around the event of restatement
announcements. We document that restatement announcements are associated with increases in
implied volatility and that the magnitude of the change in implied volatility depends on the
severity of the restatement. Next we find evidence that firm accounting quality attenuates the
relationship between change in implied volatility and restatement news. Controlling for stock
returns, we find firms with high accounting quality have a lower change in implied volatility.
Overall, the evidence provided in this paper suggests that the quality of a firms accounting
information impacts how investors view and interpret negative economic news leading to, on
average, a smaller increase in investor uncertainty.

Keywords: accounting quality; investor uncertainty, implied volatility, restatements, information

environment
Data Availability: Data used in this study are publicly available from the sources identified in
the text.
2

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

I. INTRODUCTION
This study investigates whether accounting quality affects the revisions to investors
beliefs about firm riskiness around restatement announcements.1 Prior literature on the effect of
information quality on investors reaction to economic shocks primarily focuses on the stock
price reaction; however there is an emerging literature that studies the impact of information
quality on investors uncertainty about firm value in response to new information (e.g. Rogers et
al. 2009; Subramanyam et al. 2005; Hilary 2008). Our study adds to this strand of literature by
showing that uncertainty investors have about firm value increases around the announcement of
a negative firm-specific event (accounting restatements) and that this relationship is attenuated
by high firm information quality. We hypothesize that the information environment of a firm
(proxied by firm accounting quality) impacts investors belief revisions to the riskiness of firm
value (proxied for by implied volatility of stock returns) around negative news events
(restatement announcements) as higher accounting quality sharpens the information signal
received by investors. We document that restatement announcements are associated with an
increase in investor uncertainty and that this relationship increases in the severity of the
restatement. Further, we show empirically that accounting quality attenuates this relationship
firms with high accounting quality experience smaller changes in implied volatility. This result
is robust to controlling for other known determinants of implied volatility, including cumulative
stock returns associated with the restatement announcement.
Following prior literature, we measure investor uncertainty as the change in implied
volatility of firms stock returns, using the interpolated volatility surface provided by the

We define accounting quality as the inverse of accrual quality as measured by the standard deviation of
abnormal accruals. We define revisions to investors beliefs about firm riskiness or investor uncertainty as the
change in the option implied volatility of a firm.

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

OptionMetrics database.2 Implied volatility captures investors expectations of a firms average

stock return volatility over the life of the option. We use the change in the implied volatility
around the restatement announcement to capture the conditional variance (conditional on the
restatement announcement) of investors beliefs about firm value. As investors receive new
information about the riskiness of the firm, they will use this information to update their beliefs
about the variability of firm value.3
We calculate accounting quality as the inverse of the standard deviation of abnormal
accruals (Dechow and Dichev 2002; Francis et al. 2004 and 2005). Abnormal accruals are the
residuals from the regression of total current accruals on cash flows from operations from time t1 to t+1, change in revenue, and gross plant property and equipment, all scaled by total assets
and are estimated by industry-year. The abnormal accruals capture distortions induced by an
imperfect measurement system (Dechow et al. 2010). If accounting quality captures the degree
to which reported accounting information reflects the true future cash flows of a firm, then it
should play an important role in determining how investors react to new accounting information.
Specifically, when investors receive the negative news that the firm must issue an accounting
restatement, investors should take into account the overall accounting information environment
of a firm when updating their beliefs about the variability of firm value.
We study the impact of accounting quality on investor uncertainty in the context of
restatement announcements.4 Restatement announcements are negative economic shocks that

This is the same measure of implied volatility used in Rogers et al. (2009). Prior studies have used option
volatilities derived only from call options. We use an interpolated volatility surface generated from hypothetical atthe-money options with various lengths to expiration.
3
Rogers et al. (2009) show that investors do update their beliefs about firm riskiness about presented with certain
types of voluntary disclosures. Likewise, Subramanyam et al. (2005) find evidence the there is a change in implied
volatility around earnings surprises.
4
We acknowledge that restatements are just one type of negative news. Other types of negative firm-specific news
include negative unexpected earnings announcements, decreases in dividend payments, Failed or unprofitable
acquisitions, etc. We choose to focus on restatements (further classified as regular or irregular) as it is a fairly direct

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

result from negative news about the reported accounting numbers (Palmrose et al. 2004).
Restatements can be classified as either regular restatements (unintentional errors) or irregular
restatements (intentional errors or manipulations). We obtain restatement information from the
GAO database and classify irregular restatements following the procedure of Hennes, Leone and
Miller (2008). We focus on restatement announcements as it is a direct measure of firm-specific
news about the quality of accounting information released to investors. We expect that belief
revisions about the quality of accounting information will impact investors expectations about
the variability of firm value or future cash flows (the firm level of riskiness).
Results indicate that restatement announcements are followed by an increase in investor
uncertainty about firm value. This finding corresponds to the evidence in prior literature that
negative economic shocks are associated with an increase in investor uncertainty (e.g.
Subramanyam et al. 2005). We contribute to this literature by showing that investor uncertainty
also increases around restatement announcements and that the magnitude of the change in
investor uncertainty is associated with the severity of the restatement news. When we allow the
relationship between restatement news and change in implied volatility to be conditional on firm
accounting quality, we find evidence to support our main hypothesis that accounting quality
attenuates the relationship (the coefficient on the indicator variable for high accounting quality is
negative and statistically significant).
Overall, this study contributes to the accounting literature in three ways. First, we show
that negative news in the form of restatement announcements leads to an increase in implied
volatility. This empirical finding supports the theory of Subramanyam et al. (2005); departing
from traditional price-response models which only allow new information to decrease

measure of news that changes the perception of the quality of accounting information that has been received by
investors.

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

uncertainty (Kim and Verrecchia, 1994). Secondly, we document that the magnitude of the
increase in the change in implied volatility depends on the severity of the restatement news.
Third, we find that accounting quality has a moderating effect on investors expectations. We
find that the accounting information environment affects how investors incorporate negative
news provided by restatement announcements into their beliefs about the variability of future
cash flows.
The next section provides a brief literature review on information quality and changes in
investor uncertainty. It also discusses accounting quality as a measure of firm information
environment and motivates why we expect firm accounting quality to have a moderating effect
on investor uncertainty around restatement announcements. Section 3 discusses the research
design and develops the hypotheses. Section 4 presents the results and Section 5 concludes.

2. MOTIVATION AND LITERATURE REVIEW

Our primary research question is does the quality of accounting information affect
investors assessments of uncertainty about firm value around accounting restatements? To
address this research question we first motivate why firm news and in particular restatement
announcements impact investors expectations about the uncertainty of firm value. Next we
provide motivation from the literature on accounting quality for why we expect the accounting
information environment of a firm to differentially impact investor uncertainty when there is an
accounting restatement. Lastly, we discuss the importance of controlling for stock returns when
studying the implied volatilities.
2.1 Investor Uncertainty and Information Events

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

Throughout this paper we use the term investor uncertainty to mean investors
uncertainty of the true underlying value of a firm. Since the true value of a firm is unobservable,
there is always some degree of uncertainty surrounding the markets valuation of the firm; stock
price. Our paper is interested in studying how investors assessments of uncertainty about firm
value change when investors receive firm specific information. If firm volatility, the variability
of firm price, is allowed to vary deterministically over time then the firms implied volatility is a
measure of investors assessment of the average volatility over the length of the option
(Mayhew, 1995). We therefore measure investor uncertainty as the implied volatility of a firm
where the implied volatility is captured over the length of option. An emerging literature in
accounting uses implied volatility to measure investor uncertainty and has provided some
preliminary evidence in support of new information impacting a firms implied volatility.
New information, to the extent it is a surprise, creates uncertainty which in turn increases
return volatility. Rogers et al. (2009) note that there are two primary channels by which news
leads to increases in return volatility; increases in information asymmetry and increases in
uncertainty about underlying firm profitability. When the market receives new information,
there can be increases in information asymmetry among investors, leading to a temporary
increase in the volatility of prices as the market adjusts and interprets the new information (e.g.,
Kim and Verrecchia, 1994).

Alternatively, new information can also change investors

expectations about the future cash flows of a firm, impacting the long run uncertainty of a firm.
We are interested in studying both of these channels. To do this we pick a setting, restatement
announcements, which is likely to affect both short-term uncertainty and long run uncertainty
about future firm profitability.

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

Prior literature has examined the impact of news events on investor uncertainty, making
predictions about the short-run or long-term impact of the news on investor uncertainty. Rogers
et al. (2009) study the impact of managers voluntary disclosures (categorized as regular or
sporadic) on investor uncertainty and find that mangers forecasts do increase short-term market
uncertainty. However, management forecasts cease to impact investor uncertainty once earnings
are announced. They also document that if firms that sporadically disclose provide a forecast
which conveys negative news then there is an increase in long-run investor uncertainty
indicating that investors uncertainty about firm profitability changed.
Subramanyam et al. (2005) develop a model which predicts that the level of investor
uncertainty (measured as the implied volatility of a firm) increases with the magnitude of
earnings surprises. The model in Subramanyam et al. (2005) expands on the price response to
information when the precision of information is uncertain model of Subramanyam (1996),
deviating from traditional rational expectations models where information always decreases
uncertainty (e.g. Kim and Verrecchia, 1991).

They test this model using earnings

announcements as the information event, with the relative information being the magnitude of
the earnings surprise. While they do find that small surprises lead to a decrease in investor
uncertainty, they are unable to empirically document that large surprises lead to an increase in
investor uncertainty. Our study complements Subramanyam et al. (2005) by examining one side
of information events negative news, in a different setting accounting restatements. By not
imposing symmetry in investor uncertainty, we are able to document an increase in investor
uncertainty around negative events. This increase in investor uncertainty is exacerbated when
we partition on extreme negative news irregular restatements.

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

Rogers et al. (2009) and Subramanyam et al. (2005) look at firm specific events that can
be either positive news or negative news. In a working paper by Hilary (2008), the author looks
at the impact on investor uncertainty when there is market-wide negative news. Here the author
proxies for negative news by using the 10 worst days in the market over the past 25 years. Our
study is similar to Hilary (2008) in that we also look at negative news events. Unlike Hilary
(2008) we look at negative news events that are firm specific, restatement announcements. One
advantage of looking at restatement announcements is that our negative news event is defined
independently of the markets response to the information.
Overall, the small but growing literature in accounting on implied volatility around firm
specific and market wide events provide some theory and initial evidence that investor
uncertainty changes when there is new information and that this change leads to an increase in
implied volatility when the new information is bad news. Our study contributes to this literature
by examining a new setting restatement announcements, which is always negative news. We
show that implied volatility increases after a firm announces a restatement. In addition, we
provide evidence that the relationship between the negative news event the change in investor
uncertainty depends on the overall quality of the accounting information.
2.2 Accounting Quality and Financial Accounting Information Environment
Accounting quality is a summary measure that provides a useful way to study the
financial accounting information environment of a firm.5 Many studies in the accounting quality
literature focus on the accounting measurement system by modeling the accrual process of
earnings; using the abnormal component as a proxy for earnings quality (Jones 1991; Dechow
1994; Dechow and Dichev 2002). Here the premise is that if we model the accrual process

A recent review article by Dechow, Ge, and Schrand (2010) notes that there are over 100 published papers in the
accounting literature on accounting quality.

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

correctly, then any deviations or abnormal accruals erode decision usefulness and result in lower
earnings quality or accounting quality.6
A widely accepted abnormal accrual model in this field is a modified version of the
Dechow and Dichev model (Dechow and Dichev 2002). In this model accruals serve a noise
reduction role for mapping reported earnings into firm performance (Dechow 1994). Subsequent
research adds to this model by adding growth in revenue and gross property plant and equipment
to capture performance and expand the type of accruals modeled (McNichols 2002; Francis et al.
2005). Accrual quality is then the standard deviation of the residuals from these models. We use
this measure of accounting quality (the inverse to accrual quality) to proxy for the quality of the
accounting information environment of a firm.
The accounting information environment of a firm can vary in the cross section for a
variety of reasons such as variation in manager ability to predict the firms future cash-flows,
intentional manipulation, and variation in how the accounting system tracks firm information.7
Specifically, firms will have higher accounting quality (a better accounting information
environment) if managers faithfully and accurately represent and report the firm operations and
if the accounting system (as dictation by USGAAP) is able to accurately capture and transcribe
this information.
Investor uncertainty arises from the inability of managers to predict firm profitability
(Hilary, 2008). In addition, information asymmetry can arise because the accounting reporting
system may not be able to disseminate the information known to management and/or
management may be reluctant to reveal information about the future profitability of the firm.
6

SFAC No. 1 defines accounting quality or earnings quality as Higher quality earnings provide more information
about the features of a firms financial performance that are relevant to a specific decision made by a specific
decision-maker. This definition emphasizes the information role of accounting numbers.
7
Dechow, Ge, and Scrand (2010) provide a framework for studying the mapping process of true fundamental firm
earnings and reported earnings.

10

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

Given that the accounting information environment, or accounting quality represents a measure
of believability or accuracy for the accounting information provided, we expect that the
information environment of a firm should impact investors reaction (change in investor
uncertainty) when news of an accounting restatement occurs.
2.3 Implied Volatility and Stock Market Returns
Prior research in the finance literature has shown that when firms have negative stock
returns that these are associated with increases in volatility of these returns (Black, 1976;
Christie, 1982; Cheung, 1992; Duffee, 1995).

In addition the restatement literature has

documented that restatements and in particular irregular restatements as associated with a

negative stock market reaction (Palmrose et al. 2004). As Subramanyam et al. (2005) point out,
the impact of the new information on firm price impacts investors conditional expectation of
firm value.8
While we are interested in studying how restatement news impacts investor uncertainty
(measured by the change in option implied volatility) the conditional variance of investors
beliefs about firm value, it is important to control for the conditional expectation or stock return
in our regression analysis since negative returns and volatilities are correlated. Consistent with
prior research, we find that returns are negative for firms that announce restatements and that
these negative returns increase in the severity of the restatement. In addition we find that returns
are negatively correlated with changes in implied volatility, reiterating the importance of
controlling for the conditional expectation of investors belief about firm value (conditional on
the restatement announcement).
3. RESEARCH DESIGN AND HYPOTHESIS DEVELOPMENT

Kothari (2001) provides a survey of this capital markets literature.

11

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

We start this section by identifying our data sources and describing the sample used in
this study. Next we define the construction of our main independent and dependent variables of
interest. After describing the variable construction, we formally develop testable hypotheses and
describe the regression models used to test the hypotheses.
3.1 Sample and Data Selection
We utilize four data sources to create the sample for this study: COMPUSTAT, CRSP,
OptionMetrics, and restatement data from the U.S. General Accounting Office (GAO). 9 From
the COMPUSTAT database we get all of the necessary accounting information to calculate our
measure of accounting quality: total assets, current accruals, current liabilities, short-term debt,
net income before extraordinary items, depreciation, revenues, and gross property plant and
equipment.

In addition, we classify firms by industry using the Fama-French 48 industry

classification.10 CRSP provides security prices, daily returns, and shares outstanding for each
firm.

OptionMetrics contains option information on public firms; specifically, we use the

interpolated volatility surface from OptionMetrics Standardized Options dataset as our measure
of implied volatility. Lastly we get restatement data from the GAO.11
Our sample includes all firm-years from 1997-2006 where a firm had an accounting
restatement and where all relevant data necessary to calculate accounting quality, returns, and
implied volatility were available. Our final sample consists of 529 restatements of which 27%
are classified as irregular restatements and which represent 37 of the 48 industries. Table 1
Panel A shows the number of restatements by year. One notable observation is that 35% of the

Accounting and restatement information is calculated using an annual frequency. Return and option data is
calculated daily.
10
FF 48 industry classification is available through Ken Frenchs website:
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
11
Restatements are further classified as either regular or irregular according to Hennes, Leone, and Miller (2008).

12

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

sample occurs in the year 2005.12

In addition, the number of restatements in our sample

increases over time. Table 1 Panel B shows the distribution of restatements across industries.
The single largest industry represented in our sample is the retail industry which accounts for
15% of our firms. Other prominently represented industries include utilities, computers, and
electronic equipment.13
3.2 Variable Definitions
In this subsection we describe in detail the construction of the variables used in this
paper. First we will describe the construction of our proxy for investor uncertainty change in
implied volatility. Next we will detail the accounting quality measure used in this paper. Lastly
we will describe how restatements are classified as regular or irregular.
3.2.1 Investor Uncertainty Implied Volatility
We operationalize investor uncertainty as the change in implied volatility. The Implied
volatility of an option is the volatility inputted into option pricing models which results in the
value of the option equaling the options current market price. It is therefore a forward looking
measure which captures investors expectations of a firms average stock return volatility over
the length of the option and can be calculated daily.
OptionMetrics provides a comprehensive database on U.S. equity options.

Using a

propriety algorithm (which is based on a kernel smoothing algorithm), OptionMetrics provides

an interpolated volatility surface for each security on each day, for hypothetical at-the-money
options with expirations of 30, 60, 91, 122, 152, 182, 273, 365, 547, and 730 calendar days.14

12

The increase in restatements in 2005 is most likely due to restatements for the classification of leases in response
to the February 7, 2005 letter issued by the SEC clarifying its position on the treatment of leases.
13
To account for differences across industries and over time, we calculate our measure of accounting quality by
industry-year.
14
Rogers et al. (2009) note that using these hypothetical at-the-money options reduces measurement error due to
variation in duration and the extent to which the options are in the money.

13

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

We use the interpolated volatility surface as our measure of implied volatility. Since we are
interested in how expectations about future uncertainty in the short run and the long run are
affected by restatements and accounting quality, we include all option durations in our study. In
addition, we are interested in various days around the restatement announcement (the event date)
and so we look at various windows around this event.15 The change in implied volatility around
the date of the restatement announcement is calculated as the natural log of the implied volatility
after the restatement announcement over the implied volatility prior to the restatement
announcement.
Table 2 Panel A provides summary statistics for the implied volatility measure. The
mean implied volatility prior to the restatement announcement is 0.4657 and is consistent with
prior studies that use OptionMetrics to calculate implied volatility (Rogers et al., 2009; Goyal
and Saretto, 2009). In addition the average change in implied volatility (IV) for our sample is
0.0056. This finding is consistent with Roger et al. (2009) who find that implied volatility
increases after bad news.
3.2.2 Accounting Quality
Accounting quality is measured as the inverse of accrual quality which is measured using
a modified version of the Dechow and Dichev (2002) measure of accrual quality as specified in
Francis et al. (2005):

(1)
where:
15

While we examine various option expiration lengths and event windows, for expositional purposes we only report
results for the event window +/-3 days. This window is consistent with Rogers et al. (2009). Results are
qualitatively unchanged for various event windows from -/+1day to -/+5days.

14

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

= firm js total current accruals in year t (change in current assets less current
liabilities less cash plus short term debt)16
= firm js average total assets in year t and t-1
= Cash flow from operations in year t (net income before extraordinary items
less total current accruals plus depreciation)
= firms js change in sales revenues between year t-1 and year t
= firm js gross property plant and equipment in year t
The original Dechow and Dichev (2002) model focuses on short-term working capital
accruals and models them as a function of past, present, and future cash flows. The intuition
behind the original model is that accruals anticipate future cash collection/payment and reverse
when cash previously recognized in accruals is received/paid (Dechow and Dichev 2002;
Dechow et al. 2010). The last two terms in equation 3 are the modification to the Dechow and
Dichev (2002) model (McNichols 2002; Francis et al. 2005). Here the change in sales revenue is
included to capture growth and gross PPE allows for depreciation.
We calculate equation 1 in the cross-section by year and by industry using the FamaFrench 48 industry classification for all industries with at least 20 firms in year t. The accrual
quality for firm j in year t is then the standard deviation of the firms residuals in equation 1 from
year t-4 to year t (

17

Under this specification of accruals quality, large values

of AccQ indicate lower accrual quality.

For ease of interpretability, we dichotomize our accounting quality measure, such that a
measure of 1 indicates high or good accounting quality, while a measure of 0 indicates low or
bad accounting quality. To create this indicator variable (AQ), we set AQ =1 for firm j in year t

16

We use the indirect or balance sheet approach to estimate accruals. Alternatively, we could also consider the
direct approach which calculated cash flows from the statement of cash flows (Hribar and Collins 2002).
17
We winsorize the AQ measure at the 1st and 99th percentiles.

15

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

if the firms accrual quality in year t is below the median accrual quality for our sample in year t.
Likewise, we set AQ =0 for firm j in year t if the firms accrual quality in year t is above the
median accrual quality for our sample in year t.18
Table 2 Panel A reports the mean accrual quality (AccQ) for our sample as 0.0455, which
is consistent with prior literature (Francis et al., 2005). Table 2 Panel C and Panel D breaks out
summary statistics for high accounting quality firms (Table 2 Panel C) and low accounting
quality firms (Table 2 Panel D). In comparing the mean values between high accounting quality
firms and low accounting quality firms, high accounting quality firms in this sample are larger,
have less debt, have lower implied volatility prior to announcing a restatement, have smaller
negative abnormal returns during the event window of a restatement announcement, and on
average have a negative change in implied volatility after a restatement announcement (i.e. their
implied volatility decreases following a restatement announcement).19 These differences suggest
(at least in the univariate setting) that variation in firm accounting quality may help explain the
observed variation in the change in implied volatility of a firm around negative news events like
a restatement announcement.
3.2.3 Restatements
In this study we focus on negative news events that are precipitated by the announcement
of accounting restatements. Announcements of accounting restatements are firm specific, and
thus provide a setting to study investors reaction to this new piece of negative firm-specific
information.

We use restatement data from the GAO database and we further classify

restatements as irregular restatements according to Hennes, Leone and Miller (2008).

18

Results hold if we allow AQ to be a continuous variable or categorize it by deciles.

A Welchs t-test for the difference in the means reveals that all of the mean values between high accounting
quality firms and low accounting quality firms are significant at the 1% level.
19

16

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

Hennes, Leone and Miller (2008), note that not all restatements are the same.
Specifically, they separate restatements into two categories: regular restatements and irregular
restatements.

Regular restatements are unintentional mistakes or errors in reporting while

irregular restatements are intentional errors or manipulations. To identify irregular restatements,

Hennes et al. (2008) create a procedure to independently classify restatements as irregular using
the GAO database.

The authors search through the financial statements for the words

irregularity or fraud. In addition, they also look to see if the SEC, the Department of Justice,
or an independent investigation occurred due to the restatement. Any of these words or actions
leads to the classification of the restatement being considered irregular. The authors find that
27% of the GAO restatement database is classified as irregular.
Table 2 Panel A shows summary statistics for our full sample of firms with accounting
restatements. Our sample includes 551 firms that announce a restatement. Table 2 Panel B
shows summary statistics for irregular restatements. Our sample consists of 146 firms (26%)
that announce a restatement that is classified as an irregular restatement. It is important for us to
separate restatements as either intentional (irregular) or as an error (regular) because investors
may react differently to restatement information depending on the original intent of the managers
leading to the restatement. Looking at the differences between Table 1 Panel A and Panel B we
notice that firms that announced a restatement classified as an irregular restatement, when
compared to all firms announcing a restatement, have a statistically significant higher level of
investor uncertainty prior to announcing the restatement, a larger increase in investor uncertainty
after the announcement, and experience a larger negative stock market reaction. Surprisingly,
firms that issue an irregular restatement did not have statistically significantly lower accounting
quality.

17

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

3.2.4 Controls
In our regressions we control for the cumulative returns over the event window, the size
of the firm, and the capital structure of the firm. When we think about a time-series of stock
prices we are usually interested in two things: risk and return. In this study we are interested in
understanding the how accounting quality attenuates risk or volatility changes around a
restatement announcement. Risk or volatility is captured in the second moment of the timeseries of stock prices. When studying higher-order moments, it is important to control for the
first-order moment, returns. To control for returns, we measure the cumulative abnormal valueweighted return during the event window.

We include the level of this measure in our

regressions as well an interacted term with our measure of accounting quality to allow returns to
vary over accounting quality (as indicated in the univariate statistics).20
We also control for firm size and capital structure consistent with prior literature (e.g.
Rogers et al., 2009). We measure size as the log of the market value of equity (stock price times
the average number of shares outstanding) for year t. We measure leverage as the debt to equity
ratio of a firm in year t. Table 2 Panel A-D, report the average cumulative abnormal valueweighted returns, market value of equity and leverage of the full sample, irregular restatement
sample, high accounting quality firms, and low accounting quality firms, respectively. Welchs
t-tests indicate that the mean values for the high accounting quality firms and low accounting
quality firms are significantly different. This re-iterates and confirms prior accounting quality
studies that find that it is important to control for these differences.
3.3 Hypothesis Development and Model

20

Results are unchanged if we calculate returns using total cumulative returns over the event window or if we use
cumulative abnormal equally-weighted returns over the event window.

18

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

Restatements are accounting events that require firms to restate and re-issue financial
information. Depending on the type of restatement, a firm may need to re-issue several years of
financial information. To this extent, restatements are considered to be negative events of
accounting. Prior literature has shown that the market reacts negatively to the announcement of
restatements, by documenting negative returns around restatements (e.g. Palmrose et al. 2004).
Rogers et al. (2009) provide some evidence that bad news (negative earnings
announcements) lead to an increase in implied volatility. Further Hilary (2008) finds that bad
market-wide news (as measured by the 10 worst return days) is attenuated for firms with high
accounting quality. It is then interesting to study and know if firm-level bad news (restatement
announcements) is associated with an increase in implied volatility or investor uncertainty and if
this increase in risk is attenuated for firms with high accounting quality. To test this idea we
formally test the following hypothesis:
H1: There is a negative relationship between high accounting quality and change in
implied volatility around a restatement announcement.
To test H1 we run the following regression:
(2)

where

is the log of firm is implied volatility three days after restatement announcement

divided by the implied volatility three days prior to the restatement announcement and
has higher accounting quality than the median firm in the restatement sample.

= 1 if firm i

If having high

accounting quality acts as a signal that a firm has transparent financial statements, then when a
firm announces a restatement there should be a resolution of uncertainty for these firms and we
would expect the coefficient

to be negative.

However, it may be possible that changes in risk are driven by the first moment, the
return itself. It is therefore important to control for the impact that the market reaction during the
19

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

announcement window has on the change in implied volatility.

This leads to our second

hypothesis:
H2: There is a negative relationship between high accounting quality and change in
implied volatility after controlling for the return around the restatement announcement.
To test H2 we run the following regression:
(3)

where

is the log of firm is implied volatility three days after restatement announcement

divided by the implied volatility three days prior to the restatement announcement and
has higher accounting quality than the median firm in the restatement sample,

= 1 if firm i
is the cumulative

abnormal return for firm i from t-3 days prior to the announcement of the restatement to t+3 days.
Controls include other variables that may impact the change in implied volatility such as the market value
of equity of firm i and the leverage of firm i. Our coefficients of interest in equation 3 are
interaction of firms cumulative abnormal returns and accounting quality,

and the

. We expect that both

coefficients will be negative and statistically significant.

Lastly, we expect that the relationship between the change in implied volatility and bad
news to be strongest when the news is really bad.

This occurs for firms with irregular

restatements. This leads to our third and final hypothesis:

H3: There is a negative relationship between high accounting quality and change in
implied volatility after controlling for the return around the restatement announcement
which is stronger for firms with an irregular restatement.
To test H3 we run the regression in equation 3 for our subsample of firms that have an irregular
restatement. In the next section we present the results for the above hypotheses.

20

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

4. RESULTS
Prior to running the regressions from equation 2 and 3, we first graph the change in
implied volatility around the event window for restatement announcements. Figure 1 A-F shows
the average change in implied volatility for option lengths ranging from 30 days to 182 days.
From Figure 1 it is clear that there is a spike in the change in investor uncertainty around the
announcement date of the restatement. The average change in implied volatility peaks at around
.033 for 30 day options and monotonically decreases to around .02 for 182 day options.
These figures corroborate prior findings that negative news leads to an increase in
investor uncertainty.

We add to this literature by showing that investor uncertainty also

increases when we specifically look at restatement announcements. In addition, while investor

uncertainty increases for all option lengths, the change in investor uncertainty becomes smaller
as the length of options increases. This finding makes intuitive since as we would expect near
term options to be affected the most by restatement news while longer term options still have
time for other news to hit the market before the options expire.
Figure 2 A-F shows the change in implied volatility around the event window for
irregular restatement announcements. The biggest difference between Figure 1 and Figure 2 is
the magnitude of the change in implied volatility. For the irregular restatement sample, the
change in implied volatility is double that of the overall sample; ranging from 0.05 to 0.07. The
larger increase in investor uncertainty points to investors being concerned that the irregular
restatement could be indicative of more pervasive firm problems such as fraud which may lead
to additional future bad news. Now that we have provided evidence that there is a spike in
investor uncertainty around restatement announcements, we turn our attention to how firm

21

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

accounting quality or the firms information environment as provided by the financial statements
moderates the relationship between negative news announcements and investor uncertainty.
The results to all three hypotheses formally stated in Section 3, are reported in Table 3.
To keep the tables from being too cumbersome, we report regression results for 30-day, 91-day,
and 152-day option lengths. Our first hypothesis is that

, the coefficient on the indicator

variable for high accounting quality, should be negative and statistically significant. Consistent
with our prediction, we find that
lengths. Surprisingly,

is negative and statistically significant for most of the option

is not statistically significant for the 20-day option length. We will

investigate this result further and provide an explanation for this result when we discuss the
results for hypothesis 2.
The second hypothesis states that our main finding, that high accounting quality
attenuates the relationship between negative news coming from restatement announcements and
the change in implied volatility will hold after controlling for the market reaction (the first
moment) along with firm characteristics that impact implied volatility; the firms market value of
equity and firm leverage. Our results (shown as the 5th and 7th columns in Table 3 Panel A)
support H2. We find negative and statistically significant coefficients on

and

. These

results indicate that as market returns decrease in reaction to the restatement news, the change in
implied volatility increases but this increase is attenuated for firms with high accounting quality.
It is also important to note that the average market reaction to the restatement news for firms
with high accounting quality is smaller than its low accounting quality counterpart.
Again we note that accounting quality does not seem to attenuate investor uncertainty for
the 30-day option. In fact, the only variable that is significant is the market reaction or the
cumulative abnormal return over the event window. This observation can be explained by the

22

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

fact that the most important information of these short-term options is the reaction to the current
news. This could be due to the fact that we would not expect any more formal accounting
information to be released in the next 30 days.
Our last hypothesis states that the above relationship should be stronger for our
subsample of firms that have an irregular accounting restatement. We re-run equation 3 for just
the irregular restatement sample and find that the negative coefficients for accounting quality and
accounting quality interacted with cumulative abnormal returns does get significantly more
negative. This result indicates that there is a resolution of uncertainty for firms with high
accounting quality after negative news, while firms with low accounting quality have a larger
increase in investor uncertainty. Overall, these results point to the significance of controlling for
firm accounting quality when looking at investors reaction to negative news events even after
controlling for the initial market reaction.

5. CONCLUSION
In this study we examine the impact of accounting quality on the investor uncertainty
when there is the negative news event of an accounting restatement. We provide evidence that
restatement news leads to an increase in investor uncertainty and that the magnitude of the
change in investor uncertainty is associated with the severity of the restatement news. We also
provide evidence that firm accounting quality attenuates the relationship between the negative
news and the change in implied volatility. This result holds even after controlling for the first
moment, stock returns associated with the event news.

This result supports the idea that

accounting quality acts as a proxy for the transparency of the accounting information

23

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

environment of a firm and that the announcement of bad news, for otherwise transparent firms
results in a resolution of uncertainty, rather than exacerbating the results.
Overall, this study adds to a growing literature on the impact of accounting information
on investor uncertainty about firm value. We find evidence in support of the Subramanyam et al.
(2005) theory which states that implied volatility increases when there is extreme negative news.
We document this by showing that the magnitude of the change in implied volatility increases
for firms that issue an irregular restatement.

In addition, we add to this literature by

documenting that controlling for firm accounting quality is also an important determinant in
understanding how investors update their beliefs about the variability of future cash flows in
response to negative news about reported accounting numbers

24

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

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27

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

TABLE 1
DATA SUMMARY
Panel A: Number of observations by year
YEAR
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006

Full Sample
9
8
25
25
41
43
58
74
188
58

Irregular
Restatements
6
7
4
7
3
16
20
27
37
17

TOTAL

529

144

28

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?
Panel B: Number of Observations by Industry
Industry
(48 Fama-French Classification)
Food Products
Beer & Liquor
Recreation
Entertainment
Printing and Publishing
Consumer Goods
Apparel
Healthcare
Medical Equipment
Pharmaceutical Products
Chemicals
Textiles
Construction Materials
Construction
Steel Works
Machinery
Electrical Equipment
Other
Automobiles and Trucks
Aircraft
Precious Metals
Non-Metallic and Ind. Metal Mining
Petroleum and Natural Gas
Utilities
Communication
Personal Services
Business Services
Computers
Electronic Equipment
Measuring and Control Equip.
Business Supplies
Transportation
Wholesale
Retail
Restaurants, Hotels, Motels
Insurance
Trading

29

All
Restatements

Irregular
Restatements

8
1
2
4
3
10
6
6
13
29
11
1
5
3
8
17
7
2
8
3
11
1
25
35
23
8
60
31
35
14
9
11
17
79
18
3
2

4
0
0
1
0
0
2
1
4
11
1
1
0
1
2
9
2
0
3
0
0
0
3
11
4
2
25
14
11
2
2
0
8
9
1
1
2

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

TABLE 2
SUMMARY STATISTICS
Panel A: Full Restatement Sample
Variable
IVbeg
IV
RET
AccQ
LEV
MVE

MEAN

STD DEV

P25

P50

P75

551
551
551
551
546
551

0.4657
0.0056
-0.0303
0.0455
0.6550
7.2818

0.2171
0.1344
0.1154
0.0374
1.2819
1.4742

0.3114
-0.0427
-0.0786
0.0214
-0.2571
6.3365

0.4141
-0.0041
-0.0149
0.0379
0.7290
7.1545

0.5715
0.0375
0.0277
0.0561
1.5242
8.3022

Panel B: Irregular Restatement Sample

Variable
IVbeg
IV
RET
AccQ
LEV
MVE

MEAN

STD DEV

P25

P50

P75

146
146
146
146
145
146

0.5348
0.0386
-0.0771
0.0481
0.3053
7.2633

0.2219
0.1567
0.1591
0.0478
1.2913
1.5107

0.3652
-0.0315
-0.1364
0.0232
-0.3780
6.0666

0.5014
0.0067
-0.0404
0.0397
0.3870
7.1018

0.6699
0.0851
0.0119
0.0594
1.0834
8.5278

Panel C: High Accounting Quality (AQ=1)

Variable
IVbeg
IV
RET
AccQ
LEV
MVE

MEAN

STD DEV

P25

P50

P75

269
269
269
269
267
269

0.4054
-0.0039
-0.0234
0.0220
0.4165
7.5217

0.1817
0.1476
0.1088
0.0090
1.3072
1.3927

0.2783
-0.0527
-0.0610
0.0139
-0.3779
6.5632

0.3633
-0.0077
-0.0074
0.0213
0.3870
7.4879

0.4880
0.0315
0.0289
0.0292
1.1850
8.3630

Panel D: Low Accounting Quality(AQ=0)

Variable
IVbeg
IV
RET
AccQ
LEV
MVE

MEAN

STD DEV

P25

P50

P75

282
282
282
282
279
282

0.5231
0.0146
-0.0370
0.0679
0.8833
7.0531

0.2323
0.1200
0.1212
0.0403
1.2165
1.5153

0.3567
-0.0347
-0.0891
0.0444
0.1080
5.8690

0.4773
-0.0018
-0.0228
0.0551
0.9902
6.8172

0.6424
0.0393
0.0270
0.0784
1.7757
8.1965

Summary statistics are calculated using a +/-3 days window for the option expiration of 91 days.

30

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

TABLE 3
REGRESSION RESULTS

*AQ

Panel A: Full Restatement Sample

Variable
AQ

30 days
-0.0164
(-1.00)

RET
RET*AQ
MVE
LEV

91 days
-0.0138
(-0.87)
-0.6108
(-6.99)
-0.0977
(-0.74)
-0.0027
(-0.52)
-0.0096
(-1.60)

-0.0082
(-1.78)

-0.0137
(-3.21)
-0.4250
(-18.56)
-0.1755
(-4.93)
0.0004
(0.31)
-0.0102
(-6.39)

152 days
-0.0106
(-2.51)

-0.0154
(-4.05)
-0.3876
(-18.78)
-0.1886
(-5.92)
0.0005
(0.36)
-0.0096
(-6.66)

Panel B: Irregular Restatement Sample

Variable
AQ

30 days
0.0168
(0.50)

RET
RET*AQ
MVE
LEV

91 days
-0.0076
(-0.23)
-0.6818
(-5.38)
-0.1072
(-0.60)
0.0145
(1.52)
-0.0121
(-1.07)

0.0137
(1.18)

-0.0200
(-1.92)
-0.4799
(-11.76)
-0.2060
(-3.51)
0.0057
(1.82)
-0.0243
(-6.58)

152 days
0.0126
(1.15)

-0.0191
(-1.98)
-0.4154
(-11.07)
-0.2321
(-4.32)
0.0036
(1.26)
-0.0236
(-6.92)

The dependent variable is the change in implied volatility calculated as the log of the implied volatility 3 days after the restatement
announcement over the implied volatility 3 days prior to the restatement announcement
AQ is an indicator variable that equals 1 if the firm has high accounting quality
RET is the value-weighted abnormal return for the period -/+ 3 days around the event date
MVE is the log of the market value of equity
LEV is the debt to equity ratio of the firm

31

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

Figure 1
Mean Change in Implied Volatility: Full Sample

Figure 1A: 30 day options, full sample

Figure 1B: 60 day options, full sample

AVERAGE IV

IV

122 Day Options

Figure 1D: 122 day options, full sample

AVERAGE IV

AVERAGE IV

152 Day Options

182 Day Options

0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
-0.005 -8-7-6-5-4-3-2-1 0 1 2 3 4 5 6 7 8
-0.01
Days

IV

IV

Figure 1C: 91 day options, full sample

0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
-0.005 -8-7-6-5-4-3-2-1 0 1 2 3 4 5 6 7 8
-0.01
Days

Figure 1E: 152 day options, full sample

0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
-0.005 -8-7-6-5-4-3-2-1 0 1 2 3 4 5 6 7 8
-0.01
Days

Figure 1F: 182 day options, full sample

32

Does Accounting Information Affect Investor Uncertainty about Firm Value around Restatements?

Figure 2
Mean Change in Implied Volatility: Irregular Restatement Sample

Figure 2A: 30 day options

Figure 2B: 60 day options

Figure 2C: 91 day options

Figure 2D: 122 day options

Figure 2E: 152 day options

Figure 2F: 182 day options

33