Earnings Restatements Research Articles

Asymmetric Information Consolidation and Price Discovery: Inferring Bad News from Insider Sales

Although insider selling is a potentially important proxy for undisclosed bad news, the literature has failed to document consistent evidence of insiders’ sales being informative. The lack of information in insider sales is attributed to researchers’ inability to separate liquidity-motivated from information-based insider trades. We present and evaluate a new algorithm for identifying information-based insider sales. We hypothesize that when individuals who have insider-status with respect to multiple firms sell shares of one firm in which they are insiders and at the same time buy shares of other affiliated firms, the sale is more likely to be information-based, since the proceeds are reinvested. Insider sales unaccompanied by insider purchases are more likely to be liquidity-motivated. We find that insider sales identified using this algorithm as information-based are followed by statistically and economically significant negative abnormal returns. In validation tests comparing the incidence of adverse events for firms with information-based versus liquidity-motivated sales in the year of and the two years following the sale, we find that information-based sales are significantly more likely to be associated with delistings, earnings declines, downward analyst forecast revisions, analysts dropping coverage, and earnings restatements. We conclude that it is possible to ex ante and directly identify insider sales with significant information content. Our results will be of interest to investors as well as to regulators designing insider trading rules.

Earnings Management, Restatement and Additional Tax Burden Effect

Earnings Management, Restatement and Additional Tax Burden Effect

A study on the effect of earnings management on restatement and the changes on information content of earnings following restatements: Evidence from Tehran Stock Exchange

The current impressive increase in the number of the restatements, encourage many researchers to find the causes of restatements including earnings management. Moreover, restatements increase the uncertainties of investors about earnings and decrease its information content. Therefore, the purpose of this research is to investigate the relationship between earnings management and earnings restatements. In addition, this paper examines the information content of earnings and cash flow following restatements period. For this purpose, we use one logistic regression and three multiple regressions with OLS method over the period 2001-2011. The results indicate that there was no significant relationship between discretionary accruals and earnings restatement, but magnitude of the discretionary accruals as the proxy of earnings management was significant and positively associated with the earnings restatement. Moreover, the earnings had more information content than cash flow before and after the earnings restatement. The overall result suggests that the one reason for earnings restatement is to make earnings management in an emerging market.

Do Independent Expert Directors Matter?

The generally weak correlation between board independence and firm performance is a major empirical puzzle. One possible explanation is that director independence alone is not enough. To explore this possibility, we examine the full employment histories of independent directors at S&P 1500 companies. We define an independent expert director (IED) as an independent director who has worked in the same 2-digit SIC industry as the company where he/she serves as an independent director. We show that the proportion of IEDs on a board is positively and significantly correlated with firm performance. We find that when the proportion of IEDs is higher, there are fewer earnings restatements and larger cash holdings. Firms with IEDs have higher CEO pay-performance sensitivity, higher CEO turnover-performance sensitivity, and more patents with more citations. Stock market investors react positively to IED appointments. We also find the higher the CEO power, the less likely IEDs will be on board.

A Probability Model For Earnings Restatement

<span style="font-family: Times New Roman; font-size: small;"> </span><p style="margin: 0in 0.5in 0pt; text-align: justify;" class="MsoNormal"><span style="font-family: Times New Roman;"><span style="font-size: 10pt;">Given their prevalence in recent years, earnings management and financial restatements have been at the center of much of the discussion surrounding corporate malfeasance.<span style="mso-spacerun: yes;"> </span>This study builds a probability model for predicting the likelihood of earnings restatements by analyzing the trends in and the deviations from the industry averages of the return on assets, accounts receivable turnover, net profit margin, and operating cash flow to net income measures.<span style="mso-spacerun: yes;"> </span>Data are obtained for a sample of 104 firms (restating as well as non-restating) for the 2000 to 2001 period.<span style="mso-spacerun: yes;"> </span>The results suggest that deviations from the industry average of the accounts receivable turnover and the variability in the cash flow to net income provide good barometers for detecting fraudulent accounting.<span style="mso-spacerun: yes;"> </span></span><span style="font-size: 10pt; mso-fareast-font-family: "Times New Roman"; mso-fareast-theme-font: minor-fareast;">Potential restating firms have higher accounts receivable turnover rates than their industry counterparts and downward trends in their cash flow to net income, so an increase (decrease) in the accounts receivable turnover (operating cash flow to net income) significantly increases the likelihood of a restatement, at least in the current study.</span></span></p><span style="font-family: Times New Roman; font-size: small;"> </span>

A Probability Model for Earnings Restatement

Given their prevalence in recent years, earnings management and financial restatements have been at the center of much of the discussion surrounding corporate malfeasance. This study builds a probability model for predicting the likelihood of earnings restatements by analyzing the trends in and the deviations from the industry averages of the return on assets, accounts receivable turnover, net profit margin, and operating cash flow to net income measures. Data are obtained for a sample of 104 firms (restating as well as non-restating) for the 2000 to 2001 period. The results suggest that deviations from the industry average of the accounts receivable turnover and the variability in the cash flow to net income provide good barometers for detecting fraudulent accounting. Potential restating firms have higher accounts receivable turnover rates than their industry counterparts and downward trends in their cash flow to net income, so an increase (decrease) in the accounts receivable turnover (operating cash flow to net income) significantly increases (decreases) the likelihood of a restatement, at least in the current study.

Clawing Back Executive Compensation: Will Dodd-Frank Matter?

We explore the effectiveness of the clawback provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act as a deterrent to earnings manipulations. Using a sample of firms that issued “high concern” earnings restatements, we estimate the career and monetary benefits the CEO realizes as a result of the manipulation. We examine these benefits along two dimensions: the reduced probability of termination and the amount of total unearned gains accruing to the CEO as a result of the misreporting. We find the amount of excess incentive compensation subject to clawback under the Dodd-Frank Act accounts for a small fraction of the total unearned gains. Profits from the sale of stock and option exercises, which firms are not required to recover under Dodd-Frank, are more than 85 times the value of excess incentive compensation. As a result, the amount potentially recoverable under the Dodd-Frank Clawback provision is less than one percent of the aggregate total gains, despite the fact that Dodd-Frank casts a wider net than prior clawback legislation. As the costs of recovery are likely to outweigh the amount recoverable, our results suggest that the Dodd-Frank Clawback is unlikely to be an effective deterrent to earnings manipulation.

Do Independent Directors Matter?

The generally weak correlation between board independence and firm performance is a major empirical puzzle. One possible explanation is that director independence alone is not enough. To explore this possibility, we examine the full employment histories of independent directors at S&P 1500 companies between 2000 and 2008. We define an independent director with industry experience (IDIEs) as an independent director who has worked in the same 2-digit SIC industry as the company where he/she serves as an independent director. We show that the proportion of IDIEs on a board is positively and significantly correlated with firm performance, but the proportion of independent directors without industry experience (IDNIEs) is not. These effects hold for firms with positive R&D expenditure, but not for firms with zero R&D expenditure. These effects also hold after we control for endogeneity by using Heckman 2-step or 2SLS approach. As an instrumental variable, we use the local pool of potential independent directors with industry expertise. We then explore the channels through which IDIEs influence firm performance. We find that the proportion of IDIEs is negatively and significantly correlated with earnings restatements, but the proportion of IDNIEs is not. These effects hold for firms with less entrenched CEOs, but not for firms with more entrenched CEOs. We find that the proportion of IDIEs is associated with more cash holdings, but the proportion of IDNIEs is not. These effects hold for firms with positive R&D expenditures, but not for firms with zero R&D expenditures. We find firms with IDIEs have significantly higher CEO pay-performance sensitivity, significantly higher CEO turnover-performance sensitivity, and significantly more patents with more citations. We find significant and positive stock market reactions to IDIE appointments, but not to IDNIE appointments. We also find that CEO power is negatively and significantly correlated with the presence of IDIEs.

Earnings restatements and differential timeliness of accounting conservatism

We examine whether Basu's (1997) differential timeliness metric and the related C-Score metric are effective in detecting predictable differences in conservatism surrounding corrections of overstated earnings. Cross-sectional and time-series analyses, employing 2132 firms making restatements during 1999–2005, suggest Basu-based metrics capture variation in conservatism. Further, we find that increases in conservatism following restatements are contingent on improvements in corporate governance. Collectively, these results provide evidence of the usefulness of the Basu-based metrics in the restatement setting.

Earnings Restatements and Credit Default Swaps

Earnings Restatements and Credit Default Swaps

Earnings Restatements Implications along the Supply Chain

Earnings Restatements Implications along the Supply Chain

Do Independent Expert Directors Matter?

The generally weak correlation between board independence and firm performance is a major empirical puzzle. One possible explanation is that director independence alone is not enough. To explore this possibility, we examine the full employment histories of independent directors at S&P 1500 companies. We define an independent expert director (IED) as an independent director who has worked in the same 2-digit SIC industry as the company where he/she serves as an independent director. We show that the proportion of IEDs on a board is positively and significantly correlated with firm performance. We find that when the proportion of IEDs is higher, there are fewer earnings restatements and larger cash holdings. Firms with IEDs have higher CEO pay-performance sensitivity, higher CEO turnover-performance sensitivity, and more patents with more citations. Stock market investors react positively to IED appointments. We also find the higher the CEO power, the less likely IEDs will be on board.

Casting Conference Calls

We explore a subtle but important mechanism through which firms can control information flow to the markets. We find that firms that “cast” their conference calls by disproportionately calling on bullish analysts tend to underperform in the future. Firms that call on more favorable analysts experience more negative future earnings surprises and more future earnings restatements. A long-short portfolio that exploits this differential firm behavior earns abnormal returns of up to 149 basis points per month, or almost 18 percent per year. We find similar evidence in an international sample of earnings call transcripts from the UK, Canada, France, and Japan. Firms with higher discretionary accruals, firms that barely meet/exceed earnings expectations, and firms (and their executives) that are about to issue equity, sell shares, and exercise options, are all significantly more likely to cast their earnings calls.

The Economic Consequences of Accounting Comparability in Security Pricing and Compensation Contracting

Using a sample of earnings restatements, we provide evidence that an empirical measure of the comparability in two firms’ earnings (“earnings comparability”) captures the extent to which a firm’s accounting choices and estimates are similar to those of its restating peer firm. We then document that investors appear to underreact to the implications of this earnings comparability signal. Additional analysis reveals that large traders and short-sellers react in a timely manner, and their trades trigger an immediate negative price reaction to earnings comparability. Small traders appear to behave inattentively, and their herding-driven delayed trades contribute to a negative drift in prices.

Internal corporate governance, CEO turnover, and earnings management

The likelihood and speed of forced CEO turnover – but not voluntary turnover – are positively related to a firm's earnings management. These patterns persist in tests that consider the effects of earnings restatements, regulatory enforcement actions, and the possible endogeneity of CEO turnover and earnings management. The relation between earnings management and forced turnover occurs both in firms with good and bad performance, and when the accruals work to inflate or deflate reported earnings. These results indicate that boards tend to act proactively to discipline managers who manage earnings aggressively, before the manipulations lead to costly external consequences.

Internal Corporate Governance, CEO Turnover, and Earnings Management

The likelihood and speed of forced CEO turnover - but not voluntary turnover - are positively related to a firm’s earnings management. These patterns persist in tests that consider the effects of earnings restatements, regulatory enforcement actions, and the possible endogeneity of CEO turnover and earnings management. The relation between earnings management and forced turnover occurs both in firms with good and bad performance, and when the accruals work to inflate or deflate reported earnings. These results indicate that boards tend to act proactively to discipline managers who manage earnings aggressively, before the manipulations lead to costly external consequences.

Corporate Governance, Growth Opportunities, and Earnings Restatements: Effects of a Corporate Governance Code

The study first examines whether firms that adopted the corporate governance mechanisms mandated by the newly enacted Corporate Governance Code in Taiwan are associated with lower incidence of earnings restatements. We find that firms with independent directors (supervisors) are associated with lower incidence of earnings restatements. We further examine this research question in a growth opportunity setting, a prevailing environmental feature in this emerging market, and find that high-growth firms having independent directors (supervisors) with financial expertise are associated with lower incidence of earnings restatements, suggesting that financial expertise of independent directors (supervisors) is important in the financial reporting function in high-growth firms.

Do Investors See through Mistakes in Reported Earnings?

AbstractThis study investigates whether investors see through materially misstated earnings, and whether they anticipate earnings restatements. For firms that restate at least one annual report, we find that investors are misled by mistakes in reported earnings at the time of initial earnings announcements. Investors react positively to the component of the favorable earnings surprise that will subsequently be restated, and they attach the same valuation to it as to the true earnings surprise. We also find that investors anticipate the subsequent downward restatements and start marking stock prices down several months before a restatement announcement, so that the full impact of a restatement is about three times as large as the restatement announcement effect. Indeed, we show that investors punish restating firms because the stock price gains that shareholders enjoy when firms initially announce overstated earnings are more than reversed by the time of the restatement announcement.

Earnings Restatements: A Capital Market Perspective

I investigate the stock-return behavior around earnings restatement announcements, the quantitative information and qualitative characteristics of restatements contributing to the short-term abnormal returns, and the change in the investors’ confidence in the restating firms. Using hand-collected data from between 1977 and 2001, my work demonstrates that there is a sharp increase in the number of restatements from 1998 on. I find a strongly negative short-term market reaction to restatement announcements, a significant downward pattern in the six-month period leading up to the restatement announcements, and a negative post-announcement drift for up to four months. The study shows that both quantitative information (e.g., the amount of the earnings restatement) and qualitative characteristics of restatements carry significant explanatory power for the short-term market response. Finally, the research shows that the investor-perceived earnings quality deteriorates after the restatement announcement in terms of a decrease in earnings response coefficients from those before the restatement announcements, which implies that investors lose confidence in restating firms. At least before Enron, however, this negative confidence effect did not spill over to companies with similar characteristics.

Changes in the predictive ability of earnings around earnings restatements

Purpose – The purpose of this paper is to investigate whether earnings restatements have a larger effect on the earnings quality (proxied by persistence) of restating firms relative to similar non‐restating firms and if restated earnings are more persistent than the originally reported earnings.Design/methodology/approach – Cross‐sectional earnings persistence models are used to analyze how earnings persistence changes around restatements for both the originally reported earnings and the new restated earnings numbers. The study looks at restatements from 1997 through 2006.Findings – The findings show that restating firms exhibit a larger increase in earnings persistence from the two‐year period before to the two‐year period after the restatements. Results also show that the restated portion of earnings is incrementally persistent relative to the originally reported earnings and the incremental persistence, although mitigated, is still significant after the passage of the Sarbanes‐Oxley Act. In addition, t...