The Effect of Financial Statement Restatements on Firms' Financial Reporting Strategies

Abstract

This paper examines the impact of financial statement restatements on firms' financial reporting strategies. Conventional wisdom suggests that the shock of having to restate previously published financial statements, together with significant related stock price declines and other adverse consequences will lead companies to reform their financial reporting policies. However, the continuing importance of stock-based compensation, of 'making the numbers,' and the risk/return tradeoffs of restatement all suggest that it is possible that managements' incentives are relatively unchanged in the aftermath of a restatement. Thus, it remains an empirical issue whether restatements do or do not affect firms financial reporting strategies. We identify a sample of financial statement restatements during 1997-2000 and compare various empirical measures of financial reporting strategy before and after the quarter of a restatement announcement. Our main analyses, which use total accruals as a measure of financial reporting strategy, indicate that firms do not appear to adopt a more conservative financial reporting strategy after a restatement. To the extent that the evidence from our sample is representative of restatement firms in general, the evidence suggests that the financial reporting environment - securities regulators, boards of directors, independent auditors, the security markets themselves, and/or firms' internal corporate governance mechanisms - does not appear to be successfully causing firms who are caught in violation of financial accounting rules to reform their financial reporting.