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Are Investors Smarter than We Think?

An academic report, looking at restatements, challenges the conventional wisdom that shareholders are slow to detect overstated earnings by their companies.
Sarah Johnson, CFO.com | US
March 4, 2008

Restatements — the dreaded "R" word describing needed reworking of financial statements, often accompanied by excruciatingly late nights for internal accounting teams — may well bring to mind another shudder-worthy "R" term: regulation.

It's little wonder why, when numerous studies have recorded investors' significant negative reaction to restatements issued by their companies. Restatements, after all, may lead not only to shareholders losing money, but to lawsuits, and even delisting.

But how do investors react before a restatement is issued? And have regulators been too quick to respond to these reported short-term, negative returns?

Such questions are raised in a new academic study that could challenge some widely held beliefs underlying securities regulations designed in recent years to protect investors — including the belief that investors suffer significant harm when companies mistakenly issue inaccurate earnings figures.

"Restatements are not as hurtful to investors as was believed previously, given how much other information is available," says Katsiaryna Salavei, assistant professor of finance at Fairfield University's Dolan School of Business, in Fairfield, Conn. Indeed, her research suggests that shareholders don't rely on restated numbers as much as had been previously assumed, because they use other data to supplement their investing judgments, such as the financial statements of competitors.

Questions about the value of restatements are sure to remain a matter of debate, as their volume has increased in recent years before leveling off recently. (The U.S. Government Accountability Office has said restatements practically doubled from July 2002 to September 2005). In fact, two economists from the Public Company Accounting Oversight Board recently suggested the impact of announcing an impending restatement has fallen. Negative investor reaction has been reduced by 71 percent during the two days following an announcement since the Sarbanes-Oxley Act was passed, they wrote.

Salavei's report also raises the issue of whether regulators give investors enough credit for their knowledge of corporations' accounting errors, even before a restatement announcement is issued. "Investors seem to see through mistakes, and that should be considered when further regulation is enacted or previous ones are reconsidered," Salavei told CFO.com.

In her working paper, Salavei and co-researchers Joseph Golec and John Harding, both University of Connecticut associate finance professors, explored the long-term effect of investors' reactions following the issuance of misstated financial statements, unlike previous reports that concentrated on the short-term effects. It's generally accepted that investors reward stock prices when a company overstates its net income. However, Salavei maintains that shareholder enthusiasm quickly wanes, because investors soon realize that the higher numbers are invalid.

"It is not a foregone conclusion that misstated financial statements seriously mislead investors, because investors could use other private and public information sources to estimate true earnings with reasonable accuracy," she writes.

The professors' analysis of 492 restatements between 1997 and June 2002 (before the passage of Sarbox) shows that investors' short-term inaccurate valuations of stock prices corrected themselves — at some point between the time a company makes a mistake, and the time it issues its first public concession that a restatement may be necessary.

In fact, the professors contend, investors quickly see through misstated earnings and penalize the firm's stock price. They may do this because they anticipate that a restatement will be coming down the pike and its possible downsides, such as lawsuits, could surely follow.




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