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.     

CFO gender and earnings management: evidence from China

We study the effect of chief financial officer (CFO) gender on earnings management (EM) in China’s listed firms from 1999 to 2011. In the cross-sectional analysis, we find that female CFO firm-years exhibit significantly lower discretionary accruals, lower total accruals, lower abnormal production costs, and higher abnormal discretionary expenditures, than the male CFO firm-years. We further examine the relation between CFO gender and EM surrounding CFO transitions. We find that the departing male CFOs are more aggressive than the departing female CFOs in managing up earnings during their last year with the firm and the newly appointed male CFOs are more aggressive than the new female CFOs in managing down earnings during their first year on the job. The evidence surrounding CFO transitions suggests that male CFOs are more aggressive than female CFOs in manipulating earnings, either in the last attempt to save their jobs or to take bigger credit for any future performance gains. Overall, our empirical evidence suggests that female CFOs engage in less EM and are more conservative in financial reporting than their male counterparts.     

Credibility Attributes and Investor Perceptions of Non‐GAAP Earnings Exclusions

Recent empirical evidence suggests that investors focus more on non‐GAAP (Generally Accepted Accounting Principles) than on traditional GAAP earnings because non‐GAAP earnings are believed to proxy for a firm's ongoing profitability, a measure useful for valuation. Managers determine these non‐GAAP earnings by excluding certain items from their GAAP income. However, because these non‐GAAP earnings are both unaudited and may be disclosed by a firm to manage investors’ perceptions as opposed to inform, investors must infer the credibility of the disclosure through observable firm attributes. In this study we examine whether firms with stronger credibility attributes (corporate governance, higher‐quality auditors, and higher historical information quality) will be perceived as providing more credible non‐GAAP exclusions than those with weaker attributes. Our expectation is that the market reaction to non‐GAAP earnings exclusions of firms with stronger credibility attributes will be greater than for those with weaker attributes. Our results support our expectation.     

Castries Merchandising Inc.

This two‐part case focuses on red flags of attempted earnings management for a St. Lucian company that is moving from 100 percent family‐owned to selling 50 percent of the family's shares to an equity fund. In order to increase the earnings growth rate in the three years leading up to the proposed sale to an equity fund in 2021, the earnings for the most recent three years (2016–2018) have been artificially depressed. The resulting byproduct of the earnings management is the underprovision of income taxes for the past three years, which is detected by the tax authorities in St. Lucia. The student assumes the role of a tax auditor for the tax authority in St. Lucia assigned to audit Castries Merchandising Inc. (CMI), a merchandiser of building products, hardware, and automobile parts. In Part 1 the student is provided excerpts of the financial statements of CMI with some anomalies that have been detected by a software program. In Part 2 the student is provided with further information of excerpts from the trial balance and an interview with the CFO, who is a member of the family ownership group of CMI and also a Canadian CPA registered in Ontario. Drawing on the student's knowledge of auditing, accounting principles, and financial statement analysis, the student's task is to both reassess the income taxes for the years 2016 to 2018 and contemplate how management may be manipulating the financial statements in order to benefit from the planned future sale of CMI's shares to an equity fund.     

Do Restatements Improve the Persistence of Earnings and Its Components?

We examine the persistence of earnings in the pre‐ and postrestatements periods and find that restatements generally improve the persistence of earnings. We also examine how the persistence of earnings is influenced by restatements that are voluntarily initiated by managers (voluntary restatements) and those forced onto firms by outsiders (mandated restatements). Our analysis shows that voluntary restatements are followed by improvement in the persistence of earnings and that mandated restatements are not followed by improvement in earnings persistence. We find results that are consistent with the main finding when we decompose earnings into accruals and free cash flows. We use a difference‐in‐difference research design and confirm that the improvement in the postrestatement persistence of earnings components exceeds that of control firms only for voluntary restatements. Further, we show that our results are robust after controlling for endogeneity of voluntary restatements by including a two‐stage model using the Heckman ( 1979 ) method where we first estimate the likelihood of manipulation detection and analyze change in persistence conditional on the first stage analysis. The improvement in earnings persistence around voluntary restatements is not driven by the level of earnings decomposition or a subgroup of voluntary restatements. The results support our hypothesis that voluntary restatements have distinctly different economic consequences from mandated restatements.     

Earnings Behaviour of Financially Distressed Firms: The Role of Institutional Ownership

Using a sample of 859 U.S. bankruptcy-filing firms over the period 1986–2004, we examine the earnings behaviour of managers during the distressed period by looking at sources of abnormal accruals prior to the bankruptcy-filing year. Results show that managers of highly distressed firms shift earnings downwards prior to the bankruptcy filing. We test and provide evidence in support of two potential contributing factors. First, top-level management turnover among distressed firms leads new managers to earnings bath choices during the distressed period. Second, qualified audit opinions exert pressure on managers to follow more conservative earnings behaviour during the distressed period. Evidence is also provided that the management of distressed firms with lower (higher) institutional ownership has greater (lesser) tendency to manage earnings downwards. Results also show that higher institutional ownership mitigates the negative abnormal returns of firms with top management turnover. To the authors' knowledge, this is the first study that attempts to examine whether institutional ownership relates to market reaction in conjunction with a top management turnover or a qualified audit opinion during the distressed period. Prior studies focused on the investigation of earnings management or institutional ownership (separately) during the distressed period, but did not examine if the effect of institutional ownership on earnings behaviour also influences subsequent returns. Thus, the results of this study should be of interest to analysts, standard setters and regulatory bodies since our results show that management turnover, qualified audit opinions and firm governance mechanisms affect the quality of earnings and the level of abnormal returns.     

The Allowance for Uncollectible Accounts,Conservatism, and Earnings Management

We study the interrelation between conservatism and earnings management by examining the allowance for uncollectible accounts and its income statement counterpart, bad debt expense. We find that the allowance is conservative and that it has become more conservative over time. Conservatism may, however, facilitate earnings management. We find that firms manage bad debt expense downward (and even record income‐increasing bad debt expense) to meet or beat analysts’ earnings forecasts and that conservatism accentuates the extent to which firms manage bad debt expense. Further, we find that firms manage bad debt expense downward by drawing down previously recorded over‐accruals of bad debt expense that have accumulated on the balance sheet. An implication of our study is that tighter limits on the amount by which firms are permitted to understate net assets may reduce their ability to manage earnings.     

Cash from operations and earnings management in Korea

Our study investigates the relationship between the operating performances of Korean industrial firms and the behavior of discretionary accruals during the period 1994-1997. We hypothesize that the degree of earnings management will depend on the firm operating performances. We construct 10 “cash from operations (CFO)” portfolios to test if there are systematic differences in discretionary accruals across portfolios.Four test methods (a mean accrual test, a correlation test, a regression analysis, and a sign-change test) are used to investigate if operating performances affect discretionary accruals differently. We compare three accrual estimation approaches (two discretionary accruals and total accruals) in testing the earnings management hypotheses.The results support the hypothesis that Korean industrial firms manage earnings. When operating performance is poor, the firms tend to choose income-increasing strategies. In addition, when operating performance is extremely poor, some firms tend to take a big bath, while some of the exceptionally well-performing firms tend to select income-decreasing strategies.     

Credit Ratings and Earnings Management around IPOs

This study examines the impact of having a credit rating on earnings management (EM) through accruals and real activities manipulation by initial public offering (IPO) firms. We find that firms going public with a credit rating are less likely to engage in income‐enhancing accrual‐based and real EM in the offering year. The monitoring by a credit rating agency (CRA) and the reduced information asymmetry due to the provision of a credit rating disincentivise rated issuers from managing earnings. We also suggest that the participation of a reputable auditing firm is crucial for CRAs to effectively restrain EM. Moreover, we document that for unrated issuers, at‐issue income‐increasing EM is not linked to future earnings and is negatively related to post‐issue long‐run stock performance. However, for rated issuers, at‐issue income‐increasing EM is positively associated with subsequent accounting performance and is unrelated to long‐run stock performance following the offering. The evidence indicates that managers in unrated firms generally manipulate earnings to mislead investors, while managers in rated firms tend to exercise their accounting and operating discretion for informative purposes.     

Earnings Management Surrounding CEO Turnover: Evidence from Korea

This article examines the empirical relation between chief executive officer (CEO) turnover and earnings management in Korea using a sample of 403 CEO turnovers and 806 non‐turnover control firms during the period 2001–2010. We classify CEO turnovers into four types depending on whether the departure of the outgoing CEO is peaceful or forced and whether the incoming CEO is promoted from within or recruited from outside the firm. We measure earnings management by both discretionary accruals and real activities management. We also control for the endogeneity of CEO turnover and a potential selection bias using 2SLS and Heckman's two‐stage approach. After controlling for corporate financial performance and governance structure, we find upward earnings management by the departing CEO only when the departure is forced and the new CEO is an insider. In this case, the new CEO also engages in downward earnings management using both discretionary accruals and real activities management. We also find some evidence that the new CEO recruited from outside the firm manages discretionary accruals upward following the peaceful departure of his predecessor. In all other types of CEO turnover, we do not find evidence of significant earnings management by either CEO.     

DuPont Analysis,Earnings Persistence,and Return on Equity: Evidence from Mandatory IFRS Adoption in Canada

This paper proposes four new models to forecast one‐year‐ahead return on equity (ROE) and change in ROE based on prior research in the DuPont analysis and earnings persistence, and also examines whether the persistence of ROE has improved upon mandatory IFRS adoption in Canada. Using the Granger causality test to establish the usefulness of additional explanatory variables in forecasting future earnings, I show that the DuPont components are useful in predicting one‐year‐ahead ROE, and that the persistence of ROE has decreased since Canadian firms adopted IFRS in 2011. This paper contributes to accounting research in two ways. First, it introduces a new approach to forecasting one‐year‐ahead ROE. Second, it sheds some light on the impact of IFRS adoption on reporting quality in Canada.     

Investor Attention and Earnings Management around the World

This study examines the determinants of earnings management in an international setting using the limited investor attention model of Hirshleifer and Teoh ( 2003 ). The model predicts that investor attention reduces earnings management. I use analyst following, institutional ownership, and Big N auditor choice to proxy for investor attention. I have four key findings. First, I document that financial analysts curb earnings management in U.S. firms but not in non‐U.S. firms. Second, I document that institutional block‐holdings curb earnings management across the world. Third, Big N auditors reduce earnings management in U.S. firms but not in non‐U.S. firms. Fourth, I document that corporate governance mechanisms reduce earnings management in U.S. firms but not in non‐U.S. firms.     

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.     

Using Available-for-sale Securities to Smooth Earnings: Evidence from China

Utilizing a large sample of non-financial public firms in China from 2009 to 2016, we find robust evidence that non-financial firms smooth their earnings through realized gains and losses on available-for-sale (AFS) securities. This effect is more pronounced for firms with weaker internal and external corporate governance. Firms with an incentive to manipulate up their earnings are also less likely to smooth earnings through AFS securities. Moreover, firms with more accrual earnings management or real earnings management tend to smooth earnings to a greater extent through AFS securities. Firms smooth earnings only when their net income is positive or when net income is negative and the gains from AFS securities are large enough to offset negative earnings. We do not find supporting evidence for engaging in big bath earnings management through the realization of losses on AFS securities. These findings suggest that gains and losses on AFS securities allow non-financial firms to actively smooth their earnings. Last, the accounting standards amendments in 2017 that essentially disable earnings smoothing through AFS securities increase price efficiency.     

Can CFOs resist undue pressure from CEOs to manage earnings?

Building upon the premise that, under certain conditions, the ability of the Chief Executive Officer (CEO) to pressure the Chief Financial Officer (CFO) is limited, we develop a measure of CFO resistance that captures the ability of the CFO to resist undue pressure from the CEO to manage earnings. In doing so, we consider various sources of power for both the CEO and CFO, and a market setting where CFO resistance is perceived to be high. We find that firms with resistant CFOs are less likely to engage in earnings management than firms with non-resistant CFOs, ceteris paribus. Additionally, while confirming prior evidence that CEOs with strong incentives are more likely to manage earnings, we show that this effect is significantly less pronounced in the presence of resistant CFOs. Overall, our findings suggest that firms can improve the quality of financial reporting by creating conditions that enable CFO resistance.     

Stock price response to new‐CEO earnings news

New‐CEO earnings news exhibits asymmetric effects on stock prices. Stock prices rise more on good earnings news announced by firms with new CEOs compared with those with established CEOs. By contrast, stock prices tend to fall by a smaller amount on bad earnings news for new CEOs. Both the new‐CEO quality effect and the new‐CEO honeymoon effect are more pronounced for CEOs appointed during challenging situations. The new‐CEO quality effect is stronger for firms followed by fewer analysts, while the honeymoon effect is stronger for firms followed by more analysts – illustrating the importance of a transparent information environment.     

Information Uncertainty,Earnings Management,and Long‐run Stock Performance Following Initial Public Offerings

We examine how information uncertainty surrounding IPO (initial public offering) firms influences earnings management and long‐run stock performance. For low‐information‐uncertainty issuers, at‐issue earnings’ management is positively related to subsequent unmanaged earnings and has no relationship to market reaction to earnings announcement and long‐run stock performance following the offering. For high‐information‐uncertainty issuers, however, at‐issue earnings’ management is unrelated to subsequent unmanaged earnings and negatively related to market reaction to earnings announcement and long‐run stock performance following the offer. The evidence suggests that, on average, managers in low‐information‐uncertainty firms tend to engage in earnings’ management for informative purposes, while managers in high‐information‐uncertainty firms engage in earnings’ management for opportunistic purposes.     

Effective board monitoring over earnings reports and forecasts: Evidence from CFO outside director appointments

Prior evidence that firms adjust their board structure following accounting restatements suggests that firms expect the board to effectively monitor the firm’s financial accounting system. However, little is known about signals firms use to identify monitoring weaknesses or the types of individuals firms appoint to improve the quality of monitoring. We expand on Ghannam, Bujega, Matolcsy, and Spiropolous (2019)’s evidence that firms appoint directors with accounting experience after financial fraud by investigating whether firms that file restatements or issue highly inaccurate earnings forecasts appoint individuals with CFO experience (i.e., a subset of accounting experts) to their audit committee. We find that firms are more likely to appoint an outside director with CFO experience to the audit committee when they have recently restated earnings and when they have higher prior management forecast error. We also find that the appointment of a CFO outside director to the audit committee is followed by a lower likelihood of restatement and more accurate management forecast. Together, our results suggest that firms respond to accounting failures by appointing outside directors with CFO experience. Thus, we provide insight into the signals firms use to identify weaknesses in the monitoring of the accounting function and the types of expertise firms value in addressing those weaknesses.     

Earnings Warnings and CEO Welfare

Some CEOs decide voluntarily to issue a warning when they expect a negative earnings surprise. Prior research suggests that warnings contain incremental information beyond actual earnings; warning firms tend to experience permanent earnings decreases. This paper investigates whether compensation committees take warnings into account in setting CEO compensation. We find that warnings are significantly negatively (positively) associated with CEO bonus (option grants), suggesting that compensation committees adjust CEO compensation towards a more high‐powered structure after warnings. However, the sensitivity of bonus or option grants to earnings and stock returns is not affected except for bonus sensitivity to stock returns. We also find weak evidence of an increase in forced CEO turnover after warnings, accompanied by a significant increase in its sensitivity to stock returns. This benefits CEOs with higher ability but imposes more risk on other CEOs. These findings provide a partial explanation of why not every CEO facing a negative surprise decides to issue a warning. Our results are robust to various specifications. In particular, the impact of warnings on compensation appears invariant to the timing or the number of warnings. Overall, these findings suggest that the signal from warnings is used in determining CEO compensation and retention.     

Firm Accrual Quality Following Restatements: A Signaling View

We consider whether and how firms improve their financial reporting credibility following a restatement by comparing two alternative views. The compliance view predicts that firms simply correct errors to comply with regulations; the signaling view predicts that improvements are broader to allow firms to signal higher reporting quality and thereby reduce information uncertainty. We find that accrual quality improves significantly following the restatement and that this improvement is observed for both earnings and non‐earnings error restatements. We also find that the extent of real earnings’ management decreases significantly. Further, we find that improvements in accrual quality are higher for firms with CEO turnover and higher incentives to improve, but lower for firms switching to an auditor of lower quality. Collectively, our findings suggest that firms signal improved reporting credibility following a restatement through higher accruals quality and lower real earnings management.