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PurposeThe purpose of this paper is to examine the relation between CEO option grants at the beginning of the class period (BCP) and investor reaction to announcement of restatement‐induced securities litigation.Design/methodology/approachUsing a restatement‐induced lawsuit sample over the period 1997‐2005, this study performs cross‐sectional linear regressions of three‐day litigation announcement cumulative abnormal returns (CARs) on CEO option grants, cash compensation, corporate governance and control variables. CARs are calculated over the three‐day (−1,1) interval relative to the lawsuit announcement date using a single‐factor market model, the CRSP equally‐weighted market index, and a 255‐day estimation period ending 45 days prior to the announcement.FindingsA negative association is reported between CEO option grants and investor reaction around restatement‐induced lawsuit announcement.Research limitations/implicationsIt is possible that some restatements may have triggered a securities lawsuit but because it was not explicitly stated, they were not included in the restatement‐induced lawsuit sample. Another limitation of the study is that the qualitative aspects of the internal corporate governance variables may not have been sufficiently captured in the analyses.Originality/valueThe reported result suggests that the market considers CEO option grants as an indication that a restatement‐induced securities lawsuit has merit. The finding also implies that although CEO option grants may not be exercised during the class period, the market imposes higher penalties on firms that offer higher equity compensation to their CEOs at the beginning of the class period.

Purpose This study aims to examine the use of real activities manipulation by firms implicated in the stock option backdating scandal. Design/methodology/approach The real activity manipulation measures are as follows: abnormal R&D expense, abnormal SG&A expense, abnormal production cost and abnormal cash flow from operations. Using a sample of firms alleged to have backdated options during the period 1998-2006 and non-backdating one-on-one matched firms, a separate regression is run for each of the real activity manipulation measures (dependent variables) on backdating and other variables. Findings The authors report unusually low R&D and unusually low SG&A expenses among the backdating firms. They also find evidence of unusually high production costs among backdating firms compared to the matched firms. Research limitations/implications The findings imply that backdating firms are more aggressive in the use of real activities to manipulate earnings and the use of real activities appears to be opportunistic. Originality/value The study contributes to the literature by providing evidence of the use of real activities manipulation by firms under investigation for fraud. The authors also add to the debate on whether the use of stock options as part of compensation aligns the interest of management with the interest of shareholders.

This study examines the relation between auditor litigation and the market and legal penalties imposed on sued audit clients after the private securities litigation reform act (PSLRA). A sample of accounting-related lawsuits is used in the regressions of three-day cumulative abnormal returns, settlement amount, and probability of settlement on auditor litigation and other variables. The results indicate a negative relation between auditor litigation and the 3-day cumulative abnormal returns around the announcement of litigation against the client firm. Another result from the study is a positive relation between auditor litigation and the legal penalty on the client firm. Specifically, the results indicate higher likelihood of settlement and larger settlement sizes for securities lawsuits in which the auditor is also sued. Our study contributes to the debate on the merit of litigation against auditors after the PSLRA. The findings imply that lawsuits against auditors appear to be a signal of audit failure and higher financial reporting risk. As audit failures erode investor confidence in the capital markets, the present study provides valuable evidence on the market and legal system’s perception of the merit of auditor litigation. The findings should be of interest to regulators and market participants given the increase in securities lawsuits against audit firms and the substantial reputational consequences of such lawsuits on audit firms and client firms.