Market reaction to the announcement of an accounting restatement is generally negative, but not all restatements are regarded alike, according to a study by Audit Analytics of the 1,876 restatements filed in 2006, when restatements were at a record high.
Financial Restatements and Market Reactionsprovides analysis of restatement issues which have the most powerful impact on the stock market, as well as background for the post-2006 decline in the quantity and severity of restatements, which Audit Analytics attributes to the effects of the Sarbanes-Oxley Act.
The study finds that the kinds of restatement issues, the different types of announcement filings, and the size of the company affected the market reaction differently. Consistent with Audit Analytics’s other reports on pre-Sarbanes-Oxley restatements, Financial Statements and Market Reactionsshows sharp declines in share prices before the announcement with a continuing, smaller decline after the announcement.
On average, share prices declined 5 percent in the period prior to the day before the announcement and an additional 1 percent after the announcement. The decline was greatest when associated with a revenue recognition error, and smallest when cash flow problems were involved. Share prices began to rise after the initial post-announcement loss, but still lagged the market by 2 percent after 50 days.
“Restatements dealing with operational or integrity issues had the biggest impact on stock performance,” according to the study. Errors in revenue recognition, inventory, and liabilities were considered examples of operational restatements for this study. Various executive compensation issues related to stock option irregularities were considered integrity restatements.
In 85 restatements that identified an error in revenue recognition, share prices began to decline 20 to 30 days prior to the restatement, followed by a sharp drop in value in the five-day period surrounding the restatement. “After the sharp drop, the average share price continued to decline over the remaining 50-day period despite the fact that the overall market trend was positive. The average total loss, from about 40 days prior to 50 days after the restatement, was about 10 percent.”
Restatements associated with stock options and stock-option backdating resulted in share price declines of more than 9 percent on average before the date of the restatements. After the restatement, however, the share prices did not continue to decline, unlike the case for revenue recognition errors. This pattern might have resulted from the fact that the public was aware of the companies, and the industries (high tech), where backdating was an issue well before the restatements were filed.
Restatements associated with cash flow issues resulted in much less severe share price declines – less than the average 5 percent decline. Prices trended downward for a week or two after the announcement but then approached general market levels implying that “the market responds to restatements that implicate technical issues in a markedly different manner compared to restatements that implicate integrity issues.”
Types of announcement filings
The study finds striking differences in the share price effect of these restatements from the perspective of the type of filing, for example, whether they were event filings or periodic filings. An event filing refers to an 8K (or press release) and a periodic filing refers to filings required on a periodic basis (quarterly or yearly), such as a 10K, 10KA, 10Q, 20F, or 40F.
Restatements first disclosed in periodic filings did not show a post-announcement decline. The authors theorized that “typically there is a greater period of time that elapses between internal knowledge of an impending restatement and the actual announcement.” In addition, “SEC rules allow companies that identify the need for a restatement within two weeks of submitting a periodic report to include it in that report as opposed to filing a separate 8K.”
Most of the price drop associated with revenue recognition restatements was attributable to those announced in event filings. Prices dropped sharply before the announcements, and continued lower than the average after the announcement, dropping to -3 percent instead of -1.5 percent. Of the 85 revenue recognition restatements, 57 were event filings and 28 were periodic filings.
The market reacted similarly to event and periodic restatements in executive compensation-related restatements. Both filing types experienced large declines prior to the announcement followed by relatively flat trading after the announcement.
Share prices related to cash flow restatements declined sharply in the pre-announcement period, but were followed by sharp gains in the post-announcement period. After event filings, shares traded in a relatively flat range. The study found these trends difficult to explain.
Large caps and small caps compared
Large caps fared better than small caps, according to the study. Of the original sample of 674 restatements, 295 were filed by companies listed in the Russell 3000 Index. A comparison of all restatements and the Russell 3000 Index shows that the Russell 3000 stocks lost 2 percent less in the pre-announcement period and experienced price gains after the restatement that were comparable with the market, while the average of all the restatements failed to match the market.
Overall performance affected the share values before and after the restatements. Approximately one-third of the stocks performed better than the market during the pre-announcement period. The performance of the remaining two-thirds was so poor that it dragged down the average for all companies.
Audit Analytics’s reports have compared financial restatements for the past nine years, from 2001 through 2009. Its reports total restatements by year, average number of days, average number of issues, and percentage of stealth restatements.
Audit Analytics provides detailed research on more than 20,000 public companies and more than 1,500 accounting firms.