Corporate Governance Changes Following Earnings Restatements: A Research Tool

Abstract

This study develops a research model to investigate whether firms that restate previously released financial reports implement subsequent changes in internal governance in an effort to correct underlying problems that contributed to the need for restatement in the first place. In doing so, various likely responses to financial reporting problems, including board, audit, and management changes, are indexed into a single measure to assess the joint strength of multiple corporate governance attributes within a firm. The paper demonstrates how a comparison of the Index before and after a restatement may be used to relate the nature and magnitude of a restatement with the likelihood of corporate governance changes in the aftermath of restatement. Further, the paper classifies sample restatements more finely on the basis of presence of fraud, prompter, magnitude, severity, and reason for the restatement. This more detailed classification recognizes that responses to restatements likely relate to particular characteristics of the restatement and the restatement firm. To illustrate the use of the Index in the research model, a sample hypothesis is examined, with findings showing a statistically significant association between restatements involving fraud and subsequent corporate governance changes.