Irregularities in financial statements lead to inefficiencies in capital allocation and can become costly to investors, regulators, and potentially taxpayers if left unchecked. Finding an effective way to detect accounting irregularities has been challenging for academics and regulators. Responding to this challenge, we rely on a peculiar mathematical property known as Benford’s Law to create a summary red-flag measure to capture the likelihood that a company may be manipulating its financial statement numbers.
Posts Tagged ‘Restatements’
In our paper, Regulating the Timing of Disclosure: Insights from the Acceleration of 10-K Filing Deadlines, forthcoming in the Journal of Accounting and Public Policy, we examine how regulatory reforms that accelerate 10-K filing deadlines in 2003 affect the reliability of accounting information. The intended purpose of the new deadlines is to improve the efficiency of capital markets by making accounting information available to market participants more quickly. However, accelerating filing deadlines compresses the time available for firms and their auditors to prepare, review, and audit accounting reports, suggesting potential costs in the form of increased misstatements and lower reliability. We provide empirical evidence on the effects of accelerating deadlines by comparing the likelihood of restatement of 10-K filings before and after the rule change.
In our paper, The Effect of Audit Committee Industry Expertise on Monitoring the Financial Reporting Process, forthcoming in The Accounting Review, we examine the impact of audit committee (AC) industry expertise on the AC’s effectiveness in monitoring the financial reporting process. Despite the increased responsibilities, authority, independence, and financial expertise requirements placed on ACs by the Sarbanes-Oxley Act (SOX), ACs may, nonetheless, lack sufficient industry expertise to understand and thus properly monitor complex industry specific accounting issues. For instance, expertise in the retail industry may assist ACs to ensure that companies take an adequate write-down of inventory when their products face potential obsolescence. Similarly, revenue recognition, a prominent area of accounting manipulation (Beasley et al. 2000, 2010), entails an evaluation and understanding of the earnings process, which is tied to a company’s business processes that are often industry specific.
In the paper, Measuring Intentional Manipulation: A Structural Approach, which was recently made publicly available on SSRN, I suggest a structural model of a manager’s manipulation decision that allows me to estimate his costs of manipulation and to infer the amount of undetected intentional manipulation for each executive in my sample. The model follows the economic approach to crime (Becker, 1968) and incorporates the costs and benefits of manipulation decisions. The model is a dynamic finite-horizon problem in which the risk-averse manager maximizes his terminal wealth. The manager’s total wealth depends on his equity holdings in the firm and his cash wealth. The model yields three predictions. First, according to the wealth effect, managers having greater wealth manipulate less. Second, according to the valuation effect, the current-period bias in net assets increases in the existing bias. Third, the manager’s risk aversion, the linearity of his terminal wealth in reported earnings, and the stochastic evolution of the firm’s intrinsic value produce income smoothing. Furthermore, the structural approach allows partial observability of manipulation decisions in the data; hence, I am able to estimate the probability of detection as well as the loss in the manager’s wealth using the data on detected misstatements (i.e., financial restatements).
In our paper, Accounting and Litigation Risk: Evidence from Directors’ & Officers’ Insurance Pricing, forthcoming in the Review of Accounting Studies, we study whether and how financial reporting concerns and traditional measures of corporate governance are priced by insurers that sell Directors’ and Officers’ (D&O) insurance to public firms. As D&O insurers typically assume the liabilities arising from shareholder litigation, the insurance premiums they charge for D&O coverage reflect their assessment of a company’s litigation risk.
Estimation of ex-ante litigation risk has always been a challenge for empirical research. Past studies employ ex-post lawsuits to derive an ex-ante measure of litigation risk. In such studies, a litigation risk prediction model is first estimated with the dependent variable being whether the firm got sued ex-post. The predicted values of the probability of getting sued are then used as ex-ante measures of litigation risk in an empirical model. Such measures ignore lawsuits filed in other jurisdictions and also cannot distinguish between frivolous and serious lawsuits. We employ a market-based measure of ex-ante litigation risk; that is, the D&O liability insurance premium, which incorporates the ex-ante expectation of both the likelihood of lawsuits and the magnitude of damages. In the U.S., public firms routinely purchase D&O insurance coverage for their directors and officers for reimbursement of defense costs and settlements arising from shareholder litigation. Most shareholder litigation is settled within policy limits, with the D&O insurers primarily footing the bill. Therefore, we expect the D&O insurers to price financial reporting risk and corporate governance risk efficiently in order to compensate for their expected payout obligations in the case of lawsuits.
The Public Company Accounting Oversight Board is proposing a new auditing standard that relates to the auditor’s evaluation of a company’s relationships and transactions with related parties, and amendments to existing auditing standards that relate to significant unusual transactions and financial relationships and transactions by a company with its executive officers (including incentive compensation arrangements). The new and amended standards are intended to focus auditors’ efforts on areas that may pose an increased risk of material misstatement to a company’s financial statements.
The PCAOB’s proposals largely build upon and enhance existing requirements in these areas, primarily by providing greater specificity around the procedures that must be employed and inquiries that must be made. While the proposals would not directly impact the non-financial-statement disclosure (such as proxy disclosure) relating to related party transactions and executive compensation under SEC rules, companies should anticipate greater auditor focus and additional audit procedures on the financial statement impact of these areas if these proposals are adopted.
Subject to SEC approval, the new and amended standards would be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012. The deadline for public comment is May 15, 2012.
Considerable accounting and finance research has attempted to identify whether reported financial statements have been manipulated by executives. Most of these classification models are developed using accounting and financial market explanatory variables. Despite extensive prior work, the ability of these models to identify accounting manipulations is modest. In the paper, Detecting Deceptive Discussions in Conference Calls, forthcoming in the Journal of Accounting Research, we take a different approach to detecting financial statement manipulations by analyzing linguistic features present in CEO and CFO narratives during quarterly earnings conference calls. Based on prior theoretical and empirical research from psychology and linguistics on deception detection, we select the word categories that theoretically should be able to detect deceptive behavior by executives. We use these linguistic features to develop classification models for a very large sample of quarterly conference call transcripts.
A novel feature of our methodology is that we know whether the financial statements related to each conference call were restated in subsequent time periods. Because the CEO and CFO are likely to know that financial statements have been manipulated, we are able to reasonably identify which executive discussions are actually “deceptive”. Thus, we can estimate a linguistic-based model for detecting deception and test the out-of-sample performance of this classification method.
In our paper, Internal Corporate Governance, CEO Turnover, and Earnings Management, forthcoming in the Journal of Financial Economics, we examine whether executives who manage earnings increase the risk of losing their jobs. We find that earnings management is strongly associated with the subsequent likelihood of forced CEO turnover, but is not significantly related to voluntary turnover. This basic result holds through several test specifications, including multinomial logistic regressions and competing risks hazard models. In the short run, aggressive earnings management in any given year is associated with an increased likelihood of forced ouster the next year. And in the long run, a CEO’s job tenure is negatively related to earnings management over the time he or she is in the CEO position. Similar results hold when we examine the forced turnover of CFOs. A large battery of sensitivity tests reported in the Internet Appendix indicate that these results are robust to alternate measures of earnings management and different model specifications.
In our paper, Stealth Disclosure of Accounting Restatements, which was recently accepted for publication in the Accounting Review, we investigate whether the prominence of the disclosure of a restatement is correlated with the market reaction and the likelihood of litigation. In our sample, we observe and categorize firms into three levels of disclosure. Some companies disclose their restatement prominently in the headline of a press release, usually one that is dedicated to the accounting misstatement (high prominence). Other firms provide less prominent disclosure, typically citing an earnings release in the headline, but still discussing the misstatement in the body of the press release (medium prominence). Most of the remaining firms simply restate prior-period comparative balances in an earnings release, with a footnote briefly explaining that the financial figures for the prior year have been changed (low prominence).
We investigate whether companies providing medium or low prominence disclosure of their restatement benefit from a less negative market reaction and/or a reduced likelihood of litigation. Our first finding is that the magnitude of the market response to a restatement announcement is related to press release format. Three-day returns differ substantially across the three categories of disclosure prominence, averaging -8.3 percent, -4.0 percent, and -1.5 percent for high, medium, and low prominence, respectively. Returns for the high prominence group are statistically different from those for the medium and low prominence groups. Next, we extend the return window to 20 days after the announcement to investigate post- announcement responses to restatements. We find returns of -7.9 percent, -6.4 percent, and -3.2 percent for the high, medium, and low prominence firms, respectively. These returns are considerably less dispersed than the short-window returns, and the 1.5 percent return difference between high and medium prominence is not statistically significant. Apparently, market participants initially underestimate the seriousness of some misstatements disclosed without a headline but subsequently correct their underreaction.
Next, we find that the average return for firms that have post-restatement news items is not significantly different from zero. In contrast, we find a statistically significant drift of -3.7 percent for firms with no news items in the 20-day period, which suggests that investors further evaluate the original press release information. Analysts appear to play an important role in this evaluation because most of the drift is in companies covered by three or more analysts. In addition, once we control for the seriousness of the accounting misstatement, we find that the press release remains highly significant in explaining announcement period returns (-1, +1), but not significantly associated with returns over the longer window (-1, +20).
Lastly, we find that the frequency of lawsuits declines monotonically across the three categories of disclosure prominence (27 percent, 16 percent, and 0 percent for the high, medium, and low prominence firms, respectively). The 16 percent litigation rate for medium disclosure suggests that some managers use medium prominence disclosure for an accounting misstatement that plaintiff attorneys view as serious. We estimate a logistic regression model of the likelihood of litigation in our sample, and find that the prominence index coefficient is positive and significant in the model (even after controlling for endogeneity), suggesting that the likelihood of litigation rises with disclosure prominence. Reducing disclosure prominence by one level (e.g., medium instead of high) reduces the odds of a lawsuit by about half.
The full paper is available for download here.
In our forthcoming Accounting Review paper entitled Earnings Restatements, Changes in CEO Compensation, and Firm Performance, we provide insights into the design and efficacy of chief executive officer (CEO) compensation contracts following an earnings restatement.
Using a sample of 289 restatements and the year prior to restatement announcement as the benchmark year, we find that while total CEO compensation does not significantly change by the second year after the restatement announcement, there is a significant shift from option-based compensation to salary over this period. In univariate tests, we find that the proportion of the value of option grants to total compensation declined by 5.6 percentage points for the restatement firms, while control firms experienced an increase of 2.6 percentage points in this proportion over the same period. The analyses indicate that the number of option grants also declines for restatement firms compared to control firms. The reduction in the use of option grants for restatement firms holds after we control for the level of stock and option holdings as well as other determinants of option-based compensation, such as firm size, growth opportunities, leverage, idiosyncratic risk, R&D intensity, stock returns, cash compensation, and industry and year fixed effects. Because about half of the restatement firms experienced CEO turnover after restatements, we also investigate the change in option grants separately for extant and new CEOs. We find that our results hold for both extant and new CEOs.
If the reduction in option-based compensation is a result of unwarranted negative public perception of option usage, we would expect a decrease in firm performance as firms deviate from optimal contracting. However, if restatements result from too high a level of incentive compensation and the reduction in option compensation after the restatement better aligns managerial incentives with those of shareholders, we would expect to observe improved firm performance. Overall, our results imply that economic benefits accrue to restatement firms that reduce their CEOs’ option-based compensation, indicating that the reduction in option grants helps adjust managers’ equity incentives toward optimal levels. A natural question that follows is if reducing option usage is associated with improved firm performance, why is it that all restatement firms do not do so? To help answer this question, we conduct a within-sample analysis. We find that the likelihood of a reduction in options usage is positively related to the level of option grants prior to the restatement and in some specifications, this likelihood is higher for income-decreasing restatements.
The full paper is available for download here.