Sentiment and stock returns : the case of financial restatements

Pao Yue-kong Library Electronic Theses Database

Sentiment and stock returns : the case of financial restatements


Author: Ho, Yiu-sum Michael
Title: Sentiment and stock returns : the case of financial restatements
Degree: D.B.A.
Year: 2010
Subject: Hong Kong Polytechnic University -- Dissertations
Financial statements
Stocks -- Prices
Investments -- Psychological aspects
Speculation -- Psychological aspects
Corporations -- Finance -- Mathematical models.
Department: Graduate School of Business
Pages: vii, 103 leaves : ill. ; 30 cm.
InnoPac Record:
Abstract: Financial restatements are reporting failures that can bring far-reaching consequences, such as stock price declines, permanent losses, regulatory investigations, and criminal or civil litigations. Well-publicized examples are the restatement announcements of Enron and WorldCom in 2002, which sparked two of the biggest bankruptcies in U.S. history and a sweeping reform of U.S. securities laws through the Sarbanes-Oxley Act (SOX). However, as the post-SOX era moves forward, restatements continue to draw public concerns as they persist in numbers and significance. and involve billions of shareholder funds and prominent companies such as American International Group (AIG), Fannie Mae, and HealthSouth. While investor reactions vary considerably across cases, the accounting and finance literature has highlighted a number of contributing factors, among them the effects of accounting errors, prompters, and fraud . A potential factor that has received less attention in the literature is the sentiment of the market in which the restating firms function. This thesis explores this gap. Our research objective is to investigate whether stock price response to restatement announcements is related to market sentiment at the particular time. Building on the empirical correlation between stock prices and sentiment levels, and the evidence that restatement announcements are a collective form of bad news that undermines investor confidence and is inconsistent with optimistic beliefs, we hypothesize that the average abnonnal returns related to restatement announcements tend to negatively correlate with prevailing market beliefs surrounding announcement times. As studies consistently show unfavorable effects from certain key restatement characteristics, we argue that the effects are dependent on the levels of sentiment and predict stronger investor reactions to these characteristics under high sentiment circumstances. Our investigation is based on a sample of 2,705 restatements announcements between January 1997 and June 2006 collected from the U.S. Government Accountability Office (GAO). We employ the standard event-study methodology to test the hypotheses with a model comprising variables of sentiment measures, key restatement characteristics, size, leverage, and run-up returns.
Our findings support the hypothesis that sentiment is a potential factor that negatively affects investor reactions to restatement armouncements. The evidence also shows that, when interacting with some of the key restatement characteristics, higher levels of sentiment tend to elicit greater price reactions. In particular, we find that the negative reactions to restatements prompted voluntarily by the companies or forced by the external auditors are more likely dependent on the relatively higher sentiment levels during our sample period. We document a significant positive association between abnormal returns and our post-SOX subset, implying that the controversial legislation has, to some extent, reduced shareholder loss inflicted by accounting irregularities. We affirm that severe penalties are imposed on dishonest firms, in particular when the dishonesty is exposed during optimistic periods. Our evidence supports extant claims of more pronounced negative returns for restatements that decrease firm prospects, are prompted by errors in cost, expense, and revenue, or are from small and unprofitable firms. Our results are robust in regard to differing sentiment, size, and profitability measures. This thesis makes a number of contributions in both theoretical and practical aspects. First, the investigation is one of the first to recognize the likely effect of sentiment on stock price response to erroneous accounting and public information. We recognize that the effect can potentially assist investors in minimizing systematic errors when processing new information, and reducing the risk of being exploited by others. Second, this research provides new evidence that the negative effects of some of the key restatement characteristics on investor decisions tend to be associated with sentiment levels. The evidence substantiates, complements, and extends research on restatement activities with a more innate, hence less apparent, factor that is embedded in investor behavior. Third, this study advances research on the association between sentiment and scheduled earnings announcements to restatement announcements. Restatement announcements are more unique than regular announcements in that they are not routine, and are about mistakes that are not confined only to earnings. Finally, this thesis adds a positive view to the effects of SOX, a legislation that has a profound impact on all public firms, and has been criticized for its high compliance costs that has led to unintended outcomes such as delisting of small firms. There are implications for researchers and regulators who should find this outcome useful in assessing or contemplating rules and regulations that help protect investor interests and ensure the effective functioning of the financial markets.

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