Tuesday, December 14, 2010

Do Investors See Through Mistakes in Reported Earnings?

Great read by R. Christopher Small @ HLS Forum.
In the paper Do Investors See Through Mistakes in Reported Earnings?, forthcoming in the Journal of Financial and Quantitative Analysis, we test whether investors see through mistakes in reported earnings by examining market reaction to initially reported erroneous earnings and valuation of restating firms during the error period, before earnings are corrected. We also examine the long-run return performance of restating companies in three periods: (1) the period prior to the mistake (pre-error period); (2) the period after the mistake has been made but before the restatement (error period); (3) and the period after the restatement (post-restatement period). We focus on the error period, which we split into four quartiles.
Results show that investors are initially misled by mistakes in financial statements. At the initial announcement of erroneous earnings, investors treat the error component of earnings the same as the true component. However, valuation of the error component decreases as the restatement date approaches, suggesting that investors start to catch on sometime before a restatement occurs. Valuation (CAR and BHAR) trends measured during the error period also show that investors anticipate restatements. We find that restating firms that overstate net income underperform the market and matched control firms several months before their restatement announcements.
Overall our evidence suggests that investors are initially misled by misstated earnings but start seeing through mistakes as the restatement date approaches. When anticipation of a restatement is taken into account, the effect of the restatement is more than three times its announcement effect. Our results support the view that better quality of financial information could benefit investors.
Click Here to Download: Do Investors See Through Mistakes in Reported Earnings?

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