Abstract
I examine whether accounting complexity in the area of revenue recognition increases the probability of restating reported revenue. I measure revenue recognition complexity using the number of words and recognition methods from the revenue recognition disclosure in the 10-K and a factor score based on the number of words and methods. Tests reveal that revenue recognition complexity increases the probability of revenue restatements, and these restatements are the result of both intentional and unintentional misreporting. Furthermore, complexity moderates the consequences of restatement—lower incidence of AAERs, less negative restatement announcement returns, and lower subsequent CEO turnover—suggesting that stakeholders of the firm consider accounting complexity when responding to misreporting.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
Prior literature has not developed a definition of accounting complexity. The SEC’s Advisory Committee on Improvements to Financial Reporting (ACIFR) provides a definition in its final recommendation report (SEC 2008), and it is similar to the one presented in this paper. Accounting complexity is described more thoroughly in Sect. 2.
The results in this paper do not address whether accounting complexity is pareto optimal or should be reduced. Without an examination of all costs and benefits of complexity, it is not feasible to make any case for social welfare. For example, potential benefits of accounting complexity relative to simpler accounting could be reduced earnings management or better comparability, which are not examined in this study.
My findings suggest that firms that restate revenue have more complex revenue recognition; however, from Plumlee and Yohn (2009), it seems that firms do not necessarily highlight complexity as a reason for the restatement but are more likely to use vague descriptions like “internal error.” What managers say about the causes of misreporting does not likely include a description of all relevant factors that led to the restatement (e.g., undue pressure to meet targets, executive compensation, governance failures, complexity), but examining all these factors in a multivariate setting provides a better understanding of all these effects.
No formal definition of accounting complexity exists in the academic literature. Prior research has examined firm or organization complexity (Bushman et al. 2004), information complexity (Plumlee 2003), and information overload (Schick et al. 1990 for a review), concepts not wholly unrelated to accounting complexity.
The ACIFR define financial reporting complexity for preparers as the difficulty “to properly apply [US GAAP] and communicate the economic substance of a transaction” and for investors as the difficulty in understanding “the economic substance of a transaction or event and the overall financial position and results of a company” (SEC 2008).
Although this theory suggests managers take advantage of complex accounting by managing the financial statements, complexity is not a necessary condition for manipulation. Many fraudulent practices are implemented using simple accounting settings (e.g., fictitious sales, bill-and-hold transactions, and capitalizing expenses).
I consider SAB 101 and EITF restatements as mandatory restatements caused by a change in accounting standard. During the sample period, the Emerging Issues Task Force issued EITFs 99-19, 00-10, 00-14, 00-22, 00-25 to clarify revenue recognition issues such as recognizing gross v. net, shipping and handling costs, sales incentives, and other consideration from a vendor. Including the SAB and EITF firms in testing H1 provides similar results.
I do not match on industry because it likely introduces a noisy sort on revenue recognition complexity, potentially controlling for the effect being tested. However, I do control for industry in the regression analysis.
Certain practices or factors could also lead to increased complexity and risk of misreporting beyond what may be captured by disclosure length (see AICPA Practice Alert 98-3, 1998). In unreported analysis, I measure RRC SCORE where I also include the total number of counts in the disclosure (by using key-word searches) for the following revenue recognition practices: the percentage of completion method, multiple deliverables, vendor-specific objective evidence, barter or nonmonetary exchange revenue, or fair valuing aspects of the contract. Results using this measure are consistent with the results reported in the tables for RRC SCORE.
As a test of validity of my complexity measures, I examine whether my measures are associated with the variation and error in analysts’ forecasts of revenue, an indication that complexity increases uncertainty. Results (untabulated) indicate all three proxies are positively related to both the error and variation in analysts’ revenue forecasts with p values less than 10 percent after controlling for analyst following, size, and book-to-market.
It is also interesting to note that for both the revenue restaters and non-revenue restaters, the number of WORDS and METHODS increased in the post period, but the increase was greater for the revenue restaters (91.3 and 1.57 for revenue restaters; 38.0 and 0.53 for non-revenue restaters). The greater increase in post-restatement disclosures for revenue restaters could be an attempt to resolve confusion over already complex revenue recognition.
I exclude the variable AUDITOR from the matched-sample design because matched sample firms do not have a restatement.
In untabulated results, the marginal effects of the complexity variables are not statistically different from the marginal effects of SALEFCST, PRERET, BIGN, or AR ACCRUAL.
Erickson et al. (2006) correctly argue that SEC actions do not necessarily imply fraud or gross negligence. In these cases, the action ends with a settlement and an AAER, the firm admits to no wrongdoing but agrees to avoid future securities violations. However, Karpoff et al. (2008) find that 79 percent of enforcement actions in their sample from 1978 through 2006 include charges of fraud.
References
American Institute of Certified Public Accountants (AICPA). (1998). Responding to the risk of improper revenue recognition, AICPA practice alert no. 98–3. New York, NY: AICPA.
Beneish, M. (1999). Incentives and penalties related to earnings overstatements that violate GAAP. The Accounting Review, 74(4), 425–457.
Bergstresser, D., Desai, M., & Rauh, J. (2006). Earnings manipulation, pension assumptions, and managerial investment decisions. Quarterly Journal of Economics, 121(1), 157–195.
Burns, N., & Kedia, S. (2006). The impact of performance-based compensation on misreporting. Journal of Financial Economics, 79, 35–67.
Bushman, R., Chen, Q., Engel, E., & Smith, A. (2004). Financial accounting information, organizational complexity and corporate governance systems. Journal of Accounting and Economics, 37(2), 139–201.
Callen, J., Robb, S., & Segal, D. (2009). Revenue manipulation and restatements by loss firms. Auditing: A Journal of Practice and Theory, 27(2), 1–29.
Collins, D., Kothari, S. P., & Rayburn, J. (1987). Firm size and the information content of prices with respect to earnings. Journal of Accounting and Economics, 9, 111–138.
Core, J., & Guay, W. (2002). Estimating the value of employee stock option portfolios and their sensitivities to price and volatility. Journal of Accounting Research, 40(3), 613–630.
Cox, C. (2005). Remarks before the 2005 AICPA national conference on current SEC and PCAOB developments. Washington, DC, http://www.sec.gov/news/speech/spch120505cc.htm.
Dechow, P., Ge, W., Larson, C., & Sloan. R. (2007). Predicting material accounting misstatements. Working Paper. University of Michigan and University of Washington.
Dechow, P., Sloan, R., & Hutton, A. (1996). Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research, 13, 1–36.
DeFond, M. L., & Jiambalvo, J. (1991). Incidence and circumstances of accounting errors. The Accounting Review, 66, 643–655.
Desai, H., Hogan, C., & Wilkins, M. (2006). The reputational penalty for aggressive accounting: Earnings restatements and management turnover. The Accounting Review, 81(1), 83–112.
Engel, E., Hayes, R., & Wang, X. (2003). CEO-turnover and properties of accounting information. Journal of Accounting and Economics, 36, 197–226.
Erickson, M., Hanlon, M., & Maydew, E. (2006). Is there a link between executive equity incentives and accounting fraud? Journal of Accounting Research, 44(1), 113–143.
Ertimur, Y., Livnat, J., & Martikainen, M. (2003). Differential market reactions to revenue and expense surprises. Review of Accounting Studies, 8(2–3), 185–211.
Ertimur, Y., & Stubben, S. (2005). Analysts’ incentives to issue revenue and cash flow forecasts, Working Paper. Stanford University.
Financial Accounting Standards Board (FASB). (2008). Conceptual framework for financial reporting: The objective of financial reporting and qualitative characteristics and constraints of decision-useful financial reporting information. FASB exposure draft.
Freeman, R. (1987). The association between accounting earnings and security returns for large and small firms. Journal of Accounting and Economics, 9, 195–228.
Government Accountability Office (GAO). (2002). Financial statement restatements, trends, market impacts, regulatory responses, and remaining challenges. GAO-03-138.
Government Accountability Office (GAO). (2006). Financial restatements: Update of public company trends, market impacts, and regulatory enforcement activities. GAO-06-678.
Greene, W. (1997). Econometric analysis (3rd ed., pp. 339–350). Upper Saddle River, NJ: Prentice Hall.
Hayn, C. (1995). The information content of losses. Journal of Accounting and Economics, 7, 85–107.
Hennes, K., Leone, A., & Miller, B. (2008). The importance of distinguishing errors from irregularities in restatement research: The case of restatements and CEO/CFO turnover. The Accounting Review, 83(6), 1487–1519.
Herz, R. (2005). Remarks before the 2005 AICPA national conference on current SEC and PCAOB developments. Speech given by the FASB Chairman, Washington DC.
Herz, R. (2007). Specialized industry accounting and reporting. Too much of a good thing? Speech given by the FASB Chairman, 26th Annual SEC and Financial Reporting Institute Conference.
Johnson, S., Ryan, H., Jr, & Tian, Y. (2009). Managerial incentives and corporate fraud: The sources of incentives matter. The Review of Finance, 13(1), 115–145.
Karpoff, J., Lee, D., & Martin, G. (2008). The Consequences to managers for financial misrepresentation. Journal of Financial Economics, 88(2), 193–215.
Kinney, W., & McDaniel, L. (1989). Characteristics of firms correcting previously reported quarterly earnings. Journal of Accounting & Economics, 11(February), 71–93.
Palmrose, Z., Richardson, V., & Scholz, S. (2004). Determinants of market reactions to restatement announcements. Journal of Accounting & Economics, 37, 59–89.
Picconi, M. (2006). The perils of pensions: Does pension accounting lead investors and analysts astray? The Accounting Review, 81(4), 925–955.
Plumlee, M. (2003). The effect of information complexity on analysts’ use of that information. The Accounting Review, 78(1), 275–296.
Plumlee, M., & Yohn, T. (2009). An analysis of the underlying causes attributed to restatements. University of Utah and Indiana University Working Paper.
Schick, A., Gorden, L., & Haka, S. (1990). Information overload: A temporal approach. Accounting, Organizations and Society, 15, 199–220.
Securities and Exchange Commission (SEC). (2008). Final Report of the advisory committee on improvements to financial reporting to the United States securities and exchange commissions. August, 2008, link: http://www.sec.gov/about/offices/oca/acifr/acifr-finalreport.pdf.
Sondhi, A., & Taub, S. (2006). Miller revenue recognition guide. CCH Incorporated.
Turner, L. (2001). The times, they are a-changing. Speech by SEC chief accountant, 33rd rocky mountain securities conference, Denver, Colorado. www.sec.gov/news/speech/spch493.htm.
Tversky, A., & Kahneman, D. (1974). Judgement under uncertainty: Heuristics and biases. Science, 185, 1124–1131.
Zhang, Y. (2006). An empirical analysis of revenue manipulation. Working Paper, Columbia University.
Acknowledgments
This paper is based on my dissertation at the University of Michigan. I appreciate the guidance and advice of my dissertation committee members, Russell Lundholm and Ilia Dichev, and especially my chair, Michelle Hanlon. Author also thankful to the following for helpful comments: David Guenther, Angela Davis, Judson Caskey, Lian Fen Lee, K. Ramesh, Jeff Wilks, Cathy Shakespeare, Chad Larson, Peter Demerjian, anonymous reviewers, and workshop participants at the University of Michigan, Washington University (St. Louis), University of Oregon, and Northwestern University.
Author information
Authors and Affiliations
Corresponding author
Appendix
Appendix
1.1 Example revenue recognition disclosures
1.1.1 A.C. Moore Arts & Crafts, 2005 10-K [WORDS: 8; METHODS: 1; RRC SCORE: -1.19]
Revenue is recognized at point of retail sale.
1.1.2 UStel, Inc., 1997 10-K [WORDS: 9; METHODS: 1; RRC SCORE: -1.45]
Revenue is recognized upon completion of the telephone call.
1.1.3 Regal Entertainment Group 2004 10-K [WORDS: 161; METHODS: 4; RRC SCORE: 0.14]
Revenues are generated principally through admissions and concessions sales with proceeds received in cash at the point of sale. Other operating revenues consist primarily of product advertising (including vendor marketing programs) and other ancillary revenues which are recognized as income in the period earned. We recognize payments received attributable to the marketing and advertising services provided by us under certain vendor programs as revenue in the period in which the related impressions are delivered. Such impressions are measured by the concession product sales volume, which is a mutually agreed upon proxy of attendance and reflects our marketing and advertising services delivered to our vendors. Proceeds received from advance ticket sales and gift certificates are recorded as deferred revenue. The Company recognizes revenue associated with gift certificates and advanced ticket sales at such time as the items are redeemed, they expire or redemption becomes unlikely. The determination of the likelihood of redemption is based on an analysis of our historical redemption trends.
1.1.4 Brooks Automation, 2002 10-K [WORDS: 284; METHODS: 7; RRC SCORE: 1.14]
Revenue from product sales are recorded upon transfer of title and risk of loss to the customer provided there is evidence of an arrangement, fees are fixed or determinable, no significant obligations remain, collection of the related receivable is reasonably assured and customer acceptance criteria have been successfully demonstrated. Revenue from software licenses is recorded provided there is evidence of an arrangement, fees are fixed or determinable, no significant obligations remain, collection of the related receivable is reasonably assured and customer acceptance criteria have been successfully demonstrated. Costs incurred for shipping and handling are included in cost of sales. A provision for product warranty costs is recorded to estimate costs associated with such warranty liabilities. In the event significant post-shipment obligations or uncertainties remain, revenue is deferred and recognized when such obligations are fulfilled by the Company or the uncertainties are resolved.
Revenue from services is recognized as the services are rendered. Revenue from fixed fee application consulting contracts and long-term contracts are recognized using the percentage-of-completion method of contract accounting based on the ratio that costs incurred to date bear to estimated total costs at completion. Revisions in revenue and cost estimates are recorded in the periods in which the facts that require such revisions become known. Losses, if any, are provided for in the period in which such losses are first identified by management. Generally, the terms of long-term contracts provide for progress billing based on completion of certain phases of work. For maintenance contracts, service revenue is recognized ratably over the term of the maintenance contract.
In transactions that include multiple products and/or services, the Company allocates the sales value among each of the deliverables based on their relative fair values.
Rights and permissions
About this article
Cite this article
Peterson, K. Accounting complexity, misreporting, and the consequences of misreporting. Rev Account Stud 17, 72–95 (2012). https://doi.org/10.1007/s11142-011-9164-5
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11142-011-9164-5