Mendoza School of Business

Study: Earnings restatements aren’t necessarily stock-price poison

Published: January 4, 2011 / Author: Ed Cohen

A company’s stock price always takes a hit when management has to issue revised or “restated” earnings. In many investors’ minds it amounts to admission of guilt for having cooked the books.

Now comes evidence, though, that the damage a restatement does to a stock price depends, to a significant extent, on what company insiders were doing with their stock – buying or selling it – during the misstatement period.

A team of accountancy researchers that included Notre Dame’s Brad Badertscher examined 541 firms that issued restated earnings during an 11-year period ending in 2008. Prior studies, they said, showed that a restatement leads to an average stock-price drop of 10 percent. The price can fall more than 20 percent, they said, in the case of the most sinister-looking restatements, those deemed to involve accounting “irregularities.”

In their study, Badertscher and colleagues found that stock prices fell much further when company insiders were on record as having sold stock during the misstatement period or if the company was issuing new stock at the time. In both cases, the signal to the market – fair or not – was that executives were aware something fishy was up, and they wanted to take profits for themselves or for the company before the corrected numbers came to light.

However, the opposite was also true. If insiders sent bullish signals during the restatement period – by buying more company stock personally or if the company was buying back shares at the time – it mitigated the price decline. Stocks even rebounded.

Their conclusion: When the quality of a firm’s financial reporting is called into question, the market immediately looks for corroborating or contradicting evidence of guilt, and records of insider trading are an important source.

The researchers say their study is the first to look at the role of such actions when a company’s financial reporting comes into question. Their results have been accepted for publication in the September 2011 issue of The Accounting Review. Badertscher’s co-authors are Paul Hribar of the University of Iowa and Nicole Jenkins of Vanderbilt University.


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