February 2014

When a financial restatement is necessary, it is not surprising that investors will take some time to regain trust and give full credit to future earnings announcements.  Exactly how long is a function of various factors, including the nature of the restatement and the corrective actions taken.  A recent study, developed through a collaboration of professors from Singapore Management University and Boston College, suggests that the three quarter rebuilding period described in prior research may be understated.

The current study suggests a much longer duration of approximately three years for material restatements and a shorter duration of one quarter for other restatements.  The study uses a measurement tool called an earnings response coefficient (ERC) as a proxy for the information content of earnings.  The ERC is the relationship between the stock market reaction (change in stock price) and the unexpected portion of (or new information in) companies’ earnings announcements.  The study’s authors claim their more comprehensive and recent sample of 1,208 restatements over the period 1997-2006 provides superior information than existed in prior research.

The study provides the following underlying conclusions:

  • longer recovery periods are associated with more significant credibility concerns
  • longer recovery periods are associated with a failure to take prompt actions to improve reporting credibility
  • increasing conservatism can bolster investors’ confidence in reported earnings
  • removal of both the CEO and CFO lessens the impact duration
  • dismissal of the auditor or audit committee chair can help restore credibility
  • investors are more suspicious of subsequently disclosed good news than bad news

This comprehensive analysis across a greater population of accounting restatements can be useful in many areas.  It can provide companies a basis for risk assessment and justification for additional internal control measures to improve accounting accuracy.  In addition, for those who have a need for a restatement, it provides information as to what actions can be taken to best mitigate the effects.

If one wishes to calculate damages resulting from a restatement, an analysis of the particular facts and circumstances of that case is required.  As described above, the magnitude of the restatement, the degree to which investors feel it was an honest mistake versus a manipulation, and the steps taken to correct the situation are all relevant considerations.  It may be instructive to examine historical trends, but the best information stems from the actual activity associated with the situation at hand.  An event study regarding the particular stock in question provides the basis for identifying movements that can attributed to specific events, including the notice of the restatement and any subsequent mitigation efforts, such as a resulting management or auditor change.  Event studies can illustrate how the public reacts (or fails to react) to a specific event.  Identifying and measuring such activity can substantiate (or counter) a claim for economic damages.  In addition to tracking stock movements, a damages calculation may also include other consequences, such as increased cost of capital and executive turnover.

Fulcrum Inquiry performs damages calculations.