The Effect of Restatement Detection Speed on Reporting Credibility

Abstract

A primary goal of the regulatory reforms enacted around the implementation of the Sarbanes-Oxley Act (SOX) was to improve the credibility of financial reporting. While earnings restatements resulting from accounting issues damaged investor trust prior to the implementation of SOX, we hypothesize that quicker detection of restatements in the post-SOX era should dampen investors’ skepticism that accounting problems will have long-lasting effects on reporting credibility. This study documents that irregularity-related restatements were detected more quickly after SOX, which is consistent with greater attention paid to reporting quality and higher levels of audit scrutiny. The results also show that investors have modest credibility concerns regarding firms that announced irregularity-related restatements in the post-SOX era, as the decline in the information content of earnings is short-lived and contagion effects for industry-peer firms are limited. However, this study shows that changes in reporting credibility are influenced by how quickly restatements are discovered and disclosed, as the adverse credibility effects are confined to accounting irregularities that have lengthy detection periods. The evidence from this study highlights the importance of monitoring mechanisms for discovering and resolving accounting irregularities quickly, as the market does not seem to have significant suspicions about ongoing reporting credibility for such firms.