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Rewriting earnings history

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Abstract

Research on the usefulness of financial information generally focuses on the innovation in the information examined, such as an earnings surprise or cash flow growth. Consequently, prior research sheds little light on the role of the rich historical record of financial information in users’ decision-making. Using a sample of published restatements of earnings, we show that the revision of the historical pattern of earnings, distinct from the magnitude of the restatement and its impact on current earnings, significantly affects investors’ decisions and predicts class action lawsuits. Specifically, we find that restatements that eliminate or shorten histories of earnings growth or positive earnings have significantly more adverse effects for investor valuations and the likelihood of lawsuits than other restatements. This evidence about the value-relevance of refreshing the historical record of earnings is pertinent to the FASB’s recent cautious expansion of the scope of circumstances that require a restatement of financial information in FAS 154.

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Notes

  1. There are a few other cases where firms are required to disclose revisions of historical records. For example, FAS 146 requires firms to disclose revisions of liabilities accrued for exit or disposal activities.

  2. This may be attributable in part to findings (for example, Ball & Watts, 1972) that earnings tend to follow a random walk, although Brooks and Buckmaster (1980) report that this is not the case for firms with large absolute earnings changes. We discuss the issue of earnings following a random walk in more detail in Sect. 4.

  3. There are, of course, exceptions to this statement, such as Barth, Elliott, and Finn (1999).

  4. For elaboration on the role of historical context in general in understanding and interpreting current events, see Howard (1991, Ch. 1).

  5. See, for example, Mankiw and Shapiro (1986) and Diebold and Rudenbusch (1991).

  6. A literature similarly motivated to that of earnings restatements examines property-casualty insurers’ loss reserve development disclosures. Under the Securities and Exchange Commission’s Exchange Act Industry Guide 4, property-casualty insurers are required annually to update prior estimates of their claim loss reserves for each prior accident year’s coverage. This literature documents that loss reserves are estimated with discretion (e.g., loss reserve revisions are negatively correlated with insurer solvency and positively serially correlated) and that upward loss reserve revisions have negative implications for insurers’ market value, risk, and future profitability. See Petroni (1992), Beaver and McNichols (1998, 2001), and Petroni, Ryan, and Wahlen (2000).

  7. Feroz et al. (1991) and Dechow et al. (1996) find similar negative market reactions at the announcement of SEC enforcement actions.

  8. In a specification test, Palmrose et al. (2004) replace the magnitude of the restatement with an indicator variable for restatements that decrease current income and the absolute value of the change in net income. They find that the coefficients on both variables are significantly negative.

  9. While it may seem surprising that the market reacts less adversely to SEC-enforced earnings restatements, this finding may reflect the fact that these restatements often result from the SEC’s desire to change a general accounting practices (e.g., in-process research and development) which affects multiple firms. To the extent that more firms make these restatements, they appear to reflect less negatively on any given restating firm.

  10. Palmrose et al. (2004), Anderson and Yohn (2002), and Wu (2003) include numerous control variables in their returns regression models, which they find (and in supplemental analysis we confirm) to be insignificant. Of particular note, Wu finds that the coefficient on an indicator variable for confounding significant disclosures or events in the restatement announcement window is insignificantly negative.

  11. Dechow et al. (1996) conduct similar analyses and obtain similar findings for SEC enforcement actions.

  12. Summers and Sweeney (1998) document similar stock sales by insiders before the revelation of fraud, as does Beneish (1999) before SEC enforcement actions.

  13. Bonner et al. (1998) obtain similar results for the filing of lawsuits against the auditors of firms subject to SEC enforcement actions.

  14. A related issue is that restatements of earnings, like all accrual adjustments, reverse over time. Sometimes these reversals are complete when restatements are announced (restatements that decrease earnings in certain periods and increase earnings by the same amount in other periods), and sometimes they are incomplete (e.g., restatements that only decrease earnings before announcement). Whether these reversals are complete has implications for the prediction of future earnings and so may affect returns or the likelihood of class action lawsuits differently (e.g., investors may not be fully aware of the future reversals in the second type of restatements, above). We do not explore this issue.

  15. Most of this sample was collected by Wu (2003), excluding her restatements of previously announced unofficial results. We extended her sample forward in time by collecting 83 additional restatements in 2001 and 2002. We also augmented her data with annual earnings data for nonrestated fiscal years (which we use to construct our measures of earnings history), which we collected from Compustat (data item 172), and stock returns data, which we retrieved from CRSP.

  16. The number of restatements continues to increase. According to Huron Consulting Group (quoted in Bryan, Lilien, Ruland, & Sinnett, 2005), there were 323 restatements in 2003 and 414 in 2004. Jeff Szafran, Huron’s managing director, attributes the 2004 increase to the “unprecedented level of regulatory and audit scrutiny, driven primarily by the Sarbanes-Oxley Act of 2002.” Glass Lewis & Co. reports 1,195 restatements by U.S. firms in 2005.

  17. Currentmag takes a nonzero value for 606 observations. Laggedmag takes a nonzero value for 389 observations, of which 224 involve nonzero restatements of earnings in one prior year, 106 in two prior years, 43 in three prior years, 12 in four prior years, and four in five prior years.

  18. This is the case in our hypothetical example above. The most recent restatement was for the first two quarters of 1998, which we treat as a fiscal year.

  19. In calculating undoearngrow and undoearnpos, we examined histories or earnings up to 7 years before the most recent fiscal year restated. Of the 821 restatement observations, nine have continuous histories of earnings growth of 7 years or more, five of which were eliminated by the restatement, while 130 observations have continuous histories of positive earnings of 7 years or more, 22 of which were eliminated by the restatement. Undoearngrow and undoearnpos can take values of one because of any year that is both involved in the restatement and part of the prior history of earnings growth or positive earnings, respectively.

  20. Both undoearngrow and undoearnpos take values of one for 48 (6 percent) of the observations.

  21. Given the size of our sample, we chose 4 years as the cutoff for grow4 and pos4 in an attempt to obtain a sufficient number of observations with a substantial history of earnings growth or positive earnings. The use of longer histories of earnings growth or positive earnings (e.g., the 5-year history examined by Barth et al., 1999) reduces the number of observations with such histories significantly, especially for earnings growth, whereas shorter histories provide less contrast with our primary variables.

  22. Wu (2003) classifies the primary reason for/line items affected by the restatement into nine categories: (1) both revenue and operating expenses, (2) revenue only, (3) operating expenses only, (4) loan loss allowances, (5) mergers and acquisitions, (6) in-process research and development, (7) reclassification, (8) errors, and (9) other. We include categories 1 and 2 in our indicator variable revenue.

  23. See note 14.

  24. For example, this conjecture is consistent with Burgstahler and Dichev (1997) and Dechow, Richardson, and Tuna’s (2003) findings that firms with (even slightly) positive earnings have greater cash flow and various other indicators of solvency than do firms with (even slightly) negative earnings. Moreover, we determined that 40 (4.9 percent) of the firms in our sample declared bankruptcy in the year following the restatement announcement, and that firms with pos4 = 0 are 50 percent more likely to go bankrupt in the year following the restatement than are firms with pos4 = 1 (5.7 percent versus 3.8 percent, respectively).

  25. While we predict and find that the intercept is negative in the return analysis, we make no prediction about the intercept in the logit estimation of Eq. (3), because the estimated intercept adjusts to yield the sample average probability of a class action lawsuit, given the means of and estimated slope coefficients on the explanatory variables in Eq. (3).

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Acknowledgments

We appreciate the comments of Mary Barth, Bill Beaver, Thomas Dyckman, Paul Griffin, Russell Lundholm, Sarah McVay, Craig Nichols, and Nir Yehuda, of seminar participants at Chinese University of Hong Kong, Cornell, Florida State University, Hong Kong University of Science and Technology, New York University, Peking University, Shanghai University of Finance and Economics, Stanford’s Accounting Summer Camp, and Tshinghua University, and particularly those of an anonymous reviewer and Jim Ohlson, the editor.

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  1. Stern School of Business, New York University, 44 West 4th Street, New York, NY, 10012, USA

    Baruch Lev & Stephen G. Ryan

  2. Faculty of Business and Economics, The University of Hong Kong, PokFuLam Road, Hong Kong SAR, P. R. China

    Min Wu

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  1. Baruch Lev
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Correspondence to Baruch Lev.

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Lev, B., Ryan, S.G. & Wu, M. Rewriting earnings history. Rev Account Stud 13, 419–451 (2008). https://doi.org/10.1007/s11142-007-9041-4

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