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    Restatement Disclosures and Management Earnings Forecasts.
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
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    Title:
    Restatement Disclosures and Management Earnings Forecasts.
    Practical Implications:

    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.

    Citation:

    Ettredge, M., Y. Huang, and W. Zhang. 2013. Restatement Disclosures and Management Earnings Forecasts. Accounting Horizons 27 (2): 347-369.

    Keywords:
    financial restatements, information asymmetry, litigation risk, management forecast, manager reputation repair, risk aversion
    Purpose of the Study:

    This paper examines changes in managers’ earnings forecasting behavior around earnings restatement events. As the number of restatements has increased in recent years, concerns about the quality of financial reporting have increased among investors, regulators, and analysts. Evidence suggests that some restatements reflect managers’ prior manipulation of earnings. Restatements arguably harm companies’ and managers’ reputations with respect to the financial information they provide, including forecasts. In addition to investigating the causes and consequences of restatements, researchers have investigated some actions taken by restating company managers and directors to repair their (and their firms’) reputations. The authors investigate one type of action not studied in prior research: changes in managers’ earnings forecasting behavior.

    Earnings restatement events provide managers with two powerful and competing incentives regarding voluntary disclosures such as management forecasts. One incentive, which the authors refer to as the “reputation repair” incentive, favors increased disclosure. Restatements harm companies’ and managers’ reputations as providers of reliable financial information, leading to increased information asymmetry and information risk, with attendant negative market reactions. The second managerial motive following restatements is to avoid risks arising from repeated provision of ex post unreliable financial information. A restatement draws the unfavorable attention of the Securities and Exchange Commission (SEC) and investors, leading to increased scrutiny of subsequent company disclosures.

    Design/Method/ Approach:

    Using Audit Analytics, the authors gather a sample consisting of companies that make a single restatement of their financial reports during the period 19992006, and are covered by the First Call and I/B/E/S databases. The test sample comprises 1,512 restatement events. The authors employ a one-to-one matched control sample of 1,512 non-restatement companies also covered by the First Call database.

    Findings:

    The authors find that test (restatement) firms decrease information in their management forecasts, consistent with their incentives to avert risk, rather than incentives to repair managerial reputation. This decrease takes various forms.

    First, managers of test firms decrease their propensity to issue quarterly earnings forecasts after restatements, compared to control firms. Test firms also decrease the frequency of management forecasts. Second, when the authors compare changes in forecast precision from pre- to post-periods, they find that two proxies for precision (precision form and precision magnitude) both decrease for test firms relative to control firms. These results suggest that managers are increasingly likely to issue wider-range and open-ended forecasts, rather than more precise point forecasts following restatements. Finally, the analyses indicate that managers make earnings forecasts that exhibit a decrease in optimistic bias after restatements, compared to control firms. This suggests that managers of test companies become increasingly concerned about the risk imposed by optimistic forecasts, including investor litigation risk.

    Additional analyses suggest that the changes in manager forecasting behavior are more pronounced among companies whose restatements correct core earnings accounts than among those restating non-operating income accounts.

    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk, Restatements