No company wants to issue an accounting restatement; it’s a guaranteed way for the share price to drop 10 percent, on average. Investors, analysts and journalists alike view restatements as an indication of a problem within the company. According to a professor at the Olin School of Business at Washington University in St. Louis, when a company announces a restatement of revenues or expenses, there is value in looking at its industry peer firms.
Based on an evaluation of more than 22,500 public companies, accounting professor Nicole Thorne Jenkins and her co-authors found that a company’s restatement adversely affects not only its own stock price, but also that of similar firms.
“When a firm announces a restatement, there is a significantly negative market reaction,” said Jenkins. “The information communicated by a restatement is transferred to similar firms. The market reacts to that information transfer similarly but to a lesser degree because there is some uncertainty that the same reporting problem exists in other companies.”
Upon news of a company’s accounting restatement, peer firms experience a cumulative average decrease of 1.82 percent in the 21 days following the initial restatement. The effect is even more pronounced for firms that have poor accounting quality or that have the same auditor as the restating firm.
“Once auditors become aware of a restatement issue, they are going to then look closely at the books of all of their similar clients to minimize their own liability. They are going to make sure that the problem is cleaned up everywhere.” Jenkins said.
The more similar firms are to each other, the more likely an information transfer will occur—affecting similar companies’ stock prices. Jenkins says her research could provide valuable information for managers. “If a firm in your industry restates and you know your firm does not have the same problem, it may be worthwhile to disclose that to the market to minimize the information-transfer effect.”
This phenomenon occurs because the market has based stock prices on reported earnings and accruals; however, when the market has reason to believe that its initial assessment was made on erroneous reported numbers, it reassesses their value using a smaller multiple to determine stock price, Jenkins said.
“We find that following a restatement within a given industry, the market reduces the multiple with which it prices the accruals of the peer firms. Thus, the accruals of peer firms are discounted.” Jenkins said.
Jenkins conducted the research with Cristi Gleason and W. Bruce Johnson from the University of Iowa. Additional information is available in their working paper titled “The Contagion Effects of Accounting Restatements.”
Editor’s note: Jenkins is available for interviews and comment for print and broadcast media. Television and radio can conduct live or pre-recorded interviews. Washington University has a broadcast-quality ISDN line and VYVX fiber-option video delivery in its on-campus studio.