Thursday, September 23, 2004

Maybe Fraud is not even needed--Earnings restatements and Management turnover

The Reputational Penalty for Aggressive Accounting: Earnings Restatements and Management Turnover by Desai, Hogan, and Wilkins.


At the same FMA conference session as Jayaraman, Mulford, and Wedge's Accounting fraud and Management turnover, is The Reputational Penalty for Aggressive Accounting: Earnings Restatements and Management Turnover by Desai, Hogan, and Wilkins. This latter paper finds that fraud may not be needed to increase turnover: Management turnover increases following Earnings Restatements.

Specifically:
In a sample of 146 firms that announced restatements in 1997 and 1998, we find
that at least one senior manager (Chairman, CEO or President) loses his/her job within 24 months of the announcement of the restatement in 60% of the firms. The corresponding rate of turnover among industry-, size- and age-matched control firms is 35%. The significant difference in turnover persists even after controlling for other factors associated with management turnover, such as performance, bankruptcy, and governance characteristics. Moreover, only 17 out of 114 (15%)displaced managers of the sample firms secure a comparable position at another public firm, compared to 17 out of 63 (27%) displaced managers at the control firms.

There are several points to deserve further mention.

1. Have the times changed?

Previous research by Beneish (1999) did not "find a significant difference in the managerial turnover rate between sample firms and size-, age- and industry matched control firms" following GAAP violations." And closely related is the "Agrawal, Jaffe and Karpoff's (1999) investigation of the consequences of corporate fraud"

Thus that the findings of the current paper coupled with the findings of Jayaraman, Mulford, and Wedge suggest that boards of directors are taking a harder stance on fraud and overly aggressive accounting practices.

A logical question to ask is why have Boards of Directors gotten tougher? Readily apparent explanations include because of larger institutional holdings, more active shareholder activism, and/or threats of SEC action.

2. Interestingly, both abnormal returns and management turnover are related to whether the company (or auditor) instigated the restatement or whether the restatement was SEC instigated. "68% of both company-prompted and auditor-prompted restatements result in a turnover. On the other hand, only 48% of the restatements prompted by the SEC or other parties result in a turnover."

This turnover finding is slightly surprising given the finding that SEC-prompted restatements are met with less of a price drop: the "reaction to the 60 company-prompted restatements is -11.33%, while the reaction to the 22 auditor-prompted restatements is the strongest at -15.21%.

This is consistent with the idea that if a board is concerned enough to force a restatement, then the board is also in disagreement with the manager's actions and would be more inclined to replace the manager.

Explanations as to why SEC-prompted restatements are met with less of a price change is that they may contain more leakage and thus the price drop may occur prior to the event window and/or the SEC acts on less important issues than do Boards.

3. Not surprisingly, firms that restate their earnings are more likely to end up in bankruptcy than are control firms: "there is a greater frequency of bankruptcy filings for sample firms as compared to the control firms (15 out of 146 sample firms filed for bankruptcy within 24 months of the announcement of the restatement whereas only 4 control firms filed for bankruptcy).

4. Reputation matters!

This is possibly my favorite part of the paper looks at what happens after the manager is replaced. The authors state it very nicely:

"If the managerial labor market imposes a significant penalty on displaced managers by shunning them when they attempt to locate alternative employment opportunities, such an outcome would be consistent with Fama's (1980) notion of ex-post settling up." And would therefore serve as a deterrent to risky accounting measures (including but not limited to fraudulent accounting practices).

The authors set up their findings with a quote from the Economist:

"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.)

The findings support this: "32 out of the 114 displaced managers of the sample firms (28%) are able to find some form of employment following their departure. The corresponding number for the control firms is 31 out of 63, or 49%. This difference is also significant (p-value=0.01). "

The paper goes on to check other measure of future employment with qualitatively similar results. "Collectively, these results show that the future employment prospects (at any level) for the sample firm managers are significantly worse than those of the control firm managers. This evidence is consistent with the existence of significant reputational penaltiesand/or ex-post settling up in the managerial labor market."

Why do I like this section so much? Because it shows that the managerial labor market does incorporate publicly available information and it gives further proof that reputation matters. This should reduce the incidence of fraud and risky accounting by raising their costs.

5. Given the market discpline described above, one might be tempted to ask "are efforts by government to reduce fraud necessary or merely redundant? "

While this is virtually impossible to answer, the governmental actions and fines are apt to be a little consequence, but do add to the market penalty and as such will at the margin help to discourage the undesired behavior. However, the question remains whether govenmental resources could be better spend increasing information transparency (which will increase the probablity of being cheaters being caught) rather than merely penalizing those who are caught.

VERY INTERESTING and Highly recommended!

http://207.36.165.114/NewOrleans/Papers/1401148.pdf

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