After a Restatement: Long-Run Market and Investor Response

Abstract

We examine returns and institutional trading in a long window surrounding earnings restatements. We show that abnormal returns following restatement announcements, a strongly negative event with negative pre-announcement and announcement-period returns, are significantly positive. We find significant positive returns in the one through six month period following the announcement, using raw returns, 3- and 4-factor calendar-time abnormal returns, firm-specific 4-factor adjusted returns and characteristic-adjusted returns. Results suggest that these positive returns are not due to a change in traditional risk factors or cost of capital. Given the potential variation in investors’ willingness to tolerate information risk and uncertainty associated with restatements we also examine institutional ownership changes before and after the restatement announcement. We find that dedicated institutions sell restatement firm shares steadily in the quarters surrounding the announcement, while transient and quasi-indexing institutions sell strongly before the restatement announcement and then buy significantly in the months around and after the announcement. The event-time trading of dedicated institutions has weakly positive predictive ability for future returns, meaning that the firms for which dedicated institutions maintain or buy the most shares around the restatement announcement experience the most positive returns post-announcement, while the event-time trading of transient and quasiindexing institutions has weakly negative predictive ability. The differences in the returns predicted by the three groups’ trading are statistically significant. Together, the results suggest that transient and quasi-indexing institutions are less willing to tolerate the increase in information risk immediately surrounding a restatement, and help drive a strong negative price reaction to the initial announcement, along with a later recovery in stock price.