Why are some corporate earnings restatements more damaging?

Abstract

If an earnings restatement is simply an accounting adjustment to old information that is no longer being used for valuation purposes, it will not necessarily cause a change in a firm's value. However, the restatement may contain information that is used to reassess the future cash flows and credibility of the firm. It is found that the earnings restatements elicit a strong negative market response. Moreover, the market response is conditioned on the content of the earnings restatements. The market-imposed penalty is more severe when the restatement is attributed to an adjustment in revenue, when it is forced by the auditor or the SEC, and when the revised earnings level is lower than two proxies used to measure expected earnings.

Board independence, executive compensation and restatement

“…Kinney and McDaniel, 1989;DeFond and Jiambalvo, 1991;Desai et al, 2006). Akhigbe et al (2005) confirm that investors rely on the restatements to revise their earnings or cash flow forecasts of the firm restating its earnings, while Palmrose et al (2004) and Ahmed and Goodwin (2007) argue that restating firms are penalized by the financial markets for engaging in earnings manipulation. Following the detrimental effects of stiff penalties and the enforcement of SOX and given that the restatement events for firms in the post-SOX period may decrease, these restating firms may experience a considerably worse financial condition than the restating firms of the pre-SOX period.…”

The value relevence of earnings restatements — Empirical evidence from China

“…Previous research has shown that accounting information is value relevent to earnings. Through analyzing the changes in information content after restatements' disclosure, studies have shown that restatements information is used to reassess the future cash flows and credibility of firms (Akhigbe, Kudla and Madura, 2005). It is found that earnings restatements elicit a strong negative market response, which response is conditioned on the contents of earnings restatements, and more negative returns are associated with restatements involving fraud, affecting more accounts, decreasing reported income and attributed to auditors or management (Palmrose and Scholz, 2004).…”

Accounting restatements: Market and liquidity impacts.

“…They found that more severe reactions are associated with restatements that include negative implications for management integrity and competence (fraud) and that have a more negative impact on previously reported earnings, and when the impact on net income is not quantified in the initial announcement. Akhigbe et al (2005) found that more negative returns are associated with revenue recognition problems. Wu (2002) also noted that when restatements involves revenues, the abnormal return is even lower, -14.4% or less.…”

“…The most common model for abnormal returns is the market model and . From a number of literature on stock market impacts of restatements, it is observed that market model is commonly used for event study7 (Dechow et al 1996;Turner et al 2001;Anderson and Most of the empirical studies related to stock market impacts of accounting restatements showed negative abnormal returns in the range from -4 percent to -10 percent (Dechow et al 1996;Turner et al 2001;Anderson and Yohn 2002;Richardson et al 2002;Wu 2002;Hribar and Jenkins 2004;Akhigbe et al 2005;Kravert and Shevlin 2009;Bardos 2011;Bardos et al2013). But some studies report more negative reactions to restatement involving fraud and revenue recognitions (Wu 2002;Akighbe et al 2005).…”

“…Previous researches on accounting restatements showed negative returns on stock prices of restating firms (e.g. ranging from -4 percent to -10 percent) after a restatement announcement (Dechow et al 1996;Anderson and Yohn 2002;Hribar and Jenkins 2004;Akhigbe et al 2005;Bardos 2011;Bardos et al 2013). The negative stock market reaction is attributed to increase in information risk because of increased uncertainty about management credibility and transparency of financial statements (Hribar and Jenkins 2004;Francis et al 2005;Kravert and Shevlin 2009).…”