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Do Investors See through Mistakes in Reported Earnings?

Published online by Cambridge University Press:  07 June 2011

Katsiaryna Salavei Bardos ,
Joseph Golec  and
John P. Harding
Katsiaryna Salavei Bardos
Affiliation:
Dolan School of Business, Fairfield University, 1073 N. Benson Rd., Fairfield, CT 06824. kbardos@fairfield.edu
Joseph Golec
Affiliation:
School of Business, University of Connecticut, 2100 Hillside Rd., Unit 1041, Storrs, CT 06269. joseph.golec@business.uconn.edu
John P. Harding
Affiliation:
School of Business, University of Connecticut, 2100 Hillside Rd., Unit 1041, Storrs, CT 06269. john.harding@business.uconn.edu
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Abstract

This study investigates whether investors see through materially misstated earnings, and whether they anticipate earnings restatements. For firms that restate at least one annual report, we find that investors are misled by mistakes in reported earnings at the time of initial earnings announcements. Investors react positively to the component of the favorable earnings surprise that will subsequently be restated, and they attach the same valuation to it as to the true earnings surprise. We also find that investors anticipate the subsequent downward restatements and start marking stock prices down several months before a restatement announcement, so that the full impact of a restatement is about three times as large as the restatement announcement effect. Indeed, we show that investors punish restating firms because the stock price gains that shareholders enjoy when firms initially announce overstated earnings are more than reversed by the time of the restatement announcement.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 46 , Issue 6 , December 2011 , pp. 1917 - 1946
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2011

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