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  • Jennifer M Mueller-Phillips
    Restatements: Do They Affect Auditor Reputation for Quality.
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 11.0 Audit Quality and Quality Control, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Restatements: Do They Affect Auditor Reputation for Quality.
    Practical Implications:

    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.

    Citation:

    Irani, A.J., S.L. Tate, and L. Xu. 2015. Restatements: Do They Affect Auditor Reputation for Quality. Accounting Horizons 29 (4): 829-851.

    Keywords:
    financial restatements, audit quality, auditor reputation, auditor dismissal
    Purpose of the Study:

    Signals of low audit quality should harm an audit firm’s reputation for quality in order to make the reputation more accurately reflect the firm’s true audit quality. While prior research has found negative responses from clients and the stock market following strong signals of low audit quality (e.g., SEC disciplinary actions), it is unknown how these stakeholders will react to weaker signals of low audit quality (e.g., restatements). However, the research on industry contagion effects suggests that restatements by one firm in an industry lead to decreased expectations for other firms in the industry, so it would not be surprising if restatements by one firm lead to decreased expectations for other firms that share its auditor. The authors attempt to tie up these loose ends by investigating whether restatements by one firm lead to (1) auditor dismissals by and (2) negative market adjusted returns for other firms that share its auditor(s), especially when restatements are more severe.

    Design/Method/ Approach:

    The authors use data from publicly-traded companies during the 2004-2012 time period. First, they test whether non-restating companies are more likely to dismiss auditors whose other clients filed restatements in the prior year. Second, they test whether non-restating companies experience negative market adjusted returns after one of their auditor’s other clients files a restatement. For both tests, they investigate whether the predicted reputation effect is stronger for more severe restatements.

    Findings:
    • About 4.5% of non-restating companies dismissed their auditor.
    • Non-restating companies more likely to dismiss their auditor had auditors with a higher percent of clients filing restatements and more misstated items in the restatements. The non-restating companies more likely to dismiss their auditor had weaker internal controls, a net loss, higher leverage, and a smaller size.
    • Auditor resignations are not related to the number of clients filing restatements.
    • On average, restating companies (non-restating companies sharing a restating company’s auditor) had a -1.78% (-0.04%) market adjusted return over the 2 day restatement window.
    • Over the 2 day restatement window, the decrease in market value of a non-restating company was higher when there was a stronger decrease in market value for the shared auditor’s restating client, the restatement adversely affected the restating client’s net income, the restatement had more restated items, a larger window existed between the misstatement period and the restatement announcement, the auditor was an industry expert, the auditor was one of the Big 4, the non-restating company had higher cash flow from operations, the non-restating company had lower total accruals, and the non-restating company was bigger.
    Category:
    Accountants' Reporting, Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements
  • Jennifer M Mueller-Phillips
    Do Clients Avoid “Contaminated” Offices? The Economic Con...
    research summary posted January 20, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Do Clients Avoid “Contaminated” Offices? The Economic Consequences of Low-Quality Audits.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    auditor reputation, audit offices restatements
    Purpose of the Study:

    Audit firms have an incentive to protect their reputational capital in order to maintain and improve their economic circumstances. A client restatement is a common public signal that may negatively impact the audit firm’s reputation for audit quality. Previous research suggests that office-level characteristics in particular contribute to audit quality. Therefore, when restatements occur, the audit firm office involved in the restatement is likely to be “contaminated” and suffer the most from reputational and economic damage. Specifically, the authors:

    • Examine the effect of local office contamination (measured as client restatement announcements) on local office market share.
    • Examine the effect of local office contamination on client retention and client acquisition in the local office.
    • Examine the relationship between contamination and changes in local office market share in the face of differing levels of competition.

    Additionally, the authors use their findings to demonstrate how clients perceive and react to public information related to audit quality which is a recent focus of the PCAOB.

    Design/Method/ Approach:

    The authors proxy for contamination within an office using the number of restatements announced by an office’s clients during the year. They collected office location, audit fees, restatement announcements, and auditor dismissals from several Audit Analytics databases. Client financial reporting data were obtained from Compustat, and the metropolitan statistical area information was obtained from the U.S. Census Bureau’s website. The information collected on these audit offices and related clients was for years 2003-2011.

    Findings:
    • The authors find that contaminated offices lose market share following client restatement announcements. In addition, there are significant economic penalties associated with signals of audit failure.
    • The authors find that the percentage of clients dismissing their auditor increases with office contamination (both for clients that had a restatement and those that did not have a restatement). Similarly, clients selecting a new auditor are less likely to select one from a contaminated office. This suggests that the reduction in market share is a result of the auditor’s impaired ability to both retain and attract clients.
    • The authors find that the negative consequences of contamination are reduced in geographies where there is low competition among auditors and for larger clients.
    • The authors provide some evidence that though Big 4 and non-Big 4 offices are affected by contamination; the impact is diminished for Big 4 offices.
       
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements
  • Jennifer M Mueller-Phillips
    Accelerated filing deadlines, internal controls, and...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.07 Impact of SEC Actions, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Accelerated filing deadlines, internal controls, and financial statement quality: The case of originating misstatements.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    Accelerated filing, financial statement restatements, Sarbanes-Oxley Act, filing lags, internal controls
    Purpose of the Study:

    The authors investigate whether Government regulationspecifically through changes in filing deadlines and implementation of the Sarbanes Oxley Act (SOX)influence the origination of financial statement misstatements. They specifically focus on the origination of misstatements to determine if firms sacrificed relevance and reliability to comply with accelerated filing dates.

    Design/Method/ Approach:

    The analyses use a sample of 17,216 firm-year observations from 12/15/2002 to 12/14/2007. The authors run a regression analysis predicting the likelihood of a restatement for accelerated filers and large accelerated filers relative to non-accelerated filers. The model incorporates controls for other known determinants of changes in likelihood of restatement.

    Findings:

    The authors find:

    • Accelerated filers had a higher likelihood of a misstatement following the filing deadline shift from 90 to 75 days.
    • Accelerated filers had a reduced likelihood of a misstatement following implementation of SOX.
    • Large accelerated filers did not experience a change in likelihood of a misstatement following the filing deadline shift from 75 to 60 days.

    The results suggest that the concerns of filers and their auditors regarding the potential for lower-quality information resulting from accelerated filing was valid, although only temporarily. In the long run, companies were able to file reports in a timelier manner without a corresponding increase in the likelihood of misstatement.

    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Impact of SEC Actions, Restatements
  • Jennifer M Mueller-Phillips
    SEC Division of Corporation Finance Monitoring and CEO...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.07 Impact of SEC Actions, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 12.04 Investigations in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    SEC Division of Corporation Finance Monitoring and CEO Power.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    CEO, DCF, governance, monitoring, investigations, restatements
    Purpose of the Study:

    Section 408 requires the Securities and Exchange Commission (SEC) to review the filings of all SEC registrants every three years. The SEC Division of Corporation Finance (and not the Division of Enforcement) is the part of the SEC charged with carrying most of the burden of the Section 408 monitoring. This study investigates this SEC monitoring role and differs from past SEC research by focusing on the SEC Division of Corporation Finance (DCF) rather than the Division of Enforcement and specifically on DCF's "review and comment" monitoring role.

    The authors argue that the DCF appears to realize powerful CEOs have more opportunity to deceive due to their greater board control and, therefore, they are viewed as experiencing less monitoring by other sources. In other words, the DCF appears to be naturally drawn to the firms where strong CEOs dominate the financial reporting process and firm-level monitoring by auditors and boards may be relatively lax.

    Design/Method/ Approach:

    The sample of 980 observations includes restatements from 2000 through 2007 obtained from GAO reports and Audit Analytics. The authors restrict the companies to those found in a Russell index. 209 observations were DCF prompted and 771 observations were other monitor prompted. Of the 980 observations, 825 were used in the analysis of the changes in CEO power as a response to restatement.

    Findings:
    • The authors find evidence that a powerful CEO may be able to bargain for less board scrutiny through fewer board meetings.
    • In the year prior to the discovery of the need to restate, firms with restatements prompted by the DCF have stronger CEO power and exhibit some evidence of weaker board monitoring.
    • Compared to firms with restatements prompted by other monitors, firms with restatements prompted by the DCF tend to have strong CEOs in the period prior to the discovery of restatements.
    • The authors find that companies with restatements prompted by DCF (versus other monitors) are more likely to terminate strong CEOs following the discovery of restatements.
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Impact of SEC Actions, Investigations, Restatements
  • Jennifer M Mueller-Phillips
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    Board Interlocks and Earnings Management Contagion.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.05 Board/Audit Committee Oversight in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Board Interlocks and Earnings Management Contagion.
    Practical Implications:

    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.

    Citation:

    Chiu, P. C., S. H. Teoh, and F. Tian. 2013. Board Interlocks and Earnings Management Contagion. Accounting Review 88 (3): 915-944.

    Keywords:
    board interlocks, board networks, contagion, earnings management, governance, restatements, social networks
    Purpose of the Study:

    In the corporate world, behavior may spread through board of director networks. A board link exists between two firms whenever a director sits on both firms’ boards. A typical board in the sample has nine directors, and the median number of interlocks with other boards is approximately five. In this way, firms are widely connected by their board networks, which potentially serve as conduits for spreading behaviors from firm to firm.

    In this study, the authors investigate whether financial reporting behavior spreads through interlocking corporate boards. The test design emphasizes contagion of bad financial reporting choices, specifically, earnings management that results in a subsequent earnings restatement, although it also allows for inferences about good reporting contagion. The authors use restatements to identify firms that have managed earnings and the period when the manipulation occurred. They refer to a firm that later restates earnings as contagious. The authors define the contagious period as starting in the first year for which earnings are restated and ending two years after. Any firm that shares an interlocked director with the contagious firm during the contagious period is therefore exposed to an earnings management infection via the board network. They consider a multiyear contagious period to allow the earnings management infection to incubate, which is analogous to an epidemiological setting for viral infections. The key test investigates whether an exposed firm is more likely to manage earnings during the contagious period as compared to an unexposed firm.

    Design/Method/ Approach:

    The authors use the U.S. Government Accountability Office’s (GAO) first release of restatements between January 1, 1997 to June 30, 2002 to identify contagious firms and their contagious periods. They keep only the earliest restatement within the sample period when a firm has multiple restatements. The authors obtain director names from Risk Metrics. In the 19972001 sample period the authors identify a sample of 118 observations.

    Findings:
    • The authors find strong evidence that a firm is more likely to manage earnings when exposed within a three-year period to earnings management from a common director with an earnings manipulator. The contagion effect is economically substantial.
    • The regression odds ratio suggests that a board link to a manipulator doubles the likelihood that the firm will manage earnings.
    • The authors also find evidence for good financial reporting contagion. A board link to a non-manipulator significantly decreases the likelihood of the firm being a manipulator.
    • Both bad and good accounting behaviors are contagious across board networks.
    • Earnings management contagion is stronger when the shared director has a leadership position as board chair or audit committee chair, or an accounting-relevant position as an audit committee member, in the exposed firm.
    • The contagion is also stronger when the linked director is the board chair or CEO of the contagious firm, but not when the linked director is the CEO of the exposed firm.
    • Earnings management contagion is exacerbated when the exposed firm is located within 100 miles of the contagious firm and shares a common auditor with the contagious firm.
    • The evidence supports the proposition that earnings manipulation spreads through board networks.
    Category:
    Accountants' Reporting, Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Board/Audit Committee Composition, Board/Audit Committee Oversight, Earnings Management, Earnings Management, Restatements
  • Jennifer M Mueller-Phillips
    Does SOX 404 Have Teeth? Consequences of the Failure to...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does SOX 404 Have Teeth? Consequences of the Failure to Report Existing Internal Control Weaknesses.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    enforcement, internal controls, restatements, Sarbanes-Oxley Act, SOX 404
    Purpose of the Study:

    In this paper, the authors examine several potential consequences of failing to report existing control weaknesses as required by Section 404 of the Sarbanes-Oxley Act of 2002. The investigation is motivated largely by recent concerns about the reliability of SOX 404 reports and related evidence of firms claiming to have effective internal controls over financial reporting when they instead have material weaknesses in those controls. Understanding the consequences of such reporting failures is important because it bears on managers’ and auditors’ incentives to detect and disclose internal control weaknesses and, thus, on the effectiveness of SOX 404 in achieving its intended goal of boosting investor confidence in the reliability of financial reports. This importance is underscored by the high costs of control audits, which have made these requirements the most controversial aspect of SOX. Under SOX 404, firms and their auditors are required to provide formal opinions on the effectiveness of internal controls over financial reporting within the annual 10-K filing. However, concerns have begun to emerge about the reliability of SOX 404 reports, and the effectiveness of SOX 404 in providing advance warning of potential accounting problems remains unclear.

    Design/Method/ Approach:

    The authors use Audit Analytics to create a full sample of 659 observations of firms that are subject to SOX 404 and that also have restatements. The full sample includes 134 firms that reported the existence of material weaknesses prior to their restatements and 525 that did not. The authors extracted all restatements for U.S. incorporated firms announced by the end of 2010 that include annual reporting periods ending after the effective date of SOX 404 (November 14, 2004).

    Findings:
    • The likelihood of receiving an Accounting and Auditing Enforcement Release (AAER) following a restatement is similar regardless of whether firms had reported their control weaknesses or instead claimed that their controls were effective prior to the restatement. 
    • The prior acknowledgment of control weaknesses increases the likelihood of receiving an AAER by about 6 percent.
    • The authors find no evidence of vigorous public enforcement of SOX 404; instead, the evidence is suggestive of the opposite: that reported control weaknesses aid the SEC in identifying cases where potential enforcement actions are likely to succeed and make it difficult for management to claim they were unaware of the problems that led to the restatement.
    • Class action lawsuits are 5 to 10 percent more likely when firms report internal control weaknesses prior to restatements. This is true even when the authors remove lawsuits that are later dismissed.
    • The top management turnover is 15 to 26 percent more likely at firms that report control weaknesses prior to their restatements. This result holds for both CEOs and CFOs.
    Category:
    Accountants' Reporting, Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Restatements
  • Jennifer M Mueller-Phillips
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    Empirical Evidence on Repeat Restatements.
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Empirical Evidence on Repeat Restatements.
    Practical Implications:

    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.

    Citation:

    Files, R., Sharp, N. Y., & Thompson, A. M. 2014. Empirical Evidence on Repeat Restatements. Accounting Horizons 28 (1): 93-123.

    Keywords:
    audit quality, accounting restatements, financial misreporting, repeat restatements
    Purpose of the Study:

    Restatements often have costly consequences for companies and investors including increases in the cost of capital, litigation, and SEC enforcement proceedings, as well as auditor resignations, executive turnover, reduced investor confidence, and negative market reactions at the announcement date and beyond. The authors extend research on accounting restatements by investigating a unique set of restatement firms that exhibit a serious breakdown in the financial reporting process: namely, those firms that restate previously issued financial statements more than once within a relatively short period of time. The primary purpose of this paper is to provide empirical evidence on the characteristics of repeat restatements and the firms that experience them. The authors also evaluate the market consequences of repeat restatements, including their impact on stock returns and executive turnover.

    Investigating repeat restatement firms is important for two main reasons. First, these companies have continuing difficulty correcting poor financial reporting and, as a result, expose their stakeholders to the negative consequences of multiple restatements. Second, despite the large literature on restatements, prior research has not specifically examined firms that restate more than once. Thus, little is known about repeat restatements firms, whether or how these firms differ from single restatement firms, or the specific factors that are associated with the likelihood of repeat restatements.

    Design/Method/ Approach:

    The authors use a sample of 2,212 restatements announced between 2002 and 2006 reported in Audit Analytics. In the sample, 1,003 restatements are announced by firms reporting only one restatement and 1,209 restatements are reported by 616 repeat restatement firms.

    Findings:
    • 38 percent of the companies in the sample restate more than once, and the second restatement is announced, on average, 18.5 months after the first restatement.
    • 31 percent of repeat restatement firms restate three or more times and 10 percent restate four or more times.
    • Relative to the first restatement, firms’ second restatements are less likely to involve revenue or decrease reported net income, involve fewer accounts, and are more likely to be technical, suggesting that restatement severity attenuates as more restatements are announced.
    • Repeat restatements are more likely among firms disclosing internal control (IC) weaknesses in the final year of the misstatement period.
    • Repeat restatement firms, on average, experience announcement returns of -1.55 percent, -1.34 percent, and -1.54 percent for the first, second, and third restatements, respectively. This suggests that repeat restatements convey incremental, negative news to market participants.

    In the authors' examination of firms that restate the same fiscal period they find:

    • 57 percent of the first restatements in the sample are followed by second restatements with overlapping misstatement periods.
    • Firms that employ a Big N auditor or those that switch auditors between the end of the misstatement period and the announcement of the initial restatement are less likely to report overlapping restatements.
    Category:
    Accountants' Reporting
    Sub-category:
    Restatements
  • Jennifer M Mueller-Phillips
    Does Auditor Explanatory Language in Unqualified Audit...
    research summary posted March 30, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk?
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    explanatory language; audit opinions; financial misstatements
    Purpose of the Study:

    Investor advocates believe the present-day auditor’s report is boilerplate and uninformative.  However, over 60% of audit opinions in the authors’ sample make use of explanatory language within an unqualified audit opinion to emphasize matters to financial statement users.  According to professional standards, explanatory language should not affect the auditor’s unqualified opinion on the financial statements and theoretically should not be indicative of increased financial statement risk.  But because the Securities and Exchange Commission (SEC) precludes publicly traded companies from releasing financial statements with any audit opinion except unqualified, adding explanatory language is the auditor’s only practical mechanism to communicate risk, and often is the only distinguishing feature among audit reports.  The purpose of this study is to:

    • Determine if financial statements accompanied by unqualified audit reports with explanatory language are more likely to be subsequently restated than those without explanatory language,
    • Investigate whether the likelihood of subsequent restatement differs based on the type of explanatory language, and
    • Examine whether the financial statement accounts referenced in auditor explanatory language are the financial statement accounts subsequently restated.
    Design/Method/ Approach:

    Using data from publicly-traded companies in the United States over the time period from 2000-2009, the authors investigate the association between opinions with explanatory language and the likelihood that the corresponding financial statements are subsequently restated.  The authors then classify audit opinions by the type of explanatory language based on Auditing Standard AU Section 508 into four categories: (1) Inconsistency with previously issued financial statements, (2) ‘‘Emphasis of matters’’ in financial reports, (3) Audit-related information, and (4) Other language to determine if the likelihood of subsequent restatement differs based on the type of explanatory language.  Finally, the authors conduct an additional analysis to examine whether the financial statement accounts referenced in the explanatory language are those most likely to be subsequently restated.

    Findings:

    The authors report the following findings:

    • Financial statements that have audit opinions with explanatory language are more likely to be subsequently restated than those with audit reports without explanatory language, but this association is limited to certain types of explanatory language.
    • Specifically, they find that a subsequent restatement is more likely if the auditor emphasizes inconsistency with previously issued financial statements by referencing changes in accounting principles and previous restatements in the audit report.
    • However, financial statements whose audit reports include other types of inconsistencies, such as references to fresh-start accounting or use of a non-GAAP accounting basis, are less likely to be subsequently restated.
    • The likelihood of subsequent restatement is higher for financial statements with audit reports that include ‘‘emphasis of matter’’ language referencing mergers, related-party transactions, and management’s use of estimates, but only if the restatement relates to the same account referenced in the explanatory language.
    • A subsequent restatement is more likely if the auditor divides responsibility for the opinion, but not for any other type of audit-related explanatory language.
    • The authors do not find an association between subsequent restatements and explanatory language that references supplemental information, going concern, and/or financial distress.
    • The financial statement accounts discussed in the explanatory language correspond to the financial statement accounts subsequently restated.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Restatements