Subsequent Restatements Research Articles

Does Severe Air Pollution Affect Audit Judgment?: Evidence From China

This study examines whether and how air pollution affects auditors’ proclivity for modified audit opinion issuance. We argue that air pollution affects auditors’ audit judgment through two separate channels, i.e., the productivity reduction channel and the cognitive bias channel. Our empirical tests confirm that high levels of air pollution make auditors less likely to issue modified audit opinions. Consistent with the adverse effect on audit quality, we further show that air pollution is positively associated with client companies’ discretionary accruals and subsequent restatements. Applying a discontinuity design that focuses on observations with air quality index falling in the narrow range around 100, we again confirm that local air pollution leads to lower audit quality.

Reporting Risk in Firmss 10-K Disclosures and the Auditor's Role in Mitigating Misstatements

The purpose of public company audits is to increase the integrity of firms’ financial statements. However, research provides mixed evidence on whether better auditors mitigate misstatement risk embedded in the financial reporting process. A challenge in previous studies is the lack of a powerful measure of inherent, “pre-audit” reporting risk. We overcome this issue by developing a novel, powerful measure of accounting misstatement risk (AMR) from 10-K text. We validate this measure by documenting economically significant associations with both audit fees and misstatements. We then empirically test whether relatively higher quality audits, measured using a variety of characteristics, attenuate the association between AMR and subsequent restatements. Contrary to our prediction, however, we find minimal evidence that better auditors mitigate the association between AMR and the likelihood of subsequent restatement. Further analysis supports the notion that AMR inhibits auditors’ ability to mitigate reporting risk through increased audit fees and that AMR captures innate reporting risk rather than managerial obfuscation. Overall, we expect our results to be of interest to managers, accountants, and regulators, all of whom seek to minimize negative consequences of misreporting.

Bank Audit Fees and Asset Securitization Risks

SUMMARYWe examine whether bank auditor effort, proxied by audit fees, is related to asset securitization risks (ASR) and whether the incremental auditor effort attributed to ASR is related to audit quality. Our sample period encompasses the global financial crisis (GFC) and the introduction of FAS No. 166 and FAS No. 167, which were intended to constrain accounting for asset securitizations as sales. Using U.S. bank holding company (BHC) data from 2003 to 2013, we find significantly positive associations between ASR and audit fees for Big N auditors but not for non-Big N auditors. Pre-GFC audit fees have a positive association with ASR, and are more significant for BHCs reporting a loss. After the implementation of FAS Nos. 166 and 167, this positive association persists, mainly driven by BHCs reporting a loss. With respect to the incremental auditor effort attributed to ASR, we find that, prior to the GFC, the incremental audit effort by Big N auditors, but not by non-Big N auditors, reduced the likelihood of subsequent restatements and constrained reported gains on securitizations.JEL Classifications: G14; G21; M42.

Financial Reporting Quality and Auditor Locality Contagion

SUMMARY Research in information economics seeks to understand how the actions of one individual affect the decisions of related individuals. We examine this issue in the context of information contagion between audit offices in the same locality. Specifically, we investigate whether contagion among Big N audit offices in the same metropolitan statistical area (MSA) causes their client firms' financial reporting quality to correlate. We document a relation between overstatement of earnings for one firm (as evidenced by a subsequent restatement) and higher abnormal accruals for another firm in that same year, where both firms' auditors are located in the same MSA. The correlation in reporting quality is consistent with contagion in practices between auditors. We also find evidence that auditor competition is one channel through which information contagion occurs. The between-audit office contagion we document is incremental to within-audit office contagion documented by prior research. Our evidence is important in understanding additional factors related to the quality of auditing and financial reporting and thus should be relevant to audit committees, regulators attempting to improve audit quality, and stakeholders in general.

Misclassification of Negative Core Earnings and Signal-Driven Price Association

This paper provides evidence that managers strategically report large negative special items (NSP hereafter) when the current year’s expected core earnings deviate from the previous year’s reported core earnings benchmark. The strategic reporting of NSP is consistent with misclassifying negative core earnings (operating expenses and losses) as NSP and is more likely associated with poor financial reporting firms. Decomposing NSP into misclassified negative core earnings and real NSP reveals that only the noneconomically-based component of NSP is associated with subsequent financial restatements. The misclassification practice is consistent with a conjecture by managers that misclassified negative core earnings receive less valuation implications. Consistent with this conjecture, I find that the misclassified component forecasts earnings similar to reported core earnings; however it receives an ERC (earnings response coefficient) that is inconsistent with its forecasting ability. Further results show that changes in stock price association with NSP are mainly driven by a “noisy” reporting signal of misclassification.

Detecting Financial Misreporting with Real Production Activity

This study examines whether real production activity measures available to auditors, and in some cases regulators and investors, are useful in detecting financial misreporting. In contrast to accounting performance measures drawn from accrual-basis accounting, this study employs firm-level electricity consumption data which represents a firm’s real production activities in a timely and unbiased manner. Accordingly, we posit that inconsistent growth patterns between accounting performance and electricity consumption are a useful indicator in detecting financial misreporting. Using electricity consumption data for Korean firms from 2006 to 2014, we find that discretionary accruals are increasing in the growth difference between a firm’s revenue and electricity consumption. We also find that this growth difference increases the likelihood of subsequent adverse financial accounting restatements. Our findings are robust to alternative measures of financial misreporting including accounting enforcement actions and qualified audit opinions. Overall, our study documents new evidence on the role of real production activities in detecting financial misreporting.

Family control, accounting misstatements, and market reactions to restatements: Evidence from China

We examine the impact of family control on the likelihood of accounting misstatements and on market reactions to subsequent restatements. Using a matched-firm approach, we find that family control overall reduces the incidence of misstatements, consistent with the notion that controlling families have a greater concern for reputation than nonfamily blockholders. However, compared to nonfamily firm restatements, restatements announced by family-controlled firms trigger significantly more negative market reactions. We attribute the more negative market reactions to the greater loss in reputation and higher investor scepticism of the credibility of corporate insiders for family firms than for nonfamily firms following restatements.

The Timeliness of Restatement Disclosures and Financial Reporting Credibility

AbstractThis study investigates whether prompt discovery and disclosure of earnings restatements is associated with greater post‐restatement financial reporting credibility. We measure the timeliness of restatement detection by the length of time between the end of the misstated period and the subsequent restatement announcement. We document that shorter detection periods are significantly associated with high‐quality corporate governance characteristics and executive and/or auditor turnover, but not with characteristics of restatements. We also find that firms with shorter detection periods exhibit a more moderate decline in the information content of earnings following restatement announcements relative to firms with longer detection periods, and that detection period length has an incremental effect on the information content of earnings relative to executive and/or auditor turnover alone. In addition, we find that restatement disclosures are more timely following the implementation of the SOX‐era reforms, and that only firms with shorter detection periods experience more moderate post‐restatement declines in the information content of earnings following the implementation of the SOX‐era reforms. The results from this study suggest that the timeliness of restatement detection and disclosure is associated with greater financial reporting credibility following restatements.

Accounting restatements and audit quality in China

This paper examines the effect of audit quality on accounting restatements in China. Evidence on the determinants and consequences of accounting restatements in emerging markets is scant, although these countries are more vulnerable to financial report manipulation and subsequent restatements. For accounting restatement analysis we regress non-cash flow restatement observations and cash flow restatement observations on audit quality and restatement–audit quality interaction variables. Earnings manipulation increases the likelihood of non-cash flow restatement observations, but high quality audit constrains this effect. However, no such evidence is found for cash flow restatements.

Can Management Turnover Restore the Financial Statement Credibility of Restating Firms? Further Evidence

This paper investigates the association between management turnover following financial restatements and the probability of subsequent restatements. We find that restating firms that replace management (CEO and/or CFO) are more likely to restate their financial statements again. We also find that subsequent restatements are mainly attributable to the new management. Overall, our results suggest that management turnover following restatements may not be an effective mechanism to remediate financial restatements, but the change to a new management results in a greater possibility of lower earnings quality (i.e., higher probability of subsequent financial restatements and accruals-based earnings management). Our study supports prior literature's findings that the change in the top management leads to organizational instability and higher accounting information risk. Our findings have implications for internal decisionmaking with regard to top executive replacement.

The Relationship between Audit Report Lags and Future Restatements

SUMMARY: We investigate the relationship between future financial statement restatements and audit report lags. Audit report lags are defined as the number of days between the fiscal year-end and the date of the audit report. Ex ante, it is not clear whether there should be a relationship and, if there is, whether that relationship would be negative or positive. We first discuss the underlying conceptual rationale for both negative and positive associations, then we use a two-stage approach to empirically examine the relationship. We find that compared to non-restating firms, firms that eventually restate their financial statements have longer abnormal audit report lags. In subsequent testing, we consider a number of factors that may undermine additional audit effort and, thus, influence the association between audit report lag and subsequent restatements. Of the factors examined, we find that time pressure appears to be associated with increased probability of financial restatements.

Family Control, Accounting Misstatements, and Market Reactions to Restatements: Evidence from China

We examine the impact of family control on the likelihood of accounting misstatements and market reactions to subsequent restatements. Using a matched-firm approach, we find that family control overall reduces the incidence of misstatements, consistent with the notion that controlling families have greater reputation concerns than nonfamily blockholders. However, compared to nonfamily firm restatements, restatements announced by family-controlled firms trigger significantly more negative market reactions, which are even more pronounced when the risk of expropriation by controlling shareholder is higher. We also find a larger drop in the information content of earnings in family restatement firms than in nonfamily restatement firms. We attribute the stronger market reactions and the larger loss of earnings informativeness to greater investor skepticism of the credibility of corporate insiders and lower perception of earnings quality in family-controlled firms following restatements. Our study highlights that investors are more sensitive to the deterioration in earnings quality in family-controlled firms than in nonfamily-controlled firms, which in turn affects market reactions to accounting restatements.

Empirical Evidence on Repeat Restatements

SYNOPSIS This study examines the characteristics and market consequences of repeat restatements. We find that 38 percent of the restating companies in our sample restate at least twice between 2002 and 2008, and 31 percent of repeat restatement firms restate three or more times during the same period. Our tests identify several auditor and restatement characteristics that distinguish single from repeat restatements at the time of the first restatement. Repeat restatements are more likely among clients of non-Big N auditors and those with lower ex ante accounting quality. However, firms that switch auditors between the end of their misstatement period and the restatement announcement are less likely to experience repeat restatements. Although subsequent restatements tend to be less severe than the first in a series of restatements, firms suffer similar declines in stock prices with up to three restatement announcements. In addition, firms often restate the same fiscal periods multiple times, and these “overlapping” restatements are more frequent when managers are distracted by other difficulties, such as discontinued operations or internal control weaknesses. Our findings should be valuable to investors, regulators, and other parties interested in repeat restatements. We provide research design recommendations for researchers to incorporate in future research. JEL Classifications: M41; M42; G34. Data Availability: All data used in this study are publicly available from the sources indicated.

Empirical Evidence on Repeat Restatement Firms and Their Auditors

This study examines the characteristics of repeat restatement firms and the market consequences of repeat restatements. We find that 38 percent of the restating companies in our sample restate at least twice between 2002 and 2008, and 31 percent of repeat restatement firms restate three or more times during the same period. Our tests identify several auditor and restatement characteristics that distinguish single from repeat restatements at the time of the first restatement. Repeat restatements are more likely among clients of non-Big N auditors and those with lower ex ante accounting quality. However, firms that switch auditors between the end of their misstatement period and the restatement announcement are less likely to experience repeat restatements. Although subsequent restatements tend to be less severe than the first in a series of restatements, firms suffer similar declines in stock prices with up to three restatement announcements. We also find that firms often restate the same fiscal periods multiple times, and these “overlapping” restatements are more frequent when managers are distracted by other corporate events. Our findings should be valuable to investors, regulators, and other parties interested in the characteristics of repeat restatement firms. We provide research design recommendations for future researchers analyzing restatement samples.

Managerial Ability and Earnings Quality

ABSTRACT We examine the relation between managerial ability and earnings quality. We find that earnings quality is positively associated with managerial ability. Specifically, more able managers are associated with fewer subsequent restatements, higher earnings and accruals persistence, lower errors in the bad debt provision, and higher quality accrual estimations. The results are consistent with the premise that managers can and do impact the quality of the judgments and estimates used to form earnings. Data Availability: Data are publicly available from the sources identified in the text.

Managerial Ability and Earnings Quality

We examine the relation between managerial ability and earnings quality. We find that earnings quality is positively associated with managerial ability. Specifically, more able managers are associated with fewer subsequent restatements, higher earnings and accruals persistence, lower errors in the bad debt provision, and higher quality accrual estimations. The results are consistent with the premise that managers can and do impact the quality of the judgments and estimates used to form earnings.

Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality

ABSTRACTThe Advisory Committee on the Auditing Profession (ACAP), formed by the U.S. Department of the Treasury, has recommended that all public companies be required to have shareholder ratification of auditor selection. Using data from 1,382 firms for the year ending December 31, 2006, we find that audit fees are higher in firms with shareholder voting on auditor ratification. We also find that firms that started having a shareholder vote pay higher fees than firms that stopped having a shareholder vote. In the second part of our study, we find that in firms with shareholder voting on auditor selection (1) subsequent restatements are less likely and (2) abnormal accruals are lower. Our findings are consistent with the experimental results in Mayhew and Pike (2004), and provide empirical grounding for the debate about mandating shareholder voting on auditor selection.

Spread Behavior and Multiple Restatement Announcements

In this paper we study the multiple restatement announcements and its perceived resultant information asymmetry around the announcement day. We examine the pattern of information asymmetry for multiple restatement announcements in terms of bid-ask spread around the announcement day. Study of spread behavior around corporate events that have been performed in the past show a mixed picture. While Conrad and Niden (1992) find weak evidence of spread widening around corporate information event, Barclay and Smith (1988) find an increase in spread during stock repurchases announcements. Palmrose, Richardson and Scholz (2004) do not find any significant proportionate change in bid-ask spread surrounding the financial restatement announcement day. Results from our empirical analysis support the hypotheses that the spread widens not only around the first restatement announcement day but around every subsequent restatement announcement days as well.

Why did management and auditors fail to identify ineffective internal controls in their initial SOX 404 reviews?

PurposeThe purpose of this paper is to investigate the rationale for the failure of management and auditors to identify material internal control weaknesses (ICWs) in their initial Sarbanes‐Oxley Act of 2002 (SOX) 404 reviews, resulting in subsequent restatement of their opinions.Design/methodology/approachThe paper focuses on the factors associated with the failure of management and auditor to identify material internal controls weaknesses in their initial SOX 404 reports. Logistic regression is run on a sample of 56 firms that reported material internal controls weaknesses in their amended internal control reports and a control group of 344 firms that reported material internal controls weaknesses (i.e. ineffective internal controls) in their initial internal control reports for 2004.FindingsThe results show that firm size, the use of a Big 4 auditor, the ratio of non‐audit to total fees, and the need for accounting restatements are positively associated with the probability to file an amended internal control report. The number of ICWs and the number of audit committee meetings are negatively associated with the probability to file an amended internal control report.Practical implicationsThe paper's findings suggest that regulators and corporate boards should consider providing more guidelines on audit committee practices in addition to the audit committee structure. For example, more guidance by the board is needed to ensure that the audit committee is active in overseeing the company's auditor–client relationship and its internal audit function.Originality/valueEmpirical findings on factors associated with the failure of management and auditor to identify material ICWs in their SOX 404 review can contribute to an understanding of factors affecting the efficiency of the SOX 404 review by attributing such failure to either inherent factors such as operational complexity and industry membership or to managerial choices in auditor‐client relationship and corporate governance issues. An understanding of these factors can help companies and the Public Company Accounting Oversight Board and the Securities and Exchange Commission in their efforts to improve the effectiveness and the efficiency of the current SOX 404 process.

Giving Thrasymachus his Due: The Political Argument of Republic I and its Reception

This paper focuses on the first iteration of Thrasymachus’ claim as reported in Book I of Plato’s Republic that ‘justice is the interest of the stronger’, namely, a ‘political’ interpretation, according to which ‘justice is the interest of the stronger party in each polis as established in the law’. The author contends that this argument is logically and rhetorically distinct from Thrasymachus’ subsequent restatements of his position in Republic I. The ‘political’ version of the Thrasymachean position enjoyed currency after the composition of the Republic — and in a way that was not entirely negative. The current paper examines two cases of this reception: the first, in Plato’s own late work, the Laws, where he reengages with the Thrasymachean doctrine; the second, in the De republica Anglorum of Sir Thomas Smith, an early modern theorist who self-consciously defended Thrasymachus’ theory of justice. The paper’s immediate purpose is to suggest that Thrasymachus’ conception of ‘political’ justice, in particular, has far more coherence and power than the supposed ‘refutation’ of it in the Republic might leads us to believe.