Insider Insight

Enron. WorldCom. Tyco. These are among the most notorious names associated with a wave of accounting scandals that plagued the early 2000s and ultimately helped spur passage of the 2002 accounting reform law known as Sarbanes-Oxley.

While accounting restatements haven’t gone away entirely since then—there were 735 last year, down from a peak of 1,795 in 2006, according to Audit Analytics—they don’t always result in cataclysmic failure. In fact, the market can learn much about the future fate of a company based on the buying or selling of stock by the firm and its managers preceding an accounting restatement.

That’s according to new research from Nicole Thorne Jenkins, Associate Professor of Accounting, and co-authors Brad Badertscher of the University of Notre Dame and Paul Hribar of the University of Iowa. Their paper was published in The Accounting Review in September 2011.

“We predict and find evidence that when a firm restates its financial statements, the market uses the magnitude and direction of prior insider and corporate trades to help price the implications of the restatement,” the authors wrote.

Typically when a company issues an accounting restatement, it suffers an average loss of 10 percent in market value. That figure climbs to 20 percent or greater for firms whose restatements have been caused by “irregularities.” More than half the cases of restatements in the authors’ data occurred because of an issue with revenue recognition. Nearly 30 percent were due to things such as improperly recognizing expenses or wrongly capitalizing expenditures.

In the short run at least, Jenkins and her colleagues found that the negative impact of a restatement is softened “when there are net stock repurchases or insider purchases.” The opposite is also true—losses worsen—when “there are net equity issuances or insider selling,” they wrote.

The authors take the study a step further by demonstrating that the market is in fact using a company’s insider buying or selling behavior as a signal for how to price the restatement event. The positive (and negative) effect of buying (or selling) on share price is only found for those trades which have been disclosed publicly.

Preceding a restatement, “selling suggests more nefarious behavior on the part of management, and is likely to increase the information risk premium … while prior buying might help mitigate the uncertainty facing investors,” the authors wrote.

This study offers a “directional” hypothesis, rather than trying to determine the exact magnitude of the effect. In addition, where other research looks for reasons behind accounting restatements—fraud, for example—the authors here look only at how the market acts on public information about the buying or selling actions of management and the company.

Ultimately, the authors conclude, the evidence in this study “suggests that the market begins to look for corroborating or contradicting evidence regarding the future performance of the firm once the restatement is announced.”