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Painful though they are, company restatements spur similar misreporting by others, study finds

Professor: “In a sense, restatements serve as handbooks of trickery.”

That misstatement of earnings represents a serious blot on corporate management cannot be disputed: company announcements of earnings restatements have been shown to occasion such painful consequences as sharp drops in stock price, heightened borrowing costs, and executive dismissals, not to mention increased chance of legal and regulatory troubles. Indeed, restatement announcements affect the shares not only of the firm in question but those of its industry peers, investors reasoning that they are tarred with the same brush.

But investors may not know the half of it, some new research suggests. Despite the pain associated with them, restatements actually prompt peer companies to misstate their own earnings, according to a study of thousands of firms to be published in the November issue of the American Accounting Association journal The Accounting Review.

The authors – Simi Kedia of Rutgers University Business School, Kevin Koh of Nanyang Business School (Singapore) and Shivaram Rajgopal of Columbia University Business School – believe their paper to be "the first to document that peer firms begin managing earnings after an earnings restatement is announced by target firms in their industry or in their metropolitan statistical area [MSA]."

Terming this spread of misconduct "public contagion," they distinguish it from what they call "contemporaneous adoption of earnings management." As they explain, "If the peer firm begins earnings management....when there is no public knowledge of misconduct at the target firm, it is likely due to similar economic pressures to misrepresent or from private knowledge of such practices [that] could be obtained from a common tax auditor's office or common board member...Hence, we rely on a significant increase in the likelihood that a peer firm begins misrepresenting after the announcement of a restatement by the target firm as evidence consistent with [public contagion]."

To make sure of this, the professors control for contemporaneous adoption in their research design.

Asked for an example of public contagion among the firms included in the study, Prof. Koh cites the case of America Service Group Inc., a large healthcare provider that restated its earnings after revealing manipulation of almost $2.5 million over the course of five years. Within two and a half months of this restatement, three firms in the same industry began to manage earnings, according to starting dates specified in subsequent restatements of their own – Metropolitan Health Network Services, Hooper Holmes Inc., and AMN Healthcare Services Inc.

“Of course, where just a few firms are involved, the link may be coincidental,” Prof. Koh says. “But for our sample as a whole, consisting of thousands of firms, the chance that the public contagion we have documented was just a coincidence is extremely slim.”

Still, the tendency of firms to imitate publicly announced misreporting could sometimes be thwarted. In the words of the paper, "restatement announcements accompanied by SEC enforcement actions or class-action litigation are not associated with contagion in earnings management."

Moreover, in the course of the 12-year period covered by the study, "contagion both at the industry and the MSA level disappears in the three-year period following the passage of the Sarbanes-Oxley law of 2002, presumably because of the implementation of a stricter regulatory framework...Interestingly, there is some evidence that industry-level contagion reappears in the 2005-08 period. We conjecture that questionable reporting practices resurface after the initial sting associated with the post-SOX regulatory regime has abated.”

Comments Prof. Rajgopal, "Painful though restatements are, they regularly fail to deter other firms from misreporting unless they face the prospect of additional pain at the hands of regulators or litigants or a heightened fear of being caught that evidently existed in the years following the passage of Sarbanes-Oxley."

Indeed, restatements appear to provide something akin to a learning opportunity for peer companies, the study suggests. "A pattern we saw frequently," the professor says, "was for peer firms to follow the lead of announcement companies in what they misreported and how they misreported it. Thus, if an announcing firm misstates revenues, peers commonly do the same – and so on with other ploys, whether they involve expense accounts or inventory or something else. In a sense, restatements serve as handbooks of trickery.”

The paper's findings emerge from an analysis of restatements in a large database of companies during the 12 years from 1997 through 2008. Restatements or their absence were examined firm by firm, year by year, with the data totaling 57,288 firm-years. Unusual though formal restatements are, the number of firms that issued revisions to correct income overstatements totaled 2,376.

Overall, the professors found the onset of companies' earnings manipulation to be strongly related to the percentage of firms in the same industry or the same locality that had announced restatements during the prior 12 months. But, as indicated earlier, no significant relationship was found in analysis limited to the three-year period following enactment of Sarbanes-Oxley or in cases where prior restatements spurred SEC investigations or class-action lawsuits. In addition, no contagion was found from the most severe misstatements, as such cases, the study notes, “seem to elicit a ‘we would never do that’ response from peer firms.”

The authors see their paper as being of potential value to regulators through its elucidation of “the channels through which earnings management spreads.” Since the SEC investigates only a fraction of restating firms, they observe, “it is crucial that the firms they do target deter other errant firms…The variation in contagion by the severity of restatements as well as the characteristics of the restating firms point to the potential for enforcement agents to tailor their efforts to mitigate contagion more effectively.”  

Adds Prof. Rajgopal: "Our study should resonate with all those involved in overseeing corporate financial reporting, whether as regulators, auditors, or corporate directors. Hopefully, it will also prompt some serious thinking about why the SEC budget has remained as flat as it has. Just as tax collectors calculate a tax gap – the difference between what is collected and what should be collected – maybe the SEC ought to promulgate a fraud gap – the difference between what firms are reporting and what they should be reporting – to emphasize the high priority deterrence ought to have.”

Entitled "Evidence on Contagion in Earnings Management,” the study is in the November issue of The Accounting Review, published every other month by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Auditing: A Journal of Practice and Theory,  Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, and The Journal of the American Taxation Association.