A financial restatement is perhaps the most significant indication of an accounting failure. Inability to provide reliable financial statements may shake investor confidence and raise concerns about a company’s overall health.
Moreover, a material restatement caused by an accounting irregularity may cast doubt on management integrity and expose the company to regulatory scrutiny or litigation.
Indeed, extensive prior academic research has documented notable, negative stock returns before and around the dates restatements are announced. However, post-event price movements have been less documented. In our opinion, such a study was worth exploring.
Using the buy-and-hold method to look at stock-price movements, we actually identified long-term positive abnormal returns following the filing of the restated financials.
What causes that to happen? There are several likely factors.
First, lack of reliable information during the restatement process, including limited financial guidance, may cause the market to initially misprice the bad news. That could create a window of opportunity for abnormal positive returns after the market corrects from the exaggerated reaction.
Second, the reduced financial information available to investors may influence target investor groups, such as large institutional investors focused on the “G” (governance) element of ESG investing, to avoid investing or increasing their position in the stock while the restatement process is ongoing.
Third, although some companies file restated financials as early as the day following a restatement announcement, others can take years to complete the process. During that time, companies may become delinquent with their financial reporting, raising the risk of delisting.
Fourth, to take full advantage of positive corporate developments, such as new product announcements, companies may choose to delay dissemination of such news until the remediation process is complete. Or, companies with restatements that were followed by C-level turnover may decide to delay the news until the new management comes on board.
Data and Methodology
We began our analysis with restatements disclosed in 8-K filings from January 2005 through December 2016 that were available in the Audit Analytics database. The population was limited to filings with an item 4.02 (Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review).
We further excluded restatements for which the date of restated financial statements was unavailable in the Audit Analytics database; that were filed on the same date that the restatement announcement was made; and for which the stock price on the date of the refiled financials was below $1.
In order to study the overall market reaction, we first measured the cumulative abnormal return (CAR) associated with each event by calculating daily market-adjusted returns. (In our calculations, we considered the Russell 3000 index as representative of the market.)
We then summed up these daily market-adjusted returns for up to 750 days following the date of restated financial statements. Then, we calculated the cumulative average abnormal return (CAAR) for the overall sample by computing the average of all CARs within it.
Based on an assessment of the 966 observations in the final sample, no statistically significant abnormal returns were identified in the first 30-day window following the date of restated financials.
However, significant positive abnormal returns of 1.07% were identified during the second 30-day window (days 31 to 60). The finding was consistent with our theory that the market may overreact and create window of short-term positive returns after the initial impact of the bad news.
In extending the analysis to up to 750 days following restatements, we identified abnormal positive returns of 1.55% in the event window of days 271 to 300 and 1.52% in the event window of days 331 to 360. We did not identify any windows with abnormal negative returns.
Restatements with Net Income Effect:
We further examined whether positive abnormal returns increased when restatements were perceived to be more significant, such as those affecting aggregate net income. That was the case for about 90% of the sample.
Similar to the original sample, no abnormal returns were identified in the first 30-day window, but for the second 30-day window, we identified abnormal returns of 1.16%.
We also identified cumulative average abnormal return of 1.79% in the event window of 271 to 300 days; and cumulative average abnormal return of 1.66% in the event window of 331 to 360 days. We did not identify negative abnormal returns in any of the event windows.
Restatements with Long Restatement Process:
We looked at a subset of restatements that took more than 30 days (calculated as the number of days between the filing of an 8-K Item 4.02 and the day when restated financial statements were filed). The subset included just 431 observations, emphasizing that companies were able to resolve restatements issue within a relatively short time frame in more than 50% of cases.
Consistent with the other subsets, we found abnormal positive returns of 1.74% in the second 30-day window. Notably, only in this subset did we identified abnormal negative returns (2.67%) in the third 30-day window. No abnormal negative returns were identified in any of the other windows.
As with the previous tests, we identified abnormal positive returns of 2.48% in the event window 331 to 360 days.
The significance of this finding, from an investor’s perspective, is that the share prices of companies with a long restatement process may continue to be volatile or underperform long after the restated financials are filed. Yet, the negative abnormal returns are short-lived.
For the population of restatements within this subset with a net income effect, there were similar results: abnormal positive returns of 1.91% in the second 30-day window and 2.39% in the third 30-day window.
The cumulative average abnormal return for the window of 331 to 360 days was 2.74%.
Although academic literature provides evidence of underperformance by restating companies, investors may find value in understanding stock behavior after companies clear regulatory issues related to the restatement process.
Our analysis is intended to be a starting point for a more detailed study and should not be seen as a fully developed trading strategy. For example, it is possible that documented abnormal returns are concentrated within sectors or stocks priced below $5 a share. We also did not take into consideration factors such as trading costs and volatility of the restating companies.
It is also possible that companies with abnormal returns (either positive or negative) share certain factor-based characteristics not possessed by the remaining population.
For example, looking at a case study of Bausch Health Companies (formerly Valeant Pharmaceuticals), the company was highly leveraged, with a tangible risk of default on its loan agreements.
Moreover, our analysis looked at restatements that originated as early as 2005. We cannot rule out the possibility that a more recent population (say, the five most recent years) would have produced different results. Restatement characteristics such as errors vs. irregularities and the regulatory environment could affect a stock’s behavior.
Yet, we think the study is interesting and identifies a few points that warrant further analysis. For example, not a single population tested had significant negative returns after the 90 days following the restated financials date; whereas, for the population with a lengthy restatement investigation process, there could be short-term windows with abnormal positive returns.
Derryck Coleman is a research manager and Kati Manyak a research analyst at Audit Analytics.