Investors have long memories when it comes to material misstatements

Photo courtesy of Elvert Barnes on Flickr

Photo courtesy of Elvert Barnes on Flickr

Rob Swystun, Pristine Advisers

If your company has to issue a material restatement, prepare to take a hit in the stock market and prepare to be on investors’ collective bad side for a long time.

A new joint study from the University of Singapore and Boston College says companies’ reputations will suffer with investors for as long as 11 quarters after material restatements are issued if those statements are for issues other than honest errors.

As Tammy Whitehouse points out in Compliance Week, the American Accounting Association (AAA) calls the study the most extensive analysis of response by investors to restatements ever done.

“Investors, the new study reveals, have a diminished response to earnings reports of such companies for an average of close to three years,” the AAA says in a statement.

Three years is much different than what had previously been reported, the study’s authors — professors Xia Chen and Qiang Cheng in Singapore and Alvis Lo in Boston — say.

“This is a considerably longer period than the three quarters reported in prior research, suggesting that the decline in credibility and information content of earnings after restatements is not short-lived,” the authors wrote.

The latest data on restatements suggests that while the severity of restatements has begun to diminish, the number of restatements issued has risen, according to Whitehouse.

How they did it

The researchers examined responses from investors to more than 1,200 restatements from 1997 to mid-2006. A total of 343 of the statements the researchers looked at were considered as material because they involved fraud or accounting irregularity.

Investor response to material misstatements was much different than to the other restatements, which were not issued as a result of fraud or accounting shenanigans. The stock of companies with material misstatements tumbled 7.2% and decline in investor confidence lasted for the aforementioned 11 quarters. The restatements that weren’t fraud or accounting irregularity-related resulted in only a 1.8% drop in stock price and diminished investor confidence that lasted just a single quarter.

On top of that, the study also found that those companies that issued material misstatements were able to contain the damage if they took swift action. If they did something like sack a high profile individual like the CEO or CFO, the external auditor or the audit committee chair, they managed to regain investor confidence much sooner, usually within the fourth or fifth quarter following the restatement. Investors like to see action taken, apparently.

“In short, investors are relatively forgiving when it comes to honest errors but not when it comes to material irregularities,” AAA says.

Forgive and forget … just not too quickly.

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