Ever wondered what happens when a company receives a SEC Comment Letter that has some severe implications for the company’s financial information? Especially when the SEC raises issues regarding the company’s accounting policies? A recent study, Liu and Moffit (12016) finds just that – the authors of this study provide evidence to show that the intensity of the language used in a SEC Comment Letter is associated with subsequent restatements. Specifically, when strong words are used (for example “never”, “unambiguously”, “strongly”), in the SEC Comment Letter, there is a higher likelihood that the firm will subsequently restate its financial statements, presumably in response to the SEC Comment Letter process.
Do we need to ask, ‘so what’ if a company restates its financial statements?
When a company restates its financial statements, it is correcting material errors in the previously issued financial statements. For investors, this raises a number of questions. What is the type of the error? What is the cause of the error? How was the error corrected? What implications did the error have on key measures of firm performance, like revenues and earnings? What are the implications regarding the company’s internal controls? These are important questions that could impact how investors revise their analysis of the company’s financial performance. In fact, there are a number of studies documenting the stock market reaction to the restatements of firms. For example, Palmrose et al. 2004, Hribar and Jenkins, 2004, Kravet and Shevlin, 2010. On average, there is a loss in equity value ranging from 1.5% to over 5%.
SEC comment letter process prompted restatement
Here is one example of a company that received a SEC Comment Letter related to its 2014 10-K. There were multiple correspondences between the company and the SEC related to the comment letter, including a number of conference calls with the SEC staff.
Finally, the company has restated both the 2015 and 2014 financial statements. Interestingly, the company explicitly stated in the 8-K restatement that the ongoing SEC Comment Letter process provided the impetus for the restatement.
The stock price was running up prior to the restatement announcement. Upon the restatement announcement on February 18, 2016, the stock price dropped by 2.75% by the end of the day. In the three trading days subsequent to the restatement announcement, the stock price dropped by another 1.93%. In all, the over stock price dropped by 4.65% before and after 4-day window surrounding the restatement.
According to a number of academic studies, market reaction to the announcement of an accounting restatement is generally negative, but not all restatements are regarded alike. The decline was greatest when associated with a revenue recognition error, and smallest when cash flow problems were involved. Some evidence shows that there is also an association between the severity of the language used by the SEC in its Comment Letter and the likelihood that the company will subsequently restate its financial statements. Given the negative stock market reaction to the announcement of a company’s restatements, investors may be able to analyze SEC Comment Letters and better predict or anticipate a future restatement and form their trading strategies prior to the restatement.