This study offers insights into how restatements by one client may impact an auditor’s other clients. The authors find evidence suggesting that when an auditor’s clients restate their financial statements, the auditor’s reputation for audit quality suffers. Non-restating clients experience a small negative market reaction around the restatement date and a higher likelihood of dismissing that auditor. These findings may inform audit firms and their clients about the potential negative consequences of restatements by other clients.
Irani, A.J., S.L. Tate, and L. Xu. 2015. Restatements: Do They Affect Auditor Reputation for Quality. Accounting Horizons 29 (4): 829-851.
The results of this study are important to audit regulators and auditors as the PCAOB considers disclosure of additional audit quality indicators. The results of this study indicate that clients do respond to publicly available indications of audit quality as they avoid audit firm offices that are associated with restatements. Additionally, auditors may be interested in the findings of this study as it relates to the economic implications of contaminated offices. The findings of this study provide evidence about the importance of local office reputation as client retention and new client additions decrease when offices are associated with audit failures.
Swanquist, Q.T. and R.L. Whited. 2015. Do Clients Avoid “Contaminated” Offices? The Economic Consequences of Low-Quality Audits. The Accounting Review 90(6): 2537-2570.
Given the significant amount of concern regarding the reliability of financial statement reporting under new filing deadlines (movement from 90 days to 75 days in 2003 and then to 60 days in 2006), the authors provide evidence which shows the concern was valid but only temporarily. The authors use originated misstatements to indicate the beginning of a misstatement, showing that accelerated filers experienced higher likelihood of misstatements after the first acceleration, however large accelerated filers did not experience such a change in response to the second acceleration. Additionally, implementation of SOX appears to have increased reliability with fewer originated misstatements upon implementation.
Boland, C. M., S. N. Bronson, C. E. Hogan. 2015. Accelerated filing deadlines, internal controls, and financial statement quality: The case of originating misstatements. Accounting Horizons 29 (3) 297-331.
This research is important for several reasons. First, the authors provide insight into how a monitoring mechanism, such as the staff of the DCF, adds to the oversight of the financial reporting process. The findings illuminate the importance of understanding the conflict between boards and CEOs by suggesting that a strong CEO's influence over a board may adversely affect the effectiveness of board oversight. The authors provide evidence that the DCF may target companies with strong CEOs and weak board monitoring for more intensive review. Second, the results imply that the discovery of the need to restate is different for DCF-instigated restatements. DCF-prompted restatements lead companies to re-evaluate their governance structure.
Cheng, X., L. Gao, J. E. Lawrence, and D. B. Smith. 2014. SEC Division of Corporation Finance Monitoring and CEO Power. Auditing: A Journal of Practice & Theory 33 (1): 29-56.
The authors argue that such evidence adds to the growing body of research examining how companies respond to revealed accounting failures. The findings indicate that, among other changes in behavior, managers reduce propensity to forecast following restatements. This paper also contributes to the management forecast literature. This study adds to the understanding of determinants of earnings forecast propensity and characteristics. Furthermore, the authors interpret this evidence in the context of competing theories of manager forecasting behavior subsequent to financial restatements.
Ettredge, M., Y. Huang, and W. Zhang. 2013. Restatement Disclosures and Management Earnings Forecasts. Accounting Horizons 27 (2): 347-369.
The evidence on the firm-to-firm spread of financial reporting behavior via board networks contributes to a little-studied area in accounting that should be important. The authors contribute to the corporate governance literature by offering evidence that contagion effects vary with board positions. They show that board supervision of management is important for ensuring high-quality financial reporting and that board linkages affect the success of this supervision. Regulators concerned about improving financial reporting quality should consider the board connectivity of companies.
Chiu, P. C., S. H. Teoh, and F. Tian. 2013. Board Interlocks and Earnings Management Contagion. Accounting Review 88 (3): 915-944.
The evidence showing that, all else equal, SEC sanctions following restatements are no more likely for firms that previously claimed to have effective internal controls (and, in some cases, are less likely) suggests that public enforcement of SOX 404 is unlikely to provide strong incentives to detect and disclose existing weaknesses. Also, the results showing that penalties stemming from various private mechanisms are more likely for firms that report their internal control weaknesses in advance of restatements suggests the existence of possible disincentives to detect and disclose existing weaknesses. Together, these results offer a potential explanation for why the majority of restatements occur at firms that previously claimed to have effective controls.
Rice, S. C., Weber, D. P., & Wu, Biyu. 2015. Does SOX 404 Have Teeth? Consequences of the Failure to Report Existing Internal Control Weaknesses. Accounting Review 90 (3): 1169-1200.
The study highlights that a positive relationship between restatements and financial reporting quality depends on the reliable detection and disclosure of misstatements. Foreign firms are less likely to restate, a finding that has implications for investors and regulators. The results imply that U.S.-listed foreign firms may be under-scrutinized by U.S. public and private enforcement mechanisms. The findings suggest that companies from countries with weaker domestic rule of law are a potential focus area for investors and regulators to better identify firms with opportunistic restatement behavior. Fewer restatements lowers investors’ ability to hold managers and auditors accountable for poor financial reporting through CEO turnover or securities litigation, since restatements are a major trigger for both these mechanisms.
Srinivasan, S., Wahid, A. S., & Yu, G. 2015. Admitting Mistakes: Home Country Effect on the Reliability of Restatement Reporting. Accounting Review 90 (3): 1201-1240.
The findings suggest that the initial restatement may be a way of “cleaning house;” i.e., the new auditor requiring a restatement of financial reports issued during the tenure of the previous auditor. Investors may find this information valuable as they assess the potential outcomes of auditor switches. Significant corporate changes could distract firms from fully identifying all material misstatements in one restatement. Managers and directors should pay careful attention to the remediation of financial reporting weaknesses during these times. Restatement severity decreases among later restatements, but the market reactions to the first through third restatement announcements are similar in magnitude. These findings should be useful to investors and other market participants for understanding the implications of repeat restatements.
Files, R., Sharp, N. Y., & Thompson, A. M. 2014. Empirical Evidence on Repeat Restatements. Accounting Horizons 28 (1): 93-123.
The results suggest that explanatory language modifications, although less apparent than opinion qualifications, are informative of misstatement risk. Under the present-day audit reporting requirements, auditors do communicate some risk-related information to financial statement users. This finding had implications for standard-setters who are currently considering revising the audit reporting model to make future audit reports more informative. The authors also highlight that auditors use unqualified audit reports to indicate heighted risk, building upon findings from prior research showing that auditors use going concern explanatory language to communicate risk.
Czerney, K., J. Schmidt, and A. Thompson. 2014. Does auditor explanatory language in unqualified audit reports indicate increased financial misstatement risk? The Accounting Review, 89 (6): 2115–2149.