An Analysis of the Sources of Value Loss Following Financial Restatements

• In Event: Fraud and Financial Reports

Abstract

We decompose the total value loss around firms’ announcements of financial restatements into components arising from investors’ revisions in cash flows and discount rates (or cost of equity). While we find significant contributions from both sources, the impact of revisions in the discount rate is more significant, explaining over 66% of the variation in stock returns surrounding restatement announcements. For restatements caused by financial fraud, the discount rate impact is much more important than the cash flow impact, explaining about 84% of return variation. Similarly, the discount rate impact is larger for firms with higher earnings persistence. Our decomposition of the value helps explain returns in the post-announcement period. Firms with a higher relative discount rate impact experience a significant downward stock price drift after the initial announcement-related price decline. For firms with a higher relative cash flow impact, the initial impact of the restatement announcement is long-lasting. Our findings close gaps in the evidence on financial restatements, extend the literature on the drivers of stock price movements and inform the research on the value relevance of earnings.

Authors

• Keejae P Hong, University of North Carolina Charlotte

• Sang Hyun Park, Augusta University

• Sukesh Patro, Northern Illinois University

• Jaywon Lee, Korea Advanced Institute of Science and Technology