Consequences of overvalued equity: Evidence from earnings manipulation

Firms that made earnings-decreasing restatements over the period 1990 to 2001 lost $72 billion around restatement announcements. Forty-seven large-loss firms restating their earnings in the 1998 to 2001 period account for $66 billion of these losses. Despite very good stock performance and low book-to-market values before earnings misstatements, large-loss firms are associated with mean abnormal returns of − 39% during the announcement period, and underperform matched firms by 44% during the first post-restatement year. Collectively, our results support Jensen's [Jensen, M.C. Agency costs of overvalued equity. Financial Management 2005;34; 5-19.] argument that substantial overvaluation of equity pressures managers to manipulate earnings and when investors learn about earnings restatements by overvalued firms, they reevaluate firms to correct not only for pre-misstatement overvaluation, but also for the loss of confidence in the firms' managers.