Restatements Sully Future Credibility: Study by SMU: Is the Decline in the Information Content of Earnings Following Restatements Short-Lived?

January 30, 2014, 4:40 PM ET

Restatements Sully Future Credibility: Study

MAXWELL MURPHY

Senior Editor

Companies that restate prior results due to accounting irregularities cause investors to tune out their future quarterly numbers, according to recently published academic research. How long they tune out, however, may be within the restating company’s control.

When companies have a material restatement, for example the result of fraud or other misconduct, their stocks tend to trade less volatilely after future earnings statements, an effect that can last nearly three years on average. But companies that take swift, decisive action can trim the investor shunning by more than half, a study in the current issue of the Accounting Review, an American Accounting Association publication, suggests.

The research, by academics at Singapore Management University and Boston College, finds that stock swings surrounding an earnings release, when the company takes little remedial action, are more muted for an average of 11 quarters after a material restatement. The researchers, who studied thousands of restating companies from the late 1990s through 2008, interpret that to mean investors are less trustworthy of the results reported by companies after accounting irregularities.

“When the company issues the earnings report, investors don’t react to the news,” says Alvis Lo, an assistant professor in the accounting department of Boston College’s Carroll School of Management who co-authored the study.

However, companies that move quickly to replace their chief executives and finance chiefs, rejigger the audit committees on their boards or outright fire their accountants, for example, can find their stocks responding more normally to earnings news within five quarters or fewer, Mr. Lo said.

More decisive action, Mr. Lo contends, “can limit the potential damage” to a company’s credibility with investors.

Is the Decline in the Information Content of Earnings Following Restatements Short-Lived?

Xia Chen 

Singapore Management University

Qiang Cheng 

Singapore Management University

Alvis K. Lo 

Boston College
June 3, 2013
The Accounting Review, January 2014, Forthcoming 

Abstract: 
Prior research finds that the decline in the information content of earnings after restatement announcements is short-lived and the earnings response coefficient (ERC) bounces back after three quarters. We re-examine this issue using a more recent and comprehensive sample of restatements. We find that material restatement firms experience a significant decrease in the ERC over a prolonged period – close to three years after restatement announcements. In contrast, other restatement firms experience a decline in the ERC for only one quarter. We further find that among material restatement firms, those that are subject to more credibility concerns and those that do not take prompt actions to improve reporting credibility experience a longer drop in the ERC. Lastly, reconciling with prior research, we find that using a more powerful proxy for material restatements and imposing less restrictive sampling requirements help increase the power of the tests to detect the long-run drop in the ERC.