Determinants of market reactions to restatement announcements

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Abstract

We examine the market reaction to a sample of 403 restatements announced from 1995 to 1999. We document an average abnormal return of about −9 percent over a 2-day announcement window. We find that more negative returns are associated with restatements involving fraud, affecting more accounts, decreasing reported income and attributed to auditors or management (but not the Securities and Exchange Commission). There appears to be an additional penalty for announcements that do not quantify the restatement. Finally, we provide evidence on the relation between restatement announcements and analyst earnings forecast dispersion, bid–ask spreads and subsequent revisions in analyst earnings forecasts.

Introduction

Regulators have expressed great concern over restatements to correct non-GAAP accounting in previously issued financial statements. The perceived need to reduce the number of restatements helped motivate the U.S. Securities and Exchange Commission's (SEC) earnings management initiative and formation of the Public Oversight Board (POB) Panel on Audit Effectiveness.1 It also influenced the SECs auditor independence rule-making on non-audit services provided to audit clients (Levitt, 2000; McNamee et al., 2000),2 a General Accounting Office probe of restatements (GAO, 2002), and certain provisions in the Sarbanes-Oxley Act of 2002 (e.g., Section 304).

Regulators have used the impact of restatements on equity values to justify these activities (GAO, 2002). For example, the former SEC Chairman testified before a Senate Subcommittee that, “in recent years, countless investors have suffered significant losses as market capitalizations have dropped by billions of dollars due to restatements of audited financial statements” (Levitt, 2000). While dramatic declines in market values do occur, there is limited systematic evidence on market reactions to recent restatements. Our study informs the discourse on the effect of restatements by assessing the restatement characteristics of greatest concern to market participants. Currently, such distinctions are not commonly made.

We analyze 2-day market reactions to a sample of 403 restatements of annual (10-K) and quarterly (10-Q) financial statements announced from 1995 to 1999. We investigate the association between stock price reactions to restatement announcements and restatement characteristics likely to influence market participants’ valuation of the company.

Using market-adjusted abnormal returns, we document an economically and statistically significant negative mean (median) market reaction to restatement announcements of −9.2 percent (−4.6 percent) over a 2-day event window (day 0 to day 1). We find that fraud and restatements attributed to auditors are associated with more negative returns. These results are consistent with both diminished company prospects and increased risk/uncertainty. To explore the latter, we examine analyst earnings forecast dispersion. We document a significant increase in the forecast dispersion at the time of the restatement announcement, which is negatively correlated with the market reaction to earnings restatements.

We also find that larger restatements of previously reported income and those affecting multiple accounts are associated with more negative market reactions. These results indicate a relation between restating companies’ reduced prospects and announcement returns. Further, we document a significant downward revision in earnings forecasts following restatements and find a positive relation between forecast revisions and returns. Finally, our analysis of the content of restatement announcements suggests a penalty for incomplete information; and, we find that auditor attribution appears to proxy for materiality when the initial announcement lacks quantification of the misstatement.

Section 2 of the paper provides background and discusses extant empirical research on restatements. Section 3 discusses the regression model and our test and control variables, Section 4 describes our sample, Section 5 provides the regression results, Section 6 presents additional analyses, and Section 7 contains concluding remarks.

Section snippets

Restatement identification and reporting

Various provisions of the Securities Acts require companies to correct inaccurate, incomplete, or misleading disclosures. As Skinner (1997, p. 252) explains, management has a duty to correct statements made in any filing if the statements “are later discovered to have been false and misleading from the outset, and the issuer knows or should know that persons are continuing to rely on all or any material portion of the statements.”

The company, the SEC, an independent auditor or a combination

Overview

To explore the relation between returns and restatements, we estimate a regression that includes restatement and company characteristics expected to influence the market reaction to restatement announcements. We consider information that restatements convey about changes in future company prospects as well as the risk/uncertainty of achieving them. Our approach relies on the discounted cash flow valuation in which a security's market price equals the present value of expected dividends or

Sample selection

We identify our sample primarily from searches in the Lexis-Nexis News Library and SEC Filing Library based on key-word searches for restatements (e.g., restat, revis, adjust, error). We expand our key words to recognize that some companies describe restatements in other ways (e.g., “responding to guidance from the SEC”).

We include restatements for U.S. companies that made initial announcements between January 1, 1995 and December 31, 1999. Table 1 presents sample attrition and summary

Regression results

Results of the OLS regression model for the full sample are shown in Table 5, column 1. The full sample regression model is highly significant (F-statistic=8.64, adjusted R2=17 percent). Like the univariate tests, the regression results are consistent with fraud, more negative changes in reported income and pervasive restatements being associated with more negative returns. They also indicate that an auditor-initiated restatement has an incrementally negative effect.

Contrary to univariate

Increased uncertainty

Both univariate tests and regression analyses provide mixed evidence for our conjecture on an association between increased uncertainty/risk and more negative market reactions. The significant association between fraud and more negative returns is supportive. However, the insignificant association for SEC-attributed and the negative association for company-attributed restatements are not.

To further explore the relation, we use two alternative measures of uncertainty. First we consider the

Summary and conclusions

In this study, we explain the determinants of the stock market reaction to restatement announcements. We find that, on average, the 403 firms in our sample experience an economically and statistically significant negative stock price reaction over a 2-day window of approximately 9 percent (median −5 percent).

We conjecture that restatements involving fraud and externally identified restatements are associated with more negative returns as they call into question management competence and

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  • Cited by (0)

    We appreciate the helpful comments of S.P. Kothari (the editor), Sudipta Basu (the referee), Ervin Black, Michael Ettredge, Robert Lipe, Grace Pownall, William Schwartz, James Stice, Zane Swanson, and participants in research seminars at the University of Arizona, the University of Kansas and the Kansas State Central States Accounting Research Workshop. We are also grateful for the research assistance of Amanda Booz, Xuesong Hu and Andrew Vinceguerra.

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