Academic journal article Academy of Accounting and Financial Studies Journal

Long-Term Market Reactions to Earnings Restatements

Academic journal article Academy of Accounting and Financial Studies Journal

Long-Term Market Reactions to Earnings Restatements

Article excerpt

ABSTRACT

Since the recent accounting scandals ignited by the Enron fiasco, earnings restatements due to accounting irregularities1 have drawn significant attention from the public in both academia and practice. Since accounting irregularities are intentional misrepresentations of accounting information by the reporting entity, earnings restatements due to these do have different connotations to the capital market than other earnings information releases. Thus, how efficiently the capital market reacts to information release of the restating firms can be a valuable research question. As a way of addressing this question, the long-run stock price behavior of the restating firms after the restatements will be examined in this study.

INTRODUCTION

Ever since recent accounting scandal ignited by Enron fiasco, earnings restatements due to accounting irregularities1! draw significant attention from public in academia and practice. Since accounting irregularities are intentional misrepresentations of accounting information by the reporting entity, earnings restatements due to these (hereafter called earnings restatements) do have different connotations to the capital market than other earnings information releases. First, earnings restatements may increase the uncertainty of the reporting entity because they usually cause class action lawsuits, management shuffle, restructuring, and even bankruptcy. Secondly, earnings restatements impair the information quality of the reporting entity because restating firm's information may not be as reliable to investment public as it used to be prior to the earnings restatement. Then, these higher uncertainty and lower information quality can increase the risk premium and stock return volatility of the restating firms (See Aboody (2005), Francis (2005), and Li (2005)), which may reflect that it is more difficult and time consuming for the capital market to response to restating firms' information release after the earnings restatements. Thus, how efficiently the capital market reacts to information release of the restating firms can be a valuable research question. As a way of addressing this question, the long-run stock price behavior of the restating firms after the restatements will be examined in this study.

Prior studies on the post-announcement stock price performance of earning restatement such as Hirschey et al. (2003), General Accounting Office (GAO) (2002), and Wu (2002) document negative abnormal stock returns of the restating firms in the months following the restatement announcement, which is contradictory to the efficient market hypothesis predicting no abnormal returns. All these studies exclusively used the Cumulative Abnormal Returns (CAR) approach to measure stock price performance. Hirschey et al. (2003) use the market-adjusted, the market-model adjusted and the mean-adjusted CAR approaches. GAO (2002) uses the market-adjusted CAR approach. Wu (2002) uses the ß- and size- adjusted CAR approach. For example, Wu (2002) observes over 10 percent negative CAR in the year following the announcement. She suggests two potential explanations: some firms fail to provide restated number at the same time as restatement announcements and leave the issue unconcluded; and investors keep revising their beliefs according to information received subsequently. Taken at face value, this evidence is consistent with the notion that market under-reacts to earning restatements.

However, the CAR approach does not provide a precise picture of long-term stock performance due to its embedded structural problem of simple summation of periodic abnormal returns rather than compounding of them and its cross-sectional dependence problem. And recent studies suggest that the results of long-run abnormal returns should be interpreted with caution because the abnormal return metrics are severely mis-specified. Misspecification of abnormal stock returns can cause some methods to detect spurious anomalies. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.