When a company admits that its financial situation is not as previously signalled, the response of its investors and the markets is crucial to its ability to pull itself out of its difficulties. In the worst-case scenario, as demonstrated by Enron and WorldCom, a financial restatement can expose underlying control and governance problems and trigger a crisis in confidence among investors that leads to bankruptcy.

However, not all restatements need lead to such devastating results – the severity of the outcome will often depend on the company’s approach to its restatement and its ability to handle the speculation and inquiries afterwards. This paper argues that companies can control the amount of damage to their market value resulting from a restatement. It outlines two ‘axes of evil’: the distortion of value-relevant information and the degree of intent.

The authors say that the degree of distortion and intent as perceived by the public can be aggravated by: the discrediting of management; comprehension gaps; the ‘tip-of-the-iceberg’ effect; paralysis in acting and communicating; and by non-alignment of management and external gatekeepers. On the other hand, companies that acknowledge the existence of a problem, take the blame for it, communicate about it openly, take appropriate actions aimed at corporate governance and comply with standards and regulations are likely to limit the level of perceived distortion and intent, and therefore limit the amount of damage suffered.

The authors reached their findings after a study of 14 cases of restatements from European and US companies, and use the examples of Freddie Mac and Nortel to illustrate two management approaches that resulted in two contrasting outcomes.

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