Financial Restatements, Information Asymmetry, and Market Liquidity

Abstract

This paper examine whether firms experience different liquidity effects from earnings restatements before and after the implementation of the Sarbanes-Oxley Act (SOX) by analyzing various measures of liquidity surrounding the announcement day in the period of 1997-2005.  The study is based on the premise that SOX was intended to improve the transparency and reliability of reported information. We find that the spreads measured in cents detect an abnormality in liquidity due to a general downward trend in the spreads during the period. Dividing the period into three sub-periods because the SOX reinforce more accountability and more confidence for public financial information, we find virtually all declines in liquidity come from the pre-SOX period, which conversely explains that, no significant change in liquidity in the post-Sox period. Decrease in liquidity is influenced by restatements due to revenue recognition, those prompted by party other than auditors. The results show that firms experience more severe liquidity consequences following restatements announced before SOX. Therefore, information asymmetry should be less problematic, and liquidity should be less adversely affected, for restatements announced after SOX.