Value Investing

[Archives] Do Investors See Through Mistakes In Reported Earnings?

Do Investors See Through Mistakes In Reported Earnings? via CSInvesting

Katsiaryna Salavei*

Department of Finance

Fairfield University

Joseph Golec

Department of Finance

University of Connecticut

John P. Harding

Department of Finance

University of Connecticut

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 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 initial announcement effect. Overall our findings indicate that although investors anticipate restatements several months before its announcement, they are misled by misstated earnings for several years and therefore would benefit from better quality of financial information.

Do Investors See Through Mistakes In Reported Earnings? – Introduction

Recent corporate scandals involving overstated earnings have motivated several Securities and Exchange Commission (SEC) rules and Sarbanes-Oxley Act of 2002 provisions aimed at boosting the integrity of financial reports (Palmrose, Richardson and Scholz (2004)). The premise of these rules is that investors typically do not see through the standard financial reporting to identify accounting mistakes and earnings manipulations. But if investors use other private and public information to validate reported earnings, several of the new rules may be costly and unnecessary.

Surprisingly, earlier studies spend little time examining whether investors are fooled by erroneous financial statements. Instead, most focus on the value effects and stock trading behavior just before and after restatement announcements.1 But how often and for how long are investors misled? The importance of accurate and transparent financial statements in monitoring the health of large firms is center stage as the country assesses the causes of the 2008 financial crisis and plans regulatory reforms to prevent future crises. For example, accounting irregularities, such as those that went unnoticed by auditors and regulators prior to Lehman’s demise, drew greater attention to the question of how much investors are misled by erroneous financial information (De La Merced (2010)).

The goal of this paper is to provide a comprehensive analysis of investors’ ability to see through mistakes in financial statements. Our study differs from prior literature on restatements in that it focuses on market reaction to the original announcement of misstated earnings and the valuation of restating firms in the error period, which extends from the first misstated period to the day of restatement announcement.2 To the best of our knowledge, no prior study examines the market reaction to initial announcements of incorrect earnings that are subsequently restated. Only one previous study examines valuation in the error period for an older and smaller sample of restatements (Kinney and McDaniel (1989)).

In the absence of mistakes in financial statements, abnormal returns associated with earnings announcements are an increasing function of earnings surprises. For our sample of 492 restatements, we decompose the earnings surprise into two components: the true earnings surprise and the surprise due to the error.3 If investors are misled by erroneous earnings and treat the correct and error components the same, then any associated abnormal returns will be proportionately the same for each component.

Indeed, for the sub-sample of firms that restated at least one annual report we find that, during the error period, investors react positively to the error component of the earnings surprise and attach the same valuation to the error component of the earnings surprise as to the true part of the earnings surprise. Furthermore, our evidence suggests that investors are more misled by mistakes made at the beginning rather than at the end of the error period.

Mistakes In Reported Earnings

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