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The effect of restatements on trading volume reactions to earnings announcements

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Abstract

This paper examines whether restatements affect trading volume reactions to subsequent earnings announcements. It closely follows the theoretical model developed by Kim and Verrecchia (J Account Econ 24:395–419, 1997) that decomposes the trading volume reactions around earnings announcements into the effects of pre-disclosure and event-period private information, and examines whether restatements change the trading volume reactions to earnings announcements in the post-restatement period. We find that restatements increase the degree of differential event-period information, leading to more divergent interpretation of earnings announcements subsequent to restatements. We also find that investors have less differential pre-disclosure private information in the post-restatement period, consistent with the view that investors’ beliefs converge when facing higher uncertainty in the information environment. Finally, focusing on irregularity restatement firms, we document that the effect of restatements on trading volume is more pronounced for firms announcing restatements after the passage of the Sarbanes–Oxley Act and after dismissing auditors and experiencing executive turnover. Overall, these results indicate that restatements affect investors’ behavior in forming judgments regarding earnings announcements.

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Notes

  1. We use the terms “price/return,” “price reaction,” and “returns-based” analyses interchangeably throughout the paper to refer to the tests focusing on price or price-related metrics.

  2. Hirshleifer and Teoh (2003) suggest that investors have limited attention and time for processing information. Accordingly, whether a loss in the credibility of financial reporting changes the information environment and affects individual behavior becomes an interesting question.

  3. Hennes et al. (2008) read all restatement announcements and relevant subsequent filings to classify restatements into suspected irregularities (i.e., intentional misreporting) and error groups (i.e., unintentional misapplication of GAAP). Restatements are classified by Hennes et al. (2008) as “accounting irregularities” if restatement announcements or SEC filings use words like “irregularity” or “fraud,” if the firm is charged by the SEC or the Department of Justice, or if the firm is under independent investigation. Please refer to Hennes et al. (2008) for details. Andrew Leone’s website provides the list of accounting irregularities (http://Sbaleone.bus.miami.edu/).

  4. Please refer to Kim and Verrecchia (1997), Corollary 3, page 408.

  5. Related, Loh and Rathinasamy (2003) examine the market reactions to securities class-action cases filed during the period 1996–1998 and find that firms alleged accounting irregularities and fraud experience a significant decrease in stock values.

  6. Building on the notion that restatement announcements result in negative price reactions, prior research also examines whether executives or outside directors are punished for the loss in credibility caused by restatements. Desai et al. (2006) find that firms exhibit increased executive turnover subsequent to restatement announcements, and Hennes et al. (2008) find managerial turnover rates to be higher for irregularity restatement firms. With respect to outside directors, Srinivasan (2005) finds that directors experience higher turnover and that the labor market penalty increases with the severity of restatements.

  7. While not examining price reactions, Chen et al. (2013) find that the likelihood of external financing decreases subsequent to restatements, and that this reduction lasts around three years subsequent to irregularity restatements.

  8. For example, investors can get accrual information upon receiving the financial statements and then form beliefs about firms’ accrual quality and true value. However, investors’ beliefs can vary according to their knowledge, ability to see through accruals, or information from other sources, leading to divergence in interpretation.

  9. Both Ahmed et al. (2003) and our study closely follow the theoretical model developed by Kim and Verrecchia (1997), and we have similar findings, though in different settings. Ahmed et al. (2003) expect that the advent of online trading attracts investors with less ability to interpret earnings in the short announcement period, resulting in more divergent private information regarding earnings announcements, and that these investors engage in more information seeking and processing activities in the pre-disclosure period, resulting in more homogeneous beliefs across investors. Similar to our findings, they document that in the post-online trading period, firms exhibit an increase in differential interpretation of earnings announcements and a decrease in differential precision of pre-disclosure information. Furthermore, Hope et al. (2009) also find similar behavior for firms that continue to disclose geographic earnings following the adoption of SFAS 131 (Statement of Financial Accounting Standards No. 131) and experience either of the following three conditions: (1) have a large absolute percentage change in foreign sales, (2) have a large difference between foreign and domestic profit margins, and (3) have a large percentage of foreign sales across the pre- and post-SFAS131 periods.

  10. Following Wilson (2008) and Chen et al. (2014), we remove forecasts made before the restatement (even though within the 60-day window) to ensure that only forecasts made after the restatement announcement are included in calculating expected earnings for quarter 1, the quarter immediately after the restatement announcement.

  11. To be consistent and comparable with prior studies (Hennes et al. 2008; Chen et al. 2013, 2014) and to increase the power of our tests, we do not use the AAER sample only.

  12. Consistent with prior studies (Hennes et al. 2008; Chen et al. 2014), we find that the market reactions for irregularity restatement announcements are more significant than those for error restatement announcements; the mean three-day cumulative abnormal return around restatement announcements is −7.29% for irregularity restatements versus −1.57% for error restatements (p value at less than 0.001).

  13. We obtain the AAER cases from the Center for Financial Reporting and Management (CFRM) at the University of California, Berkeley. For more details, please visit http://accounting.haas.berkeley.edu/cfrm/aaer-dataset.html.

  14. Chen et al. (2014) also experience a substantial drop in the sample size, after using the combined fraud indicators.

  15. Wilson (2008) and Chen et al. (2014) also provide evidence that investors react differently towards firms with versus without auditor dismissals.

  16. Based on the information obtained from the Audit Analytics database, of the 288 irregularity restatements, 13% of firms experience auditor dismissals.

  17. Based on the information hand collected from Form 8-K, of the 288 irregularity restatements, 24% of firms experience executive turnover.

  18. In Panel A of Table 7, the coefficients on α 2 in Column (1) are less significant than those in Column (2).

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Acknowledgements

We appreciate the helpful comments of Naoyuki Kaneda (discussant), Feng Li (discussant), Chi-Chun Liu, Krish Menon, Shu Yeh and participants at the 2014 City University of Hong Kong, National Taiwan University, and Shanghai University of Finance & Economics Joint Symposium and 2014 Annual Conference on Pacific Basin Finance, Economics, Accounting, and Management. Chunlai Ye and Lin-Hui Yu gratefully acknowledge the financial support from A. R. Sanchez, Jr. School of Business at Texas A&M International University and Ministry of Science and Technology, Taiwan.

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  1. Division of International Banking and Finance Studies, Texas A&M International University, Laredo, TX, USA

    Chunlai Ye

  2. Department of Accounting, National Taiwan University, Taipei City, Taiwan

    Lin-Hui Yu

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  1. Chunlai Ye
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Correspondence to Chunlai Ye.

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Table 9 Variable definitions
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Ye, C., Yu, LH. The effect of restatements on trading volume reactions to earnings announcements. Rev Quant Finan Acc 50, 129–180 (2018). https://doi.org/10.1007/s11156-017-0626-0

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