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    Admitting Mistakes: Home Country Effect on the Reliability...
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
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    Title:
    Admitting Mistakes: Home Country Effect on the Reliability of Restatement Reporting.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    accounting quality, accounting restatements, earnings management, enforcement, internal control weakness, SOX 404
    Purpose of the Study:

    Accounting rules in the U.S. require firms to issue a restatement correcting prior material errors upon discovery. Timely detection and reporting of accounting errors and irregularities ensure that a firm’s reported financials are free of any misstatements. Without enforcement that ensures the prudent correction of existing misstatements, there will likely be systematic underreporting of restatements, which will allow bad type firms to pool with good type firms and possibly lower investors’ faith in the reported financials. Therefore, understanding the determinants of reporting restatements is important to better assess the reliability of reported financials.

    The authors use the large number of restatements in recent years by both U.S. and foreign firms listed in the U.S. to examine the reliability of restatement reporting in a cross country setting. The self-reported nature of restatements provides a good setting to assess how home country characteristics influence the financial reporting of foreign firms listed in the U.S. Further, since foreign firms are subject to the disclosure requirements set forth by the Securities and Exchange Commission (SEC), this setting allows the authors to examine the effect of home country characteristics on the financial reporting of foreign registrants while generally holding the extent of U.S. regulation constant. In particular, the authors examine whether restatement reporting varies by country-level factors that influence how firms comply with the restatement reporting rules.

    Design/Method/ Approach:

    The sample comprises 7,453 firm-year observations for U.S.-listed foreign firms from 51 countries between 2000 and 2010. The authors include both American Depository Receipts and firms directly listen on U.S. exchanges. To classify firms as foreign, the authors use Compustat to find the headquarters. The restatement sample is obtained from Audit Analytics.

    Findings:
    • Foreign firms report accounting restatements in 4.7 percent of firm-years, compared to 7.3 percent for a matched sample of U.S. firms.
    • Firms from weak rule of law countries are less likely to restate, with 4.2 percent of firms restating, compared to 7.5 percent for the matched sample of U.S. firms. On the other hand, firms from strong rule of law countries show a smaller difference in their restatement frequency compared to matched U.S. firms (5.0 percent versus 7.2 percent of firm-years).
    • Firms from weak rule of law countries are 42 percent less likely to restate compared to firms from strong rule of law countries.
    • The lower frequency of restatements in weak rule of law countries is due to weaker compliance with restatement reporting, rather than an absence of accounting misstatements.
    • Foreign firms, especially those from weak rule of law countries, are less likely to report accounting irregularity restatements than comparable U.S. firms.
    • The sensitivity of earnings management to accounting irregularity restatements is positive and significant only for U.S. firms and foreign firms from strong rule of law countries. For foreign firms from weak rule of law countries, the authors find no relation between earnings management and the likelihood of accounting irregularity restatements. This suggests that avoidance of restatement is not limited to errors; it exists even for accounting irregularities.
    Category:
    Accountants' Reporting
    Sub-category:
    Restatements