character&5xics of firms correcting...

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Journal of Accounting and Economics 11 (1~89) 71-93. North-Holland CHARACTER&5XICS OF FIRMS CORRECTING PiREVIIBUSLY REPORTED QUARTERLY EARNINGS* William ” Kxhl”J?Y, Jr. j/ #Universig of Texas at Austin, Austin, TX 75712-1172, iJSA Linda S. McDANPEL University of Washington, Seattle, WA !%I 95, USA Keceived May 1987, final version received July lY88 This paper analyzes economic characteristics of firms that correct previously reported quarterly earnings. The basic findings are that, relative to their industry, the sampk-: (correcting) firms are smaller, iess proti?ab!e. have higher debt, are slower growing, and face more serious uncertainties. Their average stock returns between the issuance of erroneous quarterly reports tnd their correction are negative. Also, correction disclosure frequently piecedes SEC or stock:lotder suits against firm management. Results are consistent with predictions based on the economic interests of management and their airditors. 1. IrPtmduction Detectior ax! correction of material error(s) are central to auditing anit the interpretation of i;rtb!ished financial Y.I__, =+atPments. The Auditing Standards 5oard (ASB), F.GB, and SEC each exert some influence over S&I error and each is ccncerned with the level at W&&t error izhaed as ‘material’ is set. For exZiiiipk, the SEC’s Accounting Series hxase (ASK) No. 177 regulates correction of errors in quarterly earnings of pub!ic firms that are discovered by the time of the annual report. Yet little is known asbout the incidence and magnitxde of error corrections that have been repcxled tinder existing prac- tices or their effects.’ *We gratefully acknowledge the insightful comments and suggestions of Mary Barth, Vie Bernard, Bob kipe, Michele StantJn, Dave Wright, n?j Bail, and Dan Collins (the referee), the I;nancjal suF;lor? of the Price Waterhouse Foundation, and the research assistants of Ch+tine ?&her. ‘Several recent s&&es have documented characteri,tics of accounting errors discovered by auditors and {corrected before public release of year-end statements [Kinney (1979), Johnson et al. (Isal), %ylas and Ashton (1X2), Ham et al. (1985), Willingham and Wright (19853, and Kreutzfeldt and Wallace (19&Z)]. These studies provide evidence on distributions of accounting errors and the ability of auditors to detect them. However, #hey do not address the nature, mag,niiude, or circumstances of accounting errors that have appeared in published financiai statements and were subsequently corrected. 01’65-41Ol/SS/S3.ja~ 1439, Elsevier Science Publishers B.V. (North-Holland)

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Page 1: CHARACTER&5XICS OF FIRMS CORRECTING PiREVIIBUSLYhomepages.rpi.edu/home/17/wuq2/yesterday/public_html/restatement reference...This paper analyzes economic characteristics of firms that

Journal of Accounting and Economics 11 (1~89) 71-93. North-Holland

CHARACTER&5XICS OF FIRMS CORRECTING PiREVIIBUSLY REPORTED QUARTERLY EARNINGS*

William ” Kxhl”J?Y, Jr. j/

#Universig of Texas at Austin, Austin, TX 75712-1172, iJSA

Linda S. McDANPEL

University of Washington, Seattle, WA !%I 95, USA

Keceived May 1987, final version received July lY88

This paper analyzes economic characteristics of firms that correct previously reported quarterly earnings. The basic findings are that, relative to their industry, the sampk-: (correcting) firms are smaller, iess proti?ab!e. have higher debt, are slower growing, and face more serious uncertainties. Their average stock returns between the issuance of erroneous quarterly reports tnd their correction are negative. Also, correction disclosure frequently piecedes SEC or stock:lotder suits against firm management. Results are consistent with predictions based on the economic interests of management and their airditors.

1. IrPtmduction

Detectior ax! correction of material error(s) are central to auditing anit the interpretation of i;rtb!ished financial Y.I__, =+atPments. The Auditing Standards 5oard (ASB), F.GB, and SEC each exert some influence over S&I error and each is ccncerned with the level at W&&t error izhaed as ‘material’ is set. For exZiiiipk, the SEC’s Accounting Series hxase (ASK) No. 177 regulates correction of errors in quarterly earnings of pub!ic firms that are discovered by the time of the annual report. Yet little is known asbout the incidence and magnitxde of error corrections that have been repcxled tinder existing prac- tices or their effects.’

*We gratefully acknowledge the insightful comments and suggestions of Mary Barth, Vie Bernard, Bob kipe, Michele StantJn, Dave Wright, n?j Bail, and Dan Collins (the referee), the I;nancjal suF;lor? of the Price Waterhouse Foundation, and the research assistants of Ch+tine ?&her.

‘Several recent s&&es have documented characteri,tics of accounting errors discovered by auditors and {corrected before public release of year-end statements [Kinney (1979), Johnson et al. (Isal), %ylas and Ashton (1X2), Ham et al. (1985), Willingham and Wright (19853, and Kreutzfeldt and Wallace (19&Z)]. These studies provide evidence on distributions of accounting errors and the ability of auditors to detect them. However, #hey do not address the nature, mag,niiude, or circumstances of accounting errors that have appeared in published financiai statements and were subsequently corrected.

01’65-41Ol/SS/S3.ja~ 1439, Elsevier Science Publishers B.V. (North-Holland)

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72 W. R. h’inney, Jr. and L.S. McDaniel, Earnings correction characteristics

Knowledge about the nature and effect of error corrections in published financial statements is i:mportant because the errors reflect judgments about allowable imprecision in the extant public reporting system. Allowable impre- cision partially determines the value of the system as a means of providing information about firms, a basis for contracting, and a basis for monitoring managers. If allowable Cmprecision is too high, then the system’s value will be lo-w. Also, since audit cost of discovering possible errors is a decreasing function of allowable imprecision, it affects costs. If allowable imprecision is too low, then audit cost:; will be excessive.

In this paper we analyze errors that were discovered in quarterly earnings after their release and corrected in year-end statements. Specifically, we present summary statistics from 73 firms on 178 errors in quarterly earnings that were discovered and corrected under ASR No. 177 from 1976 through 1985. and statistics on economic characteristics Cn~luding stock returns) of the firms disclosing the errors.

Three conditions must precede a year-end financial statement correction of interim earnings. First,, the firm must issue quarterly financial s?atements containing accounting error. Second, management or the auditor must di,s- cover the error prior to ,the audited annual statement’s release. Third, manage- ment or the auditor must decide that public disclosure of the error is desirable or necessary.

The first condition implies a serious breac” of a %m’s internal control system (or an attempt by management to n&lea, rear ;rs CC the statements) and the second requires a technology for quarterly _ ‘-XI. The third condition implies that management, the auditor, 3. _ _ _ de that the consequences of error disclosure outtieigh the expected I ns+aen,ces of failure :o disclose. These implications form the basis for exn :ations of the disclosing firms’ characteristics.

Tbe anaiysis shows that reported corrections t,ei~I to be in statelments of companies that are smaller than the mean (and median) for their industry which may indicate poor internal controls. However, they are also less prof- itable, have relatively more debt, have lower growth, and receive more uncer- tainty-qualified alrdit opinions. These latter associations are consistent with interim ‘window dressing’ by management of financially weak fbrms, and/or auditors being more stringent in requiring correction of errors of firms with greater risk of failure, implying greater risk of stockholder lawsuits against the auditor and less growth il\ audit firm profits. Also, average stock returns between release of the orignal (misstated) report of quarterly earnings and disclosure of the misstater.?:ieat are nr,gative. The dechz was much larger for those tba: overstated quarierly earnings, and about 90% of the decline takes place prior to the first public disciosure of the correction. Thus, stock price declines may have linffuenced detection probabihties and the disc?ssure deci- sion.

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W. R. Kinney, Jr. and LS. McDaniel. Earnings correction characteristics 73

The next EY-‘?~ describes relevant regulations with respect to reporting corrections ot ;~ 8erly earnings and the bases for expectations about reported corrections. Section 3 outlines sample selection procedures and data sources, while section 4 presents descriptive statistics including Plnancial characteristics of the sample firms. Section 5 elaborates on section 4 by relating correction magnitude and sign to stock price performance. Finally, the last section presents a brief summary.

2. Regulations and expectations

2.1. Regulation of errors in quarterly statements

Interim reporting by management and attestation by auditors are regulated by the SEC, the FASB, and the AFB. These regulations are related and are of fairly recent origin. Beginning in 1970, the SEC required all registrants to report summarized quarterly financial information on form 10-Q. Initially siich reports did not involve auditors. Later, the Commission’s concern with reliability of these reports led to adoption of ASR No. 177. EFfective for firms reporting after December 23, 1975, the release required management to reconcile quarterly data in audited form 10-K (annual report) to amounts previousiy reported on form 10-Q (if different) and to disclose the reason for any dirTerence. Management was also required to include ‘the aggregate effect and the nature of year end or other adjustments which arc material to the results of that quarter’ [regulation S-X, item 302.(a)(3)]. In a related statutory deveiopment, the Foreign Corrupt Practices Act of 1977 established a require- ment that public firms maintain cost-justified internal accounting controls. The act extended the SEC’s authority to include accounting controls, focused attention on such controls, and made management legally liable for material control w’eaknasses.

In Statement of Financial Accounting Standards No. 16, the FASB set forth criteria for restatement of prior period’s information (including interim data) due to error corrections. The pronouncement, effective June P9?7, repeats criteria ?om Accounting Principles Board Opinion No. 28 (1973) that required disclos;ure of adjustments made to interim reports when the quarterly effects could be isolated and are material to quarterly income.

Tile Auditing Standards Board has issued five Statements on Auditing Standards @AS) regulating auditor association with interim information. The first two regulations, SAS No. 10 (December 1975) and SAS No. 13 (May 1976) related to interim footnotes issued with the audited annuai statements but did not require review procedures to be: conducted prior to the annual audit. SAS No. 24 (March 1979) ad SAS No. 35 (April 1981) modified and expanded guidance related to auditor reporting at k:etim dates. Finally, the auditor’s responsibihty for interim information incorporated in an SEC filing

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74 kV. R. Kkney, Jr. and LS. McDaniel, Earnings correction characteristics

is outli:led in SAS No. 37 (April 1981). SAS No. 37 makes explicit the auditor FC sponsibility to report any departr;res from generally accepted accountmg principles with respect to such interim information whether or not it had been reviewed and reported upon prior to year end.

In summary, management is require9 io report material differences in interim information previously reported and auditors are required to apply limited review procedures to determine whether quarterly statements contain material departures from GAAP.

2.2. Bases for expectations 9f error

For correct,ions to appear in a year-end Snancial statement footnote, three conditions must be present: (1) a ‘material’ error must occur in the account- ing/quarterly reporting process and not be detected by extant internal ac- counting control or by the auditor’s contemporaneous quarterly review (if applied); (2) it must be discovered by management or the auditor prior to the audited annual statement’s release; and (3) management or the auditor must de&de thar &L 7 ‘. rdrt~rivll i.3 \tdiidis:i.i, - I_ .._..,_,, 71&

The first two conditions are straightforw,ard and involve no complex legal or economic issues. The propensity to err (condition 1) and the ability to detect error before quarterly reports arc issued (condition 2) vary with the nature of a firm’s business, current bzsiness conditions, the integrity of management, the quality of its internal accountixag control, and, perhaps, audit technology. For example, managements of firms in weak financial condition are more likely to ‘window dress’ in an attempt to disguise what may be temporary difficulties.

Firms with weak controls should have higher probability of occurrence of material error. Sr,lall firms might be expected to have weaker controls for two reasons. First, Pzirge firms are more likely to have an internai au& stall whose audit activitie? might reduce the incidence of errors in reported quarterly earnings [Maatz et al. (1980, pp. &C-66)], while small firms are more likely to rely on the e;i;ternal auditor for quarterly error detection ex XE~. SLY&, size is commonly beiiuved to be correlated with internal csiitrol quality [e.g., see Mautz et al. (1980, p. 69)]. However, prior empirical studies find no consistent significant sssociation between ‘error’; detected by external auditors and firm size [Johnsc~n et al. (1981, pp. 274-275), Ham et al. (‘1985, p. 402), Willingham and Wrigh (1985, p. 68), and Kreutzfeldt and Wallace (1986, p. 3&j. Thus, any associs,tion of corrections with size may not be dale to control quality per se.

Audit &ms may differ in their ability IQ detect &statements in quarterly earnings. Fllr exam$e, since 1971, DzPoitte Haskins and Sells (M-IS) has used regression imalysis to search for unuual fluctuations jn a~rr~fino rj~fa fhr --- ___.L”““D _W... I.,1 ‘internals within the (audit) perio8’ [Strirgl- I L* (1075, p. 5)]. There were about lG,GGG regression apphcatior!s in I974 [Stringer (1975, p. S)] and DHS was the

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W. R. Kinney, Jr. and LX McDaniel, Earnings correction characteristics 75

only major firm systematically using regression analysis for such a purpose throughodt the sample period. Further, a Fortune article describing increased competition among auditors indicates recognition that the DHS regression system was ‘understandably d&rent from auditing techniques cf competitors and that competitors recognized DNS as ‘strong auditors’ [Bernstein (1978,

P. 931. The third condition invoives more subtle considerations. Correcting an error

jn quarterly data may entail legal liability for management since, defac;o, they admit that information asserted to be free of material misstatement (i.e., the IO-Q filing) was in error. Kellogg (1984) analyzes lawsuits based on allegations of material misstatements in filings under the securities acts and &id.< courts enforce penalties based on such misstatements. Public disclosure of errors in IO-Q’s increases stockholders’ awareness of such misstatements. Thus, the smaller the misstatement, the more we would expect firms to resist disclosure and correction of errors discovered in interim inron,lation and to try to persuade auditors to allow such nondisclosure. This is especially relevant for overstatements of earnings and assets since allegations of overstate,:rents predominclte as the basis of lawsuits [Kellogg (1984)].

Auditors, on the other hand, :?so Lee liability and loss of profess:mal reputation if their contemporaneous quarterly reviews fail to detect mrL:fial error or if the auditor detected material error but did not require correction and did nc;! modify the audit report, Yet, the auditor may lose the client if they are too stringent in requiring disclosure of minor errors. Consequences of client loss would depend on the client’s prospects for future profit to the auditor. By requiring error disclosure for a c1 .ient that has pvor prospects for future audit profit, the audit firm may have little direct cost and may increase the value of its reputation as an effective monitor. That is, by association with a correction, the audit km .may signal i.ts ability to detect financial statement errors and its independence or willingness to require their disclosure [see Watts and Zimmerman (1986, cfn. 1311.

Thus, isoth management and the auditor face trade-ofI2 i;_ dcci”,kg zk:h:.r to disclose errors discovered in interim information. Management and the auditor can be expec+:d to balance costs and benefits of disclosure agakrst the probability and cost of subsequent disco7.e. y by outsiders weighted by the probability of discovery. For the a nditor, COEDS of subsequent discccery of material errors would inciude loss of nr&:r:onal reputation for competence and independence and a reduction Lr the c;. .;2 audit firm’s value ds a monitor [Benston (X9515)].

However, not all malerial errorc Elected will result in correction since. according to professiona! standards, the autlitor should consider possible benefits of disciosure to users [SAS No. 36, SAS NO. 37, 2nd SAS No. 1. section 541.O.Q Factors !o bc considered are the importance of thz matter and the tune elapsed since the statements were issued. Thus, the existence of

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76 W.R. Kinney, Jr. and LX McDaniel, Earnings correction characteristics

footnote disclosure of error implies that management and/or the auditor believed that the matter was sufficiently important to their own interests to report tbc error. That, is, disclosure of the error must have been viewed by either 0r both parties as the I0west expected cost akrnative available at the time of disclosure.

Over the period 1976-1985, it is plausible to expect the rate of correctiorrs ~5 vary based OR the regulations and phenomena discussed above. Joint effects of th’z FCPA of 3’7’7, with its focus on internal accounting control, and audk2rs’ increasing involvement with contemporaneous reviews of interim state_,rerits should le:ad, over time, to decreases in the number of corre0ti~~~s at year errd. On the other hand, one might expect an increase in correct!--: frequency toward the end of the period due to joint eiTects of (a) S.G No. 5 (April 1951) establish&g a duty for auditors to report on GAAP departures dfscsvered subsequent to a.c ii%etiiz ii&W of the data, (0) poorer ecorror3ic conditions in? x952-1983 leading to increased probability of business failure and suits against auditors, and (c) pending Congressional investigation of the SEC and accountants. Perhaps mitigating these three factors is the effect of changes in the competitive ewinxment of auditing during the period, Other things equal, pressure on auditors to acquiesce in nondisclosure is likely to increase after anticompetitive provisions of the auditors’ ethics code were relaxed in 1978. Specifically, relaxation of advertising prohibitions and deie- tion of client s0hcitatioz prohibitions may have increased auditors’ willingless to acmmzodate management’s wishes, thus a ieduced incidence of public corrections might be expected after 1978.

In the work to follnw, we report characteristics of firms that met the three conditions required for corrections ‘0 be observed, the nature and magnkde of the errrxs, economic characteristics of the firms, induding stock returirs from the issuance cf the tkt quarterly report in error to correction and restatement in the annual report footnote, In deciding which characteristics to expiore we consider the economic implications of the three conditions required for disclosure.

ASR No. 117 has been ins e&t Smce 4976. Thus, there are more than te7 years of data on its ekkcis. The foD.owing procedures were used to identify reports with year-end restatement of previously issued quarterly financiaf statemEI?s:

(3) The Nationa Automaed Acwuntin g System (NAARS) data base of ---

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W. R. Kinney, Jr. and LS. Mdsniel, Earnings correction choracte.~&cics _I

il

within a footnote or segment that referenced either QUARTERLY or INTEFUM. A tot& of 1,171 firms were idectitied.

(2) Fsotnotes -:. f the identified firm were reviewed to eliminate alh restatements that related to other than error corrections (such as changes, in estimates, changes in zccou;inting methods, and tax reallocations) or that did not result in changes sufficiently material to restate quarterly amounts. This reduced the sample to 94 5. ms

(3) Firms whose quarterly ad;-. ZWZI~~ pertained r\nXy to the fourth quarter were eliminated to insure i_ ,,; z&stated earnings had been publicly disclosed,’ The resulting s:~%p:e was 83 firms,

(4) Finally, eight firms whose restatement related to a prior fiscal year were . .

ehmmated as were two firms whose errors -were mo;~ thzz forty turres thr: reported quarterly earnings amounts. Prior year restatemen& were e!inG- nated since they may represent a different level of materiality for detectins+ and correction from that for within-the-year errors. The lat;er two firms were eliminated as extreme outliers. A sample of 73 firms (178 q;larters) resulted.

Disciosure dates for each quarterly and annu a! :ep~rt were obtained from ::;e Wabi Street Journai Index and the We211 Sapeet fournai. Earnings amounts WLYC compared to hAARS_ Closing stock prices for three dates (described below) were obtained from Standard 8r Poor’s Daily Stock Price Record as were cash dividends and stock splits,

For each firm quarter, cumulative stock returns were compuzd hop two time periods and their sum. Return period 1 preceded pabbc disclosure of the error. It began two days after tke first erroneous quarterly report reiease date autl ended with the e&icr of the day prior to a pnbiic announcement of the errer (fo;r firms) or the audit report date [,109 ffrms). The auditor’s report is ordinarily dated at the close of au&t worir aim the cfient s ofices. While the decision ,o disclose mzy Eat have been made ;s 01 p t=!?*d end of ret-urn period 1,

the auditor and management Ibut aot the market) pr&abk$ knzw of ths tin-or. One or b&h could observe the stwk pmx gaf,-rz--~r;~ze & !ke 6.~ ptiw :a-*

that date and price performance could influence the deciGo,n io disclose. P.et.t~.rn period 2 began at the end of period I and ended five days after the

SEC’s date reeweu &amp on the annual for533 10-M Ming. Period 2 iikely contains the market’s reaction zc1 the correc::ion(s) T;?P 46’ since it c&s after public annoamcement. We did g%~t ar&mpt 5&ier ;>;r titicXning of the return petiod since it was not possible to d etern3in.e the release ddbe for the full te.xt of the armual report (aa4 the interim earnings error footnote). Thus, for mosi of the sample, it was 3334 passiSle to deterr&ne the date of first pub?ic

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78 W. R. Kinney, Jr. and LS. McDaniel, Earnings correction characteristics

disclosure of the error. Return period 1 accumulation period averaged 160 trading days and ranged from 61 to 236 trading days. Return period 2 averaged 11.9 days and ranged from one to 98 trading days.

Since ail fourth-quarter restatements were excluded, the period of return accumulation varied from about six to almost twelve months. To adjust returns for market-wide events, equaily-weighted market retturns for each time period from the daily CRSP file were subtracted from iirm returns. That is, the market return adjusted cumulative ‘abnormal’ returns CAR, = Ri, - Wmr, where R;, and R,, denote return for firm i and the market, respectively, for period t. Returns were not adjusted fc differences in systematic risk due to t!le predorntinance of over-the-counter (OTC) firms in the sample and the re;la:rd di@cuity of obtaining systematic risk estimates.

Size, pro%abil.ity, risk, and growth measures based on accounting data were collected from the NAARS tile. For comparison, an industry portfolio was formed for each sample firm. The industry portfolio comprised all firms with the same four-digit SIC code listed on the combined primary and OTC file of COMPUSTAT for the year of the error. Standardized ‘z ’ scores [i.e., (firm amount - industry mean)/industry standard deviation] and medians were then calculated for each measure. Data on lawsuits were obtained from the Wall Street Journal and bond prices and ratings were obtained from Moody’s Bond Record.

4. Descriptive statistics

Table 1 presents statistics describing the sample firms’ industries and correction frequencies. It begins (panel A) with observation frequencies by fiscal year and by quarter. Sample observations are diversified across the ten years [&i-square@) = 6.04: p > 0.51. Thus the nominally higher incidence during 1977-78 and 1933-84 may be due to chance and not the efIects of rule changes.

Corrections by quarters are also rather diversified. The tendency for errors to affect more than one quarter within a year is reflected by the fact that there are 2.44 quarters corrected on the average. Fifty-one of the 178 of the sample errors (29%) are in the first quarter, with 34% in the second and 37% in the third. For 51 (69.9%) sample fhms the first quarter is the initial quarter in error, for 14 firms the second quarter is the initial quarter, and for 8 firms it is the third quarter.

Tbe higher frequency for the first quarter as the initial quarter in error is rrobebly due to the application of different magnitude criteria for correcting errors in prior audit years. Errors may first occur by chance, but once an error in a quarterly statement is discovered, the auditor (or management) is likely to search subsequent and prior quarters for the ;anre error type. However, auditing standards allow greater discretion as to whether prior years’ siate-

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79

Distribution of corrections over time and industry.

Bv Fiscal Yem

By firm By El-m quarter

Frequency % Frequency m 10

1976 1977 1978 1979 1980 1981 1982 1983 ,001 L7”T 1985

6 11

8 5 6 7 5 8

11 6

73 zr.=

8.2 1j.i 11.0 6.8 8.2 9.6 6.8

il.0 12 1 _.,.A 8.2

100.0% =

15 8.4 25 14.0 18 10.1 9 5.1

13 7.3 16 9.0 14 1.9 24 13.5 79 16.3 15 8.4 - - -

178 K!O.O% = -_1

2-digit SIC code

2-digit frequercy

10 12 13 20 27 28 32 33 34 35 36 39 42 45 47 48 49 50

51 54 56 58 60 61 63 65 70 73

Metal mining Coal & IigniLe mining Crude petroleum & natural gLs Food & food products Pubhshing & printing Chemicals & drugs Glass & pottery Steel & steel products Metal & metai products Machinery Electric & electric supplies Toys & amusement Trucking Air transportation Transportation services Communic2tions XaturaI gas transmission/services Wholesale - metah, equipment, and

durables WhoIesale - food & drugs Retail - grocery stores Retail - apparel Retail - eating p!aces Banks Savings & loans litsuranice Real estate Motels Service industries

1 1 5 4 3 1 2 2 1 5 8 1 1 1 1 1 5

2 2 1 1 1 5 2 5 5 1 5

75 =

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80 W. R. Kinney, Jr. and LS. McDaniel, Earnings correction characteristics

ments should be corrected [SAS No. 1, section 561.051. The error magnitude required for a prior year ‘s corr~:~~ .Z would ordinarily be greater than that for the as yet unaudited state-men’-

Panel I3 cf ?bie 1 prese- ts &r ;;&ribution of firms by two-digit SIC code. Twenty-eight different codes AV represented and only one code had more than five firms. The eight electric and electric supply firms in code 3600 are from five different four-digit codes and the five natural gas/transmission services in code 4900 are from four different four-digit codes. Thus, there appears to be no great concentration in a particular industry.

Table 2 presents summary statistics describing characteristics of firms with error corrections. Of the 73 firms, 44 (‘o 7 ,,.,Sj are traded over-the-counter with the remainder about equally split between the NYSE and ASE. However, OTC firma comptise on!:, nbout 38% of the total NAARS population, while ASE and NYSE firms comprise 21% and 41%, respectively. Hence there is a much higher incidence of corrections for OTC firms relative to those listed on organized exchanges [chi-square(2) = 19.9, p -c O.OOl].

Standardized (z) scores for financial characteristics of sample firms relative to their industries shows the sample to be significantly smaller on all three financial measures of size (net income, revenues, and total assets). They also have higher financial risk as measured by debt to equity and are less profitable per dollar of revenue and equity. Medians are less sensitive to extreme values and analysis of the number of sample firms above and below the industry medians provides the same prcfile. Furthermore, about one quarter of the sample received ‘subject to’ or ‘going concern’ qualified audit opinions indicating auditor concerns about unusual uncertainties for the firms @hi-square(3) = 33.95, p < O.OOl]. Five of these uncertainty qualifications were first-time qualifications indicating increased loss contingencies over the year.

In addition to the descriptive statistics reported in table 2, five other types of data were collected: revenue growth, auditor changes, bond prices and ratings, bankruptcies, and lawsuits against management t&t were based on the misstated quarterly earnings. The Srst is useful in assessing a possible cause of errors since rapidly growing firms may have outgrown their control systems. The second allows assessment of whether successor auditors are more likely to be associated with corrections than are predecessor auditors and whether auditors associated with corrections are likely to be replaced. The third and fourth reflect contemporaneous and subsequent events related to overall firm conditions and the final factor measures a result of the correction.

Five-year revenue growth (ending with the correction year) was calculated for each firm in the sample and for its industry. Revenue growth rates were less than the industry median for sixty of the 73 firms or 82% [significantly different from 0.5 at p < O.OOl]. Thus, as for the other measures, the typical

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Table 2

Selected characteristics of firms dijzlosing corrections of previously reported quarterly earnings (1976-1985).

A. Exchange

Sample -- Sample %/ Frequency % % in NAARS NAAl?§ %

OTC 44 60.3 38.1 1.58 ASE 16 21.9 21.0 1.04 NYSE 0.44

Variable

5 _%a.miq! &mrterisrics qf Sayle Firms Relative to Industry’

Below median z-score

n 54, Mean Std. dev. t P(Oh Min. Max.

Net income Revenues Assets Debt/Equity Net income/

Revenues Net income/

Equity

66 90.4 - 0.276 0.642 - 3.72 0.001 - 1.159 3.000 69 94.5 - 0.254 3.787 - 2.80 0.007 - 2.168 3.000 69 94.5 -0.194 0.804 - 2.09 0.040 - 3.000 3.000 34 46.0 0.20; 1.491 1.27 0.208 - 3.000 3.000

44 60.3 - 0.464 0.997 - 4.03 0.001 - 3.000 3.000

47 64.4 - 0.326 LC62 - 3.48 0.001 - 3.000 3.000

C. Audit Opiniotz

Sample -- Frequency %

49 67.1 6 82

14 19.2 4 5.5

73 100.0 = =

Unqualified Consistency exception Subject to Going concern

% in NAARS

81.3 11.1 6.2 1.4

100.0 ==zz=zz

Sample %/ NAARS %

0.83 0.74 3.10 3.93

‘For panel B, all z-scores whose absolute vahtes exceeded 3.0 were set at 3.0 or - 3.0 as applicable. The frequpncy of replacements by variable are 2, 2, 3, 1, 5, and 5. respectively.

bTwo-sided.

firm is in a weak growth position relative to its Weak position (slow growth) seems to dominate obsolete or outgrown controls as an explanation of corrections reported. uniformly the case, however, since six of the sample firms had z-scores ranging fron 3.3 to 76.4. The sample mean z-score for revenue growth was 0.384 but is greatly influenced outliers.

Three of the sample firms had new auditors in the correction following correction. These annual

J.A.E. E

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auditor change rates (0.041 and 0.027) can be compared with rates computed for the mid-seventies for all SEC registrants of 0.044 and 0.020 [Chow and Rice (1982, p. 328) and Eichenseher and Shields (1983, p. 24)]. We conclude that auditor changes are not an imp ortant exolanatory factor for corrections.

Moody’s Corporate Bond Ratings were collected for the sample firms as of the beginning of the fiscal year in which the correction(s) arose, at the end of that year, and at the end of the year following. Only 11 of the 73 firms had rated bonds with one rated A and one A2. The lowest was Caa with eight having B ratings. Five firms had no changes in ratings and six had a total of eight decreases. Four firms had ratings lowered during the year of the correction with two of these a!so having declines in the following year, along with two other firms that had not had changes. There were no increases in ratings over the two-year period. Bond prices of these same firms declined an average of 8.3% during the year of correction and rose an average of 1.2% in the year following (with two firms deleted due to bankruptcy).

The Wall Street Journal Index was searched for litigation against the sample firms’ managements and their auditors and for notices of bankruptcy. During the year foliowing the first public notice of quarterly earnings correction, four of the firms (5.5%) filed chapter 11 bankruptcy proceedings. Also, during the same period, managements of ten firms (13.7%) were sued by either stockhold- ers or the SEC for misstatement of the financial position of the firm and/or violation of the federal securities acts. One of these suits was filed seven days after the first public announcement of the correction of quarterly earnings.

Charges listed in the suits included: ‘made fictitious entries’, ‘deliberate misstatement of operations’, ‘ filed false and misleading statements’, ‘improper recording of sales’, and ‘inaccurately reported values of inventory, royaities, certain intangible assets and financial position and unauthorized flower ship- ments’. Thus, there is evidence that more than failure of internal controls underlies the issuance of misstated earnings. That is, controls designed by top mangement to safeguard assets and to ensure compliance with generally accepted accounting principles may have been overridden by management itself. Finally, stockholders of one firm sued the independent auditors at the time that ‘millions of fictitious entries were made’. This suit led to a 2.4 million dollar settlement from the auditors.

Table 3 shows that the distribution of corrections by auditors is far from equal IchLsquare(8) = 43.2, p < O.OOl]. Almost 40% of the corrections were made by clients of Arthur Andersen and Deloitte Haskins and Sells. The approximate overall rate per NAARS client per year is 0.0020. When com- pared to the number of clients in the NAARS file, DHS and the non-Big 8 firms as a group are seen to be more than proportionately represented while Price Waterhouse, Touche Ross, and Arthur Young are underrepresented. Binomial tests (two-sided) of whether the sample rates by firm were drawn from a population with a rate of 0.0020 yields probability value of less than

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Table 3

Numbers and rates of corrections by audit firm’ (!Q%-1955).

By exchange

Auditor

Arthur Andcrsen & Co.

OTC

12 0.0048

ASE NYSE Overall

- -

2 2 16 0.0018 0.0007 0.0025

0.783

Coopers % Lybrand 5 2 2 9 0.0030 0.0031 0.0011 0.0022

0.117

Deloitte Haskins & Sells 9 1 3 13 0.0064 0.0023 0.0021 0.0040

2.443b

Ernst & Whirmey 5 0.;5*

1 I1 o.cXI21 0.006 0.0022

0.271

Peat Marwick Main 4 1 2 7 0.00164 0.0013 0.0011 0.0014

- 0.775

Frice Waterhouse & Co. 3 0 1 4 0.0022 0 0.0005 0.0010

- 1.235

Touche Ross & Co. 2 1 0 3 0.0015 0.0014 0 0.0009

- 1.091

Arthur Young & Co. 0 0 0 0 0 0 0 ii

- 2.059h

Non-Big 8 4 4 2 10 0.0023 0.0032 0.0045 0.0029

:.G;;

Overall 44 16 13 73 0.0027 0.0023 0.0009 0.0020

- ‘Entries are number of chenis with corrections, annual rate per NAARS client, and ;-statistic

for binomial test that firm rate equals overall rate of 0.0020. bProbability that firm rate = 0.0020 is less ihan 0.05 (two-sided).

0.025 fez DHS (z = 2.443) and Arthur Young (z = - 2.059) with the others not significantly different from 0.0020 at p < 0.2.3

The extent to which the DHS and Arthur Young rates are a function of the quality of cliem controls vs. stringency of the auditor cannot be determined from the available data. However, comparison of the ranks of thz Big 8’s correction rates with estimates of average systematic risk of client portfolios,

3A more appropriate test would be against the sample rate excluding the tested firm rather than the combined rate of 0.002. Such tests lead to even lower probability levels for DHS and Arthur Young and virtually no change in results for the other firms.

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W. R. Kinney, Jr. and L.S. McDaniel, Earnings correction characteristics

auditor size, technology, and the mix of audit fees to a total fees revealed no significant associations. 4 For example, Peat Marwick, DHS, and Touche Ross have structured audit technologies. Also, DHS clients have the lowest average systematic risk, vhile Arthur Andersen ran!.s fourth lowest and Touche Ross the highest. Finally, DHS clients’ correction rates exceed the exchange average for both OTC and NYSE firms by a factor of two. If control weaknesses are the primary cause of errors and weaknesses are correlated with size, then the OTC rates should be higher. For DHS, at least, this was not the case.

Table 4 presents data on the nature, sign, and magnitude of corrections. Panel A shows that errors are diversified by account with expenses comprising 63.?%, revenues adding 20X%, and a combination of unexplained errors making up the balance. Cost of sales errors are the most frequent, comprising about one fourth of the sample. In panel B the corrections are scaled by year-end (audited) net income and by quarterly net income (as corrected). The sample is reported by quarter and by the sum of all three quarters.

On average, error corrections are negative indicating earnings originally reported were overstated. The sum of the quarterly corrections as percentage of (corrected) net income for the year is -0.152. Twenty-four of 73 sums of corrections or 32% are within plus or minus 0.05, witn 39 or 53% between plus or minus 0.10. Furthermore, for eight of the firms the sum of corrections was zero. This reflects the self-correcting nature of some errors such as an inven- tor== count error at the end of the first or second quarter or a timing error. The average quarterly adjustment divided by annual net income is -0.058, which is slightly higher than traditional 5% of earnings materiality guidelines for annual earnings [Kinney and Burgstahler (1986) and Ho&urn and Messier (1982)].

Materiality guidelines for interim numbers are not specified in the literature. The sample indicates that quarterly corrections relative to that quarter’s earnings are rather large in magnitude and skewed toward overstatement. The mean is -0.833 overall and -0.225 after deleting three outlier quarters that were beyond seven standard deviations. ’ The medians of all three correction metrics are similar, however.

Finally, we consider the association of error corrections in either direction with unexpected earnings. Since the sample firms are generally too small to be the subject of analysts’ forecasts of earnings, we take the prior year’s earnings as expected earnings. ‘Good news’ on unexpected earnings is indicated when current year’s corrected earnings exceed earnings of the prior year and ‘bad news’ is indicated when current earnings is less than or equal to that of the prior year.

4Data were obtained from Kinney (1986).

%IIG~ firms had values less than - 35 due to very low quarterly net income. See table 2 for details.

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P/, R. Kin.q, Jr. and I .S. MrDaniel, Earnings couection charucteristics 8.5

Table 4

Desciiptive statistics on corrections (i976-1985).

A. Correc.ion Frequenq r!y Account

Number Nature of error of firms B

Revenues

Expenses

Timing 4 5.5 Omission I 1.4 Recording procedure IO 13.7 Total revenue Is 20.6

Depreciation 3 4.1 Cost of sales 18 24.7 Taxes 11 15.1 Cczbination of expenses 4 5.5 Other 10 13.7 Total expenses 46 63.1

Both revenues and expenses 8 11.0

Unexplained 4 5.5 75

-- Net income iOO.0

-..- B. Correction: Magnitude

Summary

n Mean Std. dev. Min. Max. - Correction sum/

Net income for year 73 -0.152 0.646 - 3.856 2.005

Correction/Net income for year 178 - 0.058 0.474 - 3.505 2.873

Correction/Net inconic for quarter= 178 - 0.833 5.074 - 44.263 11.389

Decilesb

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Correction sum/Net income for year -0.513 -0.214 -0.125 -0.076 - 0.045 - 0.012 0.001 0.030 0.163

Correction/Net income for year -0.329 -0.125 -0.056 -0.033 -0.017 -0.004 0.014 0.037 0.114

Correction/Net income for quarter - 1.410 -0.436 -0.256 - 1.52 -0.069 - 0.030 0.041 0.202 C.548

aThree firms had Correction/Quarterly net income values that were less than - 35 due to very small quarterly earnings. With these firms deleted, the mean adjustment is -0.225 and the standard deviation is 1.885. The deletions do not significantly affect results for other variables.

bSeventh decile includes eight firms with a zero sum.

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86 W. R. Kmney, Jr. and LA. McDaniel, Earning3 correction charuc:&stics

Table 5

Corrections classified by sign and sign of unexpectl,d earnings3 (19X-1985). _.

A. Correc!ron/Quarterly Earnings Ciass$ed by Urzxpecter: Ea;.zings and Correction Signs

Correction -. -

Unexpected Unaerstatea (Overstated earnings earnings earmn,: Overall

Good news 0.784 - 0.226 0.203 (Y4) (46) (80)

Bad news 0.721 - 2.7% - 1.678 (31) (671b (98)

Overall 0.754 - 1.750 - 3.833 (65) (113) (178)

&i-square(l) = 2.394, Prob. = 0.122

B. Sum of Corrections/Earnings Classified by Unexpected Earnings and Co.vection SIgnr

Correction

Unexpected ea~rnings

Understated earnings

Overstated ear&g- .l Oveiali

Good news 0.243 - 0.088 0.082 (17) (16) (33)

Bad news 0.086 -0.531 - 0.346 (12) (28) (40)

Overall 0.178 - 0.374 - 0.152 (29) (44Y (73)

(X-square (1) = 3.496, Prob. = 0.062 -.-

“Entries are mean (n). bAs noted in the footnote in table 4, three firms had Corrections/Quarterly earnings less than

- 35. With these deleted, the average for this cell is - 1.219. The &i-square va!ue for the table is then 1.812 with p = 0.178. Average error for the 98 bad news firm quarters becomes -0.564 with a standard deviation of 2.108.

‘The adjustment noted in footnote b above does not affect the analysis for the sum of corrections.

Table 5 presents the cross-classification of the sign of corrections and the sign of unexpected earnings. Panel A shows results by firm-quarter and panel B shows the sum of quarterly cor:ections by tirm. Ckerstatements of earnings prpdominate in number and absolute magnitude for both the quarterly and sum of quarterly corrections. Fiowever, *magnitudes differ according to the sign of unexpected earnings. Average quarterly error as a percentage of quarterly net income is more negatke for bad news on unexpected earnings than when there is good news on unexpected earnings. As to nominal cross-classification, independence of unexpected earnings sign and correction sign can be rejected at the 0.122 and 0.062 levels, respectively. The concentrations in both panels is in the ‘bad news and overstated earnings’ zell.

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5. Stock price behavicz

As outlined in section 3, market return adjusted cumulative abnormal returns (CARS) are calcylated from t-:X &i-is c;f? The C:,t CTHOllttc?i'i quarterly

earnings were annsrlnced through the day before the first pubh; announce- ment of the ~sor or the audit report date (return period I j, from that date ;LVLL& five trading days after the 10-K filing date (return period 2). and their sum (combined period). The partitioning allows an assessment of possible causal links between stock prices and corrections as elaborated below.

In table 6 the overall sample of 73 firms is partitioned according to the sign

of correction and/or earnings news. A firm is thus classified as either ‘good news’ or ‘bad news’ on each variable. For example, in panel 3, a firm with corrections of prior understatements and good news on earnings is a firm that understated interim earnings for the initial quarter in error and actual earnings for the year exceeded earning:; of the prior year.

Table 6, panel A shows that the mean CAR for the entire sample for the combined period is -0.232. Firms restating quarterly earnings have stock price declines that are significam at the O.tlOl ievel.6 This result can be compared to the mean CAR for the 1L months preceding the initial quarter in error of -0.173 (standard deviation 0,459). Yhe prior CAR is signifir?;uly negative but also significantly greater than that of the error period at p < 0.01. When partitioned on the correction sign, combined period mean CARS are -0.023 (p = 0.410) and -0.340 ( p < 0.001) for firms reporting quarterly earnings understatements and overstatements, respectively. Thus, firms cor- recting understated earnings had market adjusted returns near zero and their returns were significantly above that of those with averstatements ( p = 0.005).

Partitioning the return period shows that most of the negative return occurs during period 1 (i.e., before public disclosure of the error). Specifically, 89.2% of the overall negative return occurs during period 1 and 95.6% of the overstatement negative return occurs during period 1. For period 2, overall sample CARS as well as understatement and overstatement CARS are statisti- cally indistinguishable from zero. None of the understatement CARS are significant in any period.

Table 6, panel B partitions the sample on the sign of unexpected earnings. Mean CAR for firms with good news on anruts! earnings ih -0.i59, while for the bad news firms it is -0.292. Both are significantly negative at the 0.05 level. For bad news on earnings, corrections reducing previously reported

‘Tables 6 and 7 repcrc resuits without adjustment for the unequal accumulation periods for CAR. This was dons on the assumption that differences in CAR due :o other than accounting error would be relatively small and scaling by accumulation peiod length would dilute the effect. Failure to control for the accumulation period violates the assumption of equal variances of the daily return sums, however, and r-statistic significance will be misstated. The analyses were rerun using CAR/days-in-the-accumulation period with essentially the same parameter estimates and r-statistics.

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88 W.R. Kiitney, Jr. and L.S. McDaniel, Earnings correction hracteristics

Table 6

Cumulative market adjusted returns (CAR) by sign of correction for initia! quar;er in erro- and unexpected earnings (1976-1985).

A. By Sign of Correction

n Mean Std. dev. t p(t)”

Corn bined period

Overall sample

By sign of initial correction Understatement ( + ) correction Overstatement (-) correction Difference

Period 1 b

Overall sample

By sign of initial correction Understatement (+) correction Overstatement ( - i correction Difference

Period 2

Overall sample

By sign of initial correction Understatement (+) correction Overstatement (- ) correction Difference

73 - 0.232 0.442 - 4.48 0.001

25 - 0.023 0.511 48 - 0.340 0.361

-0.23 0.4io - 6.53 0.001

2.76 0.005

73

25 48

73 - 0.025 0.236 - 0.91 0.183

25 -0.044 0.328 48 - 0.015 0.173

- 0.67 0.255 - 0.61 0.271 - 0.41 0.343

- 0.207 0.429 -4.11 0.001

0.021 0.448 - 0.325 0.3?1

0.23 - 6.06

3.51

0.410 O.iiol 0.001=

B. By Sign of Unexpected Earnings and Corrections

Corn bin ed period

Good news on unexpected earnings for year

Oveiall sample

By sign of initial correction Understatement (-I-) correction Overstatement (-) correction Difference

Bad new.9 on unexpected earnings for year

Overall sample

By sign of initial correction Understatement (+) correction Overstatement (-) correction Difference

n

33

16 17

40

9 31

Mean Std. dev. t p(t)”

-0.159 0.484 - 1.88 0.034

- 0.052 0.587 - 0.36 0.364 - 0.259 0.351 - 3.04 0.004

1.22 0.117

- 0.292 0.400 - 4.62 0.001

0.028 0.363 0.23 0.422 - 0.385 0.364 - 5.88 O.OOF

2.99 0.002

‘One-sided. bRetum pedod 1 is two days after release of earnings for first quarter in error through the

earlier of the day before public announcement of error or audit report date; period 2 is the end date of period 1 through 5 trading days after the 10-K received stamp date; combined period is period 1 plus period 2.

‘Assuming equal variances (otherwise difference tests assume unequal variances).

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W. P. Kinney, Jr. and L.S. McDaniel, Emnings correction cha mferisrics 89

quarteriy earnings are associated with much lower stoci: prices than are corrections for firms with good news for the year. For a given sign of unexpected earnings, returns for overstatements are signiEcantly less than returns for understatements. Mean CARS for firms with overstatement errors are not significantly different from zero for good or bad news on earnings. Partitioning on time period yields results similar to that of panel A.

For all sample firms, the period 1 return precedes public announcement of the error but should include auditor and management awareness of tne error. A possible explanation for the observed association between earnings and stock price deciines with corrections is that the auditor observes stock price declines in conjunction with declining earnings and extends the planned audit (increasing the probability of discovering errors) or decides to require correc- tion of any known misstatements. Thus, the overall results and particularly rest&s for t%.ms with overstatements and declining earnings are consistent with price declines causing the disclosures rather than disclosure causing the price de Tlines.’

As stated above, it was possible to identify disciosure dates for the four firms with prior public anno u cement of the corrections. Price changes for the Pi day of announcement were -20.5%, - 12.3% 4.3%, and 5%. Returns for a nine-day window surrounding the announcements were - 0.177, - 0.015, -0,040, and -0.089. It should be noted that each of these firms sold for less than $10.00 at the announcement date although the first two had sold for almost $30.00 at the start of their fiscal years and had no stock dividends or splits. The first two were also sued by stockholders following the correction announcement.

To allow a more complete assessment of the association of prior-to-public- knowledge-of-error returns and error magnitude, table 7 presents an analvsis of period ? based on the amount of unexpected earnings and the in&t! correction magnitude. Panel A presents an estimate of the model:

CAR, = a + b& + b& + e,, 0)

where CAR, is for period 1, Ui is tne amount of unexpected earnings for the year of correction scaled by prior year’s earnings, and Ci is the magnitude of correction to earnings reported for the initiaf quarter in error scaled by prior year’s earnings. U is included as a covariate to adjust CAR for the effect of unexpected earnings magnitude. As shown in panel A, the estimate of b2 is positive and significant at the 0.024 level. Knowledge of the correction amount significantly adds to the explanatory power of unexpected earnings.

‘A similar interpretation can be placed on a recent study of first time uncertainty qualified audit opinions. Specifically, the probability of a first time ‘subject to’ auditor’s opinion. is negatively correlated with stock returns and positively correlated with accounting losses for the audit year Wopuch et al. (1987, pp. 440~441)].

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90 W. R. Kitmy, Jr. nrxi L. S. MrDnniel, Earnings correction chracterisiics

Table I

Cumulative market adjusted returns for period 1 as a function of unexpected earnings and correction magnitudesa (1976-1985).

A. CAR, = a + b,l/, + b,C, + e,

Parameter Estimate t p(t)”

t,

-0.184 - 3.87 0.001 0.031 1.44 0.077

9 0.468 2.01 0.24

R2 = 0.156, Standard error = 0.400

B. CAR, = 4 + b,LI, + b2C, -- bjCP, + e:

Parameter Estimate i P(rT

z,

- 0.104 - 1.72 0.045 0.035 1.65 0.352

9 1.217 2.83 0.003

bs - 1.096 - 2.05 0.022

ha + 4 0.121 0.43 0.335

R2 = 0.205, Standard error = 0.391

“CAR = cumulative return minus the cumulative return of the market from two days after release of initial quarterly report in error to day prior to public disclosure or date of auditor’s report (i.e., period l), U = unexpected earnings scaled by prior year’s earnings, C = correction scaled by prior year’s earnings, CP = 0 for C < 0 and = C for C 2 0.

‘One-sided.

Analysis of residuals from the estimate of eq. (1) revealed that the relation of unexpected earnings to CXR was not different between good news and bad news. However, the relation between corrections and CAR was diKerent and we estimated a piecewise linear model based on the sign of correction. Panel B of table 7 shows an estimate of the model

C_4Ri=a+b,i_Jj+b,Cj+b,CPj+e,, (2)

where CPi = 0 for C, < 0 and CPi = Ci for C, > 0. The b, coefficient now relates to the overstatement of initially reported earnings portion (C, < 0) [Neter and Wassermap (1974, pp. 313-314)].

The t-statistics for b, in panel B indicate that the amount of initial quarterly earnings overstatement has a significant positive association with CAR. The estimated coefficient for understatement (6,) is significantly below that of &. The sum of 6, + A,, which relates to C 2 0 or initial understatement of earnings, is insignificantly different from zero indicating almost no association between corrections and CAR for understatements of earnings. Consistent with the results for misstatement sign alone, there is a positive relation between the amount of overstatement of earnings and period 1 CAR but little

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re!ltion fcr understatements.s Thus, the .gn and magnitude of _misstatement are important in explaining the magnitude of period 1 CAR.9

Overall, CAR results conditional on the presence of corrections in pwbhshed interim earnings are consistent with the following two-factor model. First, the market acts as if the existence of corrections is bad news irrespective of whether originally reported earnings are overstated or understated. This may be due to the negative implications of a breach in the internal accounting control/reporting system, intent by management to mislead, and perh_ms discounting of possible future legal costs. However, there is little indication that the existence of error and the announcement of error correction were themselves the cause of stock price declines. Given the fact that most of the stock price declines occur prior to public disclosure of the errors, it seems !ikeIy that the price ‘reaction and the existence and disclosure of errors in previously reported quarterly earnings are both caused by the poor state of the firm. That is, it seems likely that the corrections and stock prices are jointly determined.

Second, the sign and magnitude of misstatement are important in explaining the magnitude of CAR. The differential return performance for overstatement errors is consistent with the view that the market reflects more than the mere existence of a breach in internal accounting control/reporting system that allowed substantial error in interim earnings.

6. Summary and conclusions

This study provides an analysis of quarterly financial statement errors that are detected and deemed sufficiently ma!erial for correction at year end. The population of error corrections from the NAARS file for the ten years subsequent to the SEC’s issuance of ASR No. 177 was examined. The analysis reveals that the majority of restatements are made for firms !&ted over-the- counter and the typical firm is smaller, less profitable, more highly leveraged, slower growing, and received more uncertainty quaiified opinions than others in the same industry. Also, on average, the corrections reduce earnings originally reported. The magnitude of errors appear high relative to traditional ru!e of thumb measures of materiality.

“‘The same modeis were estimaied for period 2 and the combined period. None of the estimated coefficients were significant at the 0.10 level ES period 2 and the combined period results were -’ .at thi same as ior period 1.

9Bmks and Kinney (1982) report negative risk adjusted returns for the year preceding a first-time uncertainty qualified (‘subject to’) opinion by the auditor. For the presci,; ham&, TIve or the uncertainty qualifications were the initial qualification. To assess whether such qualifications explain a significant portion of the negative return reported in panel B of table 7, we included an indicator variable for uncertainty qualified opinion and reestimated the model. The estimated coefiicient was insignificant at the 0.20 level (one tail) and increased the e\:kti!<< .tandard error cf the regression.

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92 W.R. Kinnqv, Jr. and LX McDanie!! Earnings correction characteristics

The association of corrections with firm size and financial condLn may be due to any of the three conditions required for correction of previously reported quarterly earning,. * .:c__+:,, ,_$ +h E The present data LO not allow rdennuc;a~,ull vk %*,e i prop::rti6;in due to each. Incidence of ‘material’ errors or their detection probabilities may be higher for smaller firms or fii,ms in weaker financial condition. Mowcver, prior empirical studies of errors detected by external auditors s low no consistent association between firm size a.T:d error. if there is no relatioaz between firm size and the occurrence/detection of errors, then the results reported here suggest that the probability of disclosure of extant accounting error is a function of the firm’s financial condition. That is, economic incent+es for disclosure by management or the auditor may have more effect than their concern for monetary precision per se.

This study also filzds that, irrespective of the sign of the earnings correction or change in annual earnings, short positions taken in securities whose interim financial statements are restated due to material errors would yield abnormal market adjusted returns. Also, short positions based on the signs of unex- pected earnings and error corrections would yield even greater abnormal returns. The existence of a significant difference in price performance of ffirms with overstatements and understatements implies that the market may be misled by the misstated quarterly earnings reports.

References

American Institute of Certified Public Accountants, 1X, in&e&u financial reporting, Accounting Principles Board Opinion No. 28, May.

American Institute of Certified Public Accountants, 1972, Codification of auditing standards and procedures, Statement on Auditing Standards No. 1, Nov.

American Institute of Certified Public Accountants, 1975, Limited review of interim financial information, Statement on Auditing Standards No. 10, Dec.

American Institute of Certified Public Accountants, 1976, Reports on a limited review of interim financial information, Statement on Auditing Standards No. 13, May.

American Institute of Certified Public Accountants, 1979, Review of interim financial information, Statement on Auditing Standards No. 24, March.

American Institute of Certified Public Accountants, 1981, Review of interim financial information, Statement on Auditing Standards No. 36, April.

American Institute of Certified Public Accountants, 1981, Filings under federal securities statutes, Statement on Auditing Standards No. 37, April.

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