The Effect of Accounting Restatements on Earnings Revisions and the Estimated Cost of Capital

Abstract

This paper examines the effect of accounting restatements on a firm's cost of equity capital. We show that, on average, accounting restatements lead to both decreases in expected future earnings and increases in the firm's cost of equity capital. Depending on the model used, relative percentage increases in the cost of equity capital average between 7 and 19 percent in the month immediately following a restatement. The increase in the cost of capital dissipates as time passes and after controlling for analyst forecast biases, but continues to average between 6 and 15 percent in the most conservative setting. We also show that restatements initiated by auditors are associated with the largest increase in the cost of capital, and that firms with greater leverage experience greater increases in their cost of capital. Overall, our evidence is consistent with accounting restatements lowering the perceived earnings quality of the firm and increasing investors' required rates of return.

Keywords: Accounting restatements, cost of capital, earnings quality

JEL Classification: M41, G12