Executive Summary:
Market Penalties on Firms and Their Management for Aggressive Accounting
A significant increase in earnings restatements over the last few years has caused concern for regulators, practitioners and executives. Since the Securities and Exchange Commission (SEC) prioritizes whom it will investigate— each and every violator cannot be prosecuted given the SEC’s limited resources. In the study “The Reputational Penalty for Aggressive Accounting: Earnings Restatements and Management Turnover,” accounting professors Hemang Desai and Chris Hogan of SMUCox and Michael Wilkins of Texas A&M shed new light on the way in which corporate boards and the labor market penalize executive level management of firms reporting restatements.
Background
The quality of earnings and financial reporting has eroded in the 1990s, as evidenced by the proliferation of earnings restatements. Of particular concern is the extent to which managers’ actions are adequately monitored. Prior research on penalties associated with aggressive accounting did not find a high management turnover rate associated with the revelation of GAAP violations, which has contributed to a popular perception that managers often “get away” with earnings manipulation and/or corporate fraud. In this new research, the reputational consequences, measured by management turnover and subsequent re-hiring, are investigated for top managers of firms that restated their earnings in 1997 or 1998.
For many reasons, the incidence of and penalties associated with aggressive accounting are expected to be greater in the 1990s relative to earlier time periods. The increased use of stock-based compensation in the ‘90s provided more incentive to manipulate earnings. “Another dynamic is that much of the assets of today versus earlier periods are intangibles such as brand image and intellectual property,” Desai said. “Previously there was relatively less subjectivity in measurement of assets as the majority of assets were of a more bricks and mortar type. This greater subjectivity allows for more flexibility in accounting practices, and thus more opportunity to manage earnings.” At the same time however, there has been an increase in shareholder activism and a focus on corporate governance and internal controls, which suggests an increase in the expectation that managers will suffer consequences for negative behavior. While on one hand, governance was improving as well as internal controls, on the other hand, the incentives to manipulate were high. It may come down to a cost-benefit analysis. “Our sense is that by managing earnings these firms believe the market may be fooled,” suggested Desai. “And if the penalty is not too high, then rational managers may engage in earnings management. Lack of evidence from prior research about lack of significant consequences for the managers seems to suggest that previously costs were lower for engaging in these types of actions.”
Findings
This study documents that the firms announcing restatements in 1997 or 1998 are smaller, less profitable and more leveraged than their industry peers prior to the announcement of the restatement. Mean market equity value is $871.41 million, and the average age of restating firms is 7.6 years. Negative stock market performance occurs prior to the restatement announcement, and firms continue to perform poorly in the year following the restatement announcement (the average market-adjusted return is –19.25%). In addition, there is a significant negative reaction on average to the announcement of a restatement—a cumulative abnormal return of –11% from the day before to the day after the announcement. The large decline in market value upon the announcement of the restatement suggests that the market is imposing significant penalties on the firm. In such circumstances, it may be optimal to effect a managerial change to restore the faith of the investors in the firm and try to recover the firm’s reputation.
Results of the management turnover analysis indicate that earnings restatements are very costly for the managers of restating firms. In 60% of firms that announced restatements (87 out of 146), at least one senior manager —Chairman, CEO or President—lost his/her job within 24 months of the restatement announcement. This is significantly higher than the turnover rate of 35% over the same period for a group of comparable firms (selected based on firm age, size and industry). The significantly higher turnover rate for restatement firms still holds even after controlling for other factors related to management turnover (e.g. poor performance, bankruptcy, management entrenchment, etc.).
Managers Movements Post-Partum
Anecdotal evidence as expressed by a group of Dallas 200 executives showed that once tainted by accounting scandal, a manager or executive’s reputation suffers and makes them less likely to get comparable employment. Desai commented, “Often times these firings are sugar-coated, inducing resignation. But the labor market also imposes subsequent consequences through not re-hiring the offenders or not providing the same level of employment.” Such costs seem to be substantial as related by the following recent report:
"A sacked CEO, says Tom Neff, chairman of Spencer Stuart and doyen of America's recruiters of chief executives, 'may be literally unemployable.' He is extremely unlikely ever to run another public company, although he may be able to 'hang on to a board or two' as a non-executive, or to gain a seat on the board of a couple of unimportant companies. Hardly anyone returns from the dead." (The Economist, Oct. 25, 2003, p. 13.)
Based on a very thorough search for subsequent employment for the displaced managers, the research finds that only 17 out of 114 (15%) displaced managers of the restatement firms secure a comparable position at another public firm. This is even more significant given that the average age of the CEO in the restatement firms is 49 years and the average tenure with the firm is 6.5 years. This re-hire rate is benchmarked by comparing the subsequent employment opportunities for displaced managers of other firms (control firms) that are similar in characteristics to the restatement firms. For firms having no restatement, we find that the re-hire rate for their displaced managers is 27% (17 out of 63). An additional fifteen of the sample firm managers (13%) were employed either at private firms or at public companies in various capacities other than the top three positions. Overall, a total of 32 (out of 114) of the displaced managers are able to find some form of employment following departure (28%).
A restatement significantly reduces the likelihood of subsequent employment for the displaced manager. Thus, the managerial labor market imposes a severe reputational penalty on the restating firms’ managers. Given that the SEC did not pursue all of the violators in the sample (SEC initiated actions against only 34 firms out of 146), the evidence suggests that the private penalties have the potential to serve as partial substitutes for governmental enforcement. Restating firms also experience an increase in the proportion of outside directors and the ownership of 5% and greater blockholders following restatement, suggesting that these firms are taking steps in addition to replacing top management to restore investors’ confidence.
Conclusion
There are significant negative personal consequences for failing to adhere to GAAP or for aggressive interpretation of GAAP, which mitigates some of the widespread concern that managers get away with earnings manipulation. The findings show that once earnings manipulation is discovered, in the majority of cases the board’s reaction is quick and decisive. Subsequently, the external labor market also imposes significant reputation-related penalties on the managers as indicated by the significantly lower re-hire rate. Managers of restating firms incur significant losses in power, prestige, reputation and, presumably, financial wealth for violating or aggressively interpreting GAAP. As suggested, private penalties may serve as partial substitutes for public enforcement of GAAP violations, thereby potentially reducing the costs of enforcement. An increased awareness of the penalties imposed coupled with recent regulatory and legal actions have the potential to influence managerial actions—consequently reducing the incidence of aggressive accounting or outright fraud. |
