Shorting Companies That Restate Previously Issued Financial Statements

Abstract

A new disclosure in Form 8-K is required when a company needs to warn investors that they cannot rely on previously issued financial statements. Using such disclosures in 2005, the authors find that the initial stock market reaction to the filing of the Form 8-K is negative, with an average three-day abnormal return centered on the Form 8-K filing date of –1.5% for a sample of 182 such disclosures. There are even greater average negative initial market reactions to announcements of errors or misapplications of GAAP. The authors further find that abnormal returns continue to drift downward for a sample of errors and misapplication of GAAP and reach a cumulative abnormal return of –5.3% by (trading) day 43 after the initial disclosure of the Form 8-K. Thus, investors can take advantage of such non-reliance disclosures and short the underlying stock. <b>TOPICS:</b>Factors, risk premia, statistical methods, exchanges/markets/clearinghouses