The Impact of Earnings Quality on Investors' and Analysts' Reactions to Restatement Announcements
Romanus, Robin Nicole
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Despite countless efforts to elucidate market participants" understanding of the implications of earnings quality, empirical accounting research has rendered two distinct perspectives. The first perspective considers market participants naïve users of accounting information who fail to grasp the implications of earnings quality resulting in temporary security mispricing. The second perspective suggests that market participants scrutinize earnings reports carefully and subsequently discern and price the quality of earnings. The purpose of my research is to help clarify the ambiguity surrounding market participants" pricing of earnings quality using one clearly observable indicator of low-quality earnings, accounting restatements. This study examines the effect pre-restatement earnings quality has on short-window returns and analyst forecast revisions and dispersion following restatement announcements using a cross-section of 719 publicly traded firms that announced restatements between 1997 and 2004. Accrual and book-tax difference metrics are used to proxy for earnings quality. The metrics are examined separately and collectively to ascertain their individual and incremental effects in modeling the market reaction. Further analyses investigate the effects that various levels of investor sophistication have on the market reaction. Results indicate that the market reaction to restatement announcements is significantly influenced by pre-restatement earnings quality. Specifically, both the accrual and book-tax difference measures of earnings quality are significantly and negatively related to the market reaction. Further analysis indicates the predictive power of the model is improved by including both the accrual and book-tax difference proxies. This finding suggests the information in book-tax differences may provide market participants with signals from which to assess earnings quality that are distinct from those contained in accruals. Basic results for analyst forecast dispersion and revisions are not conclusive. Results of the interactions between each earnings quality proxy and level of investor sophistication are significant only for the accrual based measure of earnings quality. This suggests that sophisticated investors are more attuned to the implication of accrual based measures of earnings quality than book-tax difference measures.
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