This study examines the extent to which management’s intent to mislead investors affects the probability that CEOs and CFOs are terminated around restatement announcements. Our research is motivated by the fact that, although recent studies report that executive turnover rates around restatements are statistically significantly different from turnover rates in a control sample of non-restaters, some question whether the observed turnover rates are too low.
Abelson, for example, is one member of the press who comments that when managers are “manipulating a company’s financial numbers to mislead investors, the punishment is often anything but sharp and swift” 1996). Further, in a recent study on restatements, Collins, Reitenga, and Sanchez-Cuevas (2005) conclude that “half the sample appear to have taken little or no action to penalize management.”
One explanation for the seemingly low turnover rates is that recent studies, such as Collins et al. (2005), draw from the U.S. General Accounting Office (GAO) database (2003), which contains substantial variation in the types of the restatements included. Although this database has generally been characterized as one containing cases of “aggressive accounting,” there are a large number of restatements resulting from seemingly honest bookkeeping errors or from misinterpretations of somewhat ambiguous GAAP. This raises the question of whether the relatively low turnover rates for executives around restatements found in prior research are due to widespread governance problems (e.g., management entrenchment) or to the mixing together of both intentional GAAP violations, which merit management turnover, and unintentional GAAP violations, which may not.
We predict that restatements due to intentional GAAP violations are much more likely to lead to management turnover for the following reasons. First, Palmrose, Richardson, and Scholz (2004) report that the market reaction to restatements caused by fraud is over three times more negative than in non-fraud cases (-20% versus -6%). Given that investors view the restatements involving fraud as more severe, management’s intention to deliberately misreport is likely to play a significant role in boards’ decision to terminate managers when these misstatements are identified. Second, termination of a top executive may be partly to punish the manager for the loss in shareholder value caused by the restatement, but the termination is also a highly visible means of restoring financial reporting credibility. Consequently, we predict that the turnover rates for CEOs and CFOs are much higher for restatements related to intentional GAAP violations than for restatements related to unintentional errors.
In contrast to prior research, our study does not focus on whether turnover is in fact higher for restating firms than for non-restating firms. Instead, we attempt to explain cross-sectional variation in turnover rates conditional on firms restating earnings. We argue that the severity of a restatement is better captured as a function of management intent (or at least the perception of managements’ intent as actual intent is never fully known to anyone but the managers) than by any of the previously used measures. We proxy for management intent with the presence or absence of an independent investigation or with the presence or absences of the word “irregularity” in discussions of the GAAP violation.
We consider the occurrence of investigations by (or funded by) the board of directors or investigations by external regulatory bodies (e.g., SEC, Office of the Attorney General, U.S. Department of Labor, etc.) to indicate that there is at least some suspicion of managerial misbehavior because, as discussed further in Section 2.1, restatements that initiate or evolve from independent investigations typically involve allegations of intentional misreporting. As an accounting “irregularity” is an intentional misstatement by definition, we classify these cases as intentional misstatements as well.
