Hostname: page-component-586b7cd67f-tf8b9 Total loading time: 0 Render date: 2024-12-02T23:14:24.188Z Has data issue: false hasContentIssue false
  • English
  • Français

Do Investors See through Mistakes in Reported Earnings?

Published online by Cambridge University Press:  07 June 2011

Katsiaryna Salavei Bardos ,
Joseph Golec  and
John P. Harding
Katsiaryna Salavei Bardos
Affiliation:
Dolan School of Business, Fairfield University, 1073 N. Benson Rd., Fairfield, CT 06824. [email protected]
Joseph Golec
Affiliation:
School of Business, University of Connecticut, 2100 Hillside Rd., Unit 1041, Storrs, CT 06269. [email protected]
John P. Harding
Affiliation:
School of Business, University of Connecticut, 2100 Hillside Rd., Unit 1041, Storrs, CT 06269. [email protected]
Get access Rights & Permissions [Opens in a new window]

Abstract

This study investigates whether investors see through materially misstated earnings, and whether they anticipate earnings restatements. For firms that restate at least one annual report, we find that investors are misled by mistakes in reported earnings at the time of initial earnings announcements. Investors react positively to the component of the favorable earnings surprise that will subsequently be restated, and they attach the same valuation to it as to the true earnings surprise. We also find that investors anticipate the subsequent downward restatements and start marking stock prices down several months before a restatement announcement, so that the full impact of a restatement is about three times as large as the restatement announcement effect. Indeed, we show that investors punish restating firms because the stock price gains that shareholders enjoy when firms initially announce overstated earnings are more than reversed by the time of the restatement announcement.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 46 , Issue 6 , December 2011 , pp. 1917 - 1946
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2011

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Agrawal, A., and Chadha, S.. “Corporate Governance and Accounting Scandals.” Journal of Law and Economics, 48 (2005), 371–406.CrossRefGoogle Scholar
Agrawal, A., and Cooper, T.. “Insider Trading Before Accounting Scandals.” Working Paper, University of Alabama (2007).CrossRefGoogle Scholar
Badertscher, B.; Collins, D. W.; and Lys, T. Z.. “Earnings Management and the Predictive Ability of Accruals with Respect to Future Cash Flows.” Working Paper, University of Notre Dame, University of Iowa, and Northwestern University (2007).Google Scholar
Ball, R., and Brown, P.. “An Empirical Evaluation of Accounting Income Numbers.” Journal of Accounting Research, 6 (1968), 159–178.CrossRefGoogle Scholar
Ball, R., and Kothari, S. P.. “Security Returns around Earnings Announcements.” Accounting Review, 66 (1991), 718–738.Google Scholar
Barber, B. M., and Lyon, J. D.. “Detecting Long-Run Abnormal Stock Returns: The Empirical Power and Specification of Test Statistics.” Journal of Financial Economics, 43 (1997), 341–372.CrossRefGoogle Scholar
Bardos, K. S.; Golec, J.; and Harding, J. P.. “Litigation Risk and Market Reaction to Restatements.” Working Paper, University of Connecticut and Fairfield University (2011).Google Scholar
Beaver, W. “The Information Content of Annual Earnings Announcements.” Empirical Studies in Accounting: Selected Studies, Supplement to Journal of Accounting Research, 10 (1968), 1–38.Google Scholar
Bhojraj, S.; Lee, C. M. C.; and Oler, D. K.. “What’s My Line? A Comparison of Industry Classification Schemes for Capital Market Research.” Journal of Accounting Research, 41 (2003), 745–774.CrossRefGoogle Scholar
Block, S. B. “A Study of Financial Analysts: Practice and Theory.” Financial Analysts Journal, 55 (1999), 86–95.CrossRefGoogle Scholar
Bradshaw, M. T., and Sloan, R. G.. “GAAP versus the Street: An Empirical Assessment of Two Alternative Definitions of Earnings.” Journal of Accounting Research, 40 (2002), 41–66.CrossRefGoogle Scholar
Burns, N., and Kedia, S.. “The Impact of Performance-Based Compensation on Misreporting.” Journal of Financial Economics, 79 (2007), 35–67.CrossRefGoogle Scholar
Chari, V. V.; Jagannathan, R.; and Ofer, A. R.. “Seasonalities in Security Returns: The Case of Earnings Announcements.” Journal of Financial Economics, 21 (1988), 101–121.CrossRefGoogle Scholar
Chen, X.; Cheng, Q.; and Lo, A. K.. “The Consequence of Aggressive Financial Reporting: The Case of External Financing.” Working Paper, University of Wisconsin-Madison and University of British Columbia (2009).CrossRefGoogle Scholar
Cohen, D. A.; Dey, A.; Lys, T. Z.; and Sunder, S. V.. “Earnings Announcement Premia and the Limits to Arbitrage.” Journal of Accounting and Economics, 43 (2007), 153–180.CrossRefGoogle Scholar
Collins, D. W., and Kothari, S. P.. “An Analysis of Intertemporal and Cross-Sectional Determinants of Earnings Response Coefficients.” Journal of Accounting and Economics, 11 (1989), 143–181.CrossRefGoogle Scholar
Dechow, P. M., and Skinner, D. J.. “Earnings Management: Reconciling the Views of Accounting Academics, Practitioners, and Regulators.” Accounting Horizons, 14 (2000), 235–250.CrossRefGoogle Scholar
DeFond, M. L., and Jiambalvo, J.. “Incidence and Circumstances of Accounting Errors.” Accounting Review, 66 (1991), 643–655.Google Scholar
De la Merced, M. J. “Auditor Could Face Liability in Lehman Case.” New York Times (March 15, 2010), B.2.Google Scholar
Desai, H.; Hogan, C. E.; and Wilkins, M. S.. “The Reputational Penalty for Aggressive Accounting: Earnings Restatements and Management Turnover.” Accounting Review, 81 (2006), 83–112.CrossRefGoogle Scholar
Desai, H.; Krishnamurthy, S.; and Venkataraman, K.. “Do Short Sellers Target Firms with Poor Earnings Quality? Evidence from Earnings Restatements.” Review of Accounting Studies, 11 (2006), 71–90.CrossRefGoogle Scholar
Efendi, J.; Kenney, M.; and Swanson, E. P.. “Can Short Sellers Predict Accounting Restatements?” Working Paper, Texas A&M University (2004).CrossRefGoogle Scholar
Efendi, J.; Srivastava, A.; and Swanson, E. P.. “Why Do Corporate Managers Misstate Financial Statements? The Role of Option Compensation and Other Factors.” Journal of Financial Economics, 85 (2007), 667–708.CrossRefGoogle Scholar
Elliott, J. A., and Hanna, J. D.. “Repeated Accounting Write-Offs and the Informational Content of Earnings.” Journal of Accounting Research (Supplement), 34 (1996), 135–155.CrossRefGoogle Scholar
Frieder, L., and Shanthikumar, D.. “Investor and Price Reaction to Earnings Restatements.” Working Paper, Harvard University and Purdue University (2007).CrossRefGoogle Scholar
General Accounting Office. “Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining Challenges.” GAO-03–138 (2002).Google Scholar
Graham, J. R.; Harvey, C. R.; and Rajgopal, S.. “The Economic Consequences of Corporate Financial Reporting.” Journal of Accounting and Economics, 40 (2005), 3–73.CrossRefGoogle Scholar
Graham, J. R.; Li, S.; and Qiu, J.. “Corporate Misreporting and Bank Loan Contracting.” Journal of Financial Economics, 89 (2008), 44–61.CrossRefGoogle Scholar
Griffin, P. A. “A League of Their Own? Financial Analysts’ Responses to Restatements and Corrective Disclosures.” Journal of Accounting, Auditing, and Finance, 18 (2003), 479–518.CrossRefGoogle Scholar
Hribar, P., and Jenkins, N. T.. “The Effect of Accounting Restatements on Earnings Revisions and the Estimated Cost of Capital.” Review of Accounting Studies, 9 (2004), 337–356.CrossRefGoogle Scholar
Hribar, P.; Jenkins, N. T.; and Wang, J.. “Institutional Investors and Accounting Restatements.” Working Paper, University of Iowa, Vanderbilt University, and Singapore Management University (2005).CrossRefGoogle Scholar
Jensen, M. C. “Agency Costs of Overvalued Equity.” Financial Management, 34 (2005), 5–19.CrossRefGoogle Scholar
Kahle, K. M., and Walkling, R. A.. “The Impact of Industry Classifications on Financial Research.” Journal of Financial and Quantitative Analysis, 31 (1996), 309–335.CrossRefGoogle Scholar
Karpoff, J. M.; Lee, D. S.; and Martin, G. S.. “The Cost to Firms of Cooking the Books.” Journal of Financial and Quantitative Analysis, 43 (2008), 581–612.CrossRefGoogle Scholar
Kedia, S., and Philippon, T.. “The Economics of Fraudulent Accounting.” Review of Financial Studies, 22 (2009), 2169–2199.CrossRefGoogle Scholar
Kinney, W. R. Jr., and McDaniel, L. S.. “Characteristics of Firms Correcting Previously Reported Quarterly Earnings.” Journal of Accounting and Economics, 11 (1989), 71–93.CrossRefGoogle Scholar
Kothari, S. P., and Warner, J. B.. “Measuring Long-Horizon Security Price Performance.” Journal of Financial Economics, 43 (1997), 301–339.CrossRefGoogle Scholar
Kravet, T., and Shevlin, T.. “Accounting Restatements and Information Risk.” Review of Accounting Studies, 15 (2010), 264–294.CrossRefGoogle Scholar
Landsman, W. R., and Maydew, E. L.. “Has the Information Content of Quarterly Earnings Announcements Declined over the Past Three Decades? ” Journal of Accounting Research, 40 (2002), 797–808.CrossRefGoogle Scholar
Livnat, J., and Mendenhall, R. R.. “Comparing the Post-Earnings Announcement Drift for Surprises Calculated from Analyst and Time Series Forecasts.” Journal of Accounting Research, 44 (2006), 177–205.CrossRefGoogle Scholar
Lyon, J. D.; Barber, B. M.; and Tsai, C.-L.. “Improved Methods for Tests of Long-Run Abnormal Stock Returns.” Journal of Finance, 54 (1999), 165–201.CrossRefGoogle Scholar
Palmrose, Z.-V.; Richardson, V. J.; and Scholz, S.. “Determinants of Market Reactions to Restatement Announcements.” Journal of Accounting and Economics, 37 (2004), 59–89.CrossRefGoogle Scholar
Richardson, S.; Tuna, A.; and Wu, M.. “Predicting Earnings Management: The Case of Earnings Restatements.” Working Paper, University of Pennsylvania, and Hong Kong University of Science and Technology (2003).Google Scholar
Spiess, D. K., and Affleck-Graves, J.. “The Long-Run Performance of Stock Returns following Debt Offerings.” Journal of Financial Economics, 54 (1999), 45–73.CrossRefGoogle Scholar
Wilson, W. M. “An Empirical Analysis of the Decline in the Information Content of Earnings following Restatements.” Accounting Review, 83 (2008), 519–548.CrossRefGoogle Scholar