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Bringing Darkness to Light: 'e In(uence of
Auditor Quality and Audit Commi)ee Expertise
on the Timeliness of Financial Statement
Restatement Disclosures
Jaime Schmidt
Michael S. Wilkins
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Auditing: A Journal of Practice & Theory American Accounting Association
Vol. 32, No. 1 DOI: 10.2308/ajpt-50307
February 2013
pp. 221–244
Bringing Darkness to Light: The Influence of
Auditor Quality and Audit Committee
Expertise on the Timeliness of Financial
Statement Restatement Disclosures
Jaime Schmidt and Michael S. Wilkins
SUMMARY: This study investigates whether auditor quality and audit committee
expertise are associated with improved financial reporting timeliness as measured by the
duration of a financial statement restatement’s ‘‘dark period.’’ The restatement dark
period represents the length of time between a company’s discovery that it will need to
restate financial data and the subsequent disclosure of the restatement’s effect on
earnings. For a sample of dark restatements disclosed between 2004 and 2009, we find
that companies that engage Big 4 auditors have shorter dark periods than companies
that do not engage Big 4 auditors. We also find that companies with more financial
experts on the audit committee have shorter dark periods, but only when such financial
expertise relates specifically to accounting. Finally, companies with audit committee
chairs that have accounting financial expertise provide the most timely disclosures, as
the dark periods for these firms are reduced by approximately 38 percent. Our results
suggest that both auditor and audit committee expertise are associated with the timely
disclosure of restatement details.
Keywords: financial reporting timeliness; financial statement restatements; audit
quality; audit committees; financial expertise; accounting expertise.
Data Availability: All data are publicly available from sources identified in the paper.
Jaime Schmidt is an Assistant Professor at The University of Texas at Austin, and Michael S. Wilkins is a
Professor at Trinity University.
We thank Neil Fargher, Rebecca Files, Chris Hogan, Nate Sharp, and workshop participants at Trinity University for
helpful comments and suggestions. We also thank Linda Myers, Sue Scholz, and Nate Sharp for allowing us to use a
subset of their sample firms. We thank Kareem Aridi, Lauren Gibbs, Lauren Huelskamp, Brent Lao, Michele Perry, and
Logan Sain for research assistance. We are grateful for financial support from the PwC INQuires grant program.
Editor’s note: Accepted by Jean Bedard.
Submitted: March 2011
Accepted: September 2012
Published Online: September 2012
221
INTRODUCTION
S
everal recent regulatory actions suggest that the timely reporting of financial data is a top
priority of investors and regulators (SEC 2002, 2004). One such action is the requirement
that firms disclose a pending restatement within four business days of management’s initial
non-reliance judgment (SEC 2004). While a vast majority of firms is in compliance with the
‘‘four-day rule,’’ many of these initial filings fail to provide investors with the quantitative
information needed to properly evaluate the severity of the restatement. In addition, subsequent
filings often are delayed, such that lengthy informational ‘‘dark periods’’ exist between the initial
restatement announcement and the eventual disclosure of quantitative restatement details. In sum,
the delays created by dark periods make it difficult for investors to value companies and also may
result in costly loan defaults or stock delistings for the restating companies themselves (ACIFR
2008). As Greg Jonas, a member of the Advisory Committee on Improvements to Financial
Reporting (ACIFR) and managing director at Moody’s Investors Services, states, ‘‘the dark period
is bad for [financial statement] users’’ (Leone 2008).
In this paper, we use the dark restatement setting to address the fundamental question of
whether better governance helps companies resolve financial reporting problems. Previous research
shows that companies with better governance—as proxied by various characteristics related to
boards of directors and audit committees—are better able to prevent financial reporting problems
such as accounting restatements, financial fraud, and internal control weaknesses (e.g., Beasley
1996; Abbott et al. 2004; Hoitash et al. 2009). Our paper differs in that it examines how better
governance helps companies respond to problems when they do arise. Similar to Goh (2009) who
investigates whether better governance helps firms remediate material weaknesses (MWs) in
internal controls more quickly, we examine whether auditor quality and audit committee (AC)
expertise are associated with more timely remediation of misstatements and the subsequent
provision of restatement details.
We examine auditors and audit committees because these two participants in the governance
process are responsible for financial reporting oversight and should be best equipped to address the
complicated accounting issues that often are associated with restatements.
1
Prior research that
examines the association between auditor quality and the timeliness of annual accounting
disclosures finds that clients of Big N auditors have shorter audit reporting lags, measured as the
number of days between a client’s fiscal year-end and the audit report date (Leventis et al. 2005).
However, little is known about the auditor’s involvement in the financial reporting process outside
of the standard year-end audit. In addition, although prior research shows that AC financial
expertise is associated with higher quality financial reporting (Krishnan and Visvanathan 2008;
Abbott et al. 2004; Bedard et al., 2004; Carcello et al. 2009), little is known about the AC’s
involvement in the remediation of financial reporting problems.
Our paper is largely an extension of Badertscher and Burks (2011) who investigate disclosure
lags for a broad sample of restatements (a majority of which are not ‘‘dark’’) announced between
1997 and 2005. Badertscher and Burks (2011, 609) conclude that dark restatements result primarily
from a need for investigation into cases of fraud or multiple, longstanding, or large errors and state
that ‘‘long lags appear to be caused by inherent constraints on producing reliable information.’’
Badertscher and Burks (2011) do not document a significant relationship between disclosure lags
and auditor quality nor do they investigate how governance might influence the timely provision of
restatement details. By restricting our analysis to (1) companies with initial restatement disclosures
1
The primary role of the auditor and the audit committee in the oversight process is to provide assurance, ex ante,
that material financial statement misstatements do not occur. However, Francis and Yu (2011) document a
restatement frequency rate of roughly 20 percent among Big 4 clients.
222 Schmidt and Wilkins
Auditing: A Journal of Practice & Theory
February 2013
that do not provide specific quantitative details, and (2) disclosures occurring after the effective date
of the four-day rule, we hope to shed light on the relationships that may exist between auditors, audit
committees, and disclosure timeliness for the subset of restating firms with ‘‘inherent constraints.’’
After controlling for a variety of factors including firm size, auditor changes, the magnitude
and direction of the restatement, and the presence of fraud, we find that Big 4 clients disclose
quantitative restatement details significantly more quickly than non-Big 4 clients do. We also find
that restatement disclosures are timelier when clients have ACs with more financial expertise, but
only when such expertise relates specifically to accounting. Finally, we find that dark periods are
reduced most dramatically (by approximately 38 percent, on average) when the AC chair is an
accounting financial expert. Overall, our results suggest that the expertise of both auditors and audit
committees contributes to the remediation of financial reporting problems by enabling clients to
disclose dark restatement details more quickly.
Our study should be of interest to policymakers, boards of directors, and investors concerned
with corporate governance. Our findings suggest that governance participants contribute to the dark
restatement remediation process and, therefore, are important to the financial reporting process
beyond the review of annual/quarterly financial statements. In addition, while prior research does not
provide evidence that the presence of a Big N auditor is associated with restatement disclosure lags,
our analysis suggests that in cases where companies are unable to provide quantitative restatement
details in initial filings, Big 4 auditors do improve the timeliness of subsequent disclosures.
The remainder of the paper is organized as follows. The second section presents background
information and develops our hypotheses. The third section describes our research design. The fourth
section discusses the sample selection and presents descriptive statistics. The fifth section presents
our multivariate results and additional tests. Concluding remarks are provided in the sixth section.
BACKGROUND AND HYPOTHESIS DEVELOPMENT
The Importance of Timely Disclosures
The FASB/IASB Conceptual Framework for Financial Reporting defines timeliness as
‘‘having information available to decision makers in time to be capable of influencing their
decisions’’ (FASB 2010). Recently passed legislation indicates that lawmakers and regulators desire
timelier financial reporting. For example, in 2002 the SEC initiated a three-year phase-in period that
shortened mandatory 10-K filing deadlines for large (small) accelerated filers from 90 days to 60
days (75 days).
2
Section 409 of the Sarbanes-Oxley Act of 2002 (SOX) also requires that
companies disclose, ‘‘on a rapid and current basis ... information concerning material changes in
the financial condition or operations of the issuer’’ (U.S. House of Representatives 2002).
In order to implement SOX Section 409, the SEC issued a new rule in 2004 that requires
companies to disclose a forthcoming restatement within four business days following
management’s non-reliance judgment, even if the precise impact of the restatement on the
company’s earnings is not yet known (SEC 2004). One of the intents of the four-day rule was to
provide investors with more timely disclosure about accounting restatements. However, the
requirement to provide timely notification of a need to restate does not necessarily result in timely
disclosure of the restatement’s quantitative impact on earnings. Unfortunately, company
investigations related to restatements can be extensive—lasting several months or even beyond a
year in some cases—and earnings-related regulatory filings often are absent during this time period.
In its 2008 report, the ACIFR stated that there are ‘‘many circumstances [where] investors could
benefit from improvements in the nature and timeliness of disclosure in the [dark] period’’ (ACIFR
2
Non-accelerated filers continue to have 90-day filing deadlines.
Bringing Darkness to Light: The Influence of Auditor Quality and Audit Committee Expertise 223
Auditing: A Journal of Practice & Theory
February 2013
2008, 80). We investigate whether disclosures are timelier in the presence of higher quality auditors
and audit committees.
In a study that is related to ours, Badertscher and Burks (2011; hereafter BB) investigate the
causes and consequences of a number of different types of disclosure lags for restating firms having
data available between 1997 and 2005. They find that in their broad sample of restatements, long
disclosure lags are uncommon and are largely due to board, regulatory, or fraud investigations.
However, BB do not document a significant relationship between disclosure lags and auditor
quality and do not investigate the potential effects of corporate governance. Badertscher and Burks
(2011) ultimately conclude that additional regulation mandating the timely disclosure of
restatement data would not be likely to reduce disclosure lags because the majority of firms with
significant delays seem unable to provide disclosure information on a timely basis. We extend BB
by focusing exclusively on dark restatements and limiting our analysis to restatements that were
announced after the introduction of the four-day rule. Our purpose is to evaluate the subset of
restatement firms for which disclosure problems do exist and to investigate whether disclosure
timeliness is associated with certain characteristics of auditors and audit committees.
3
Costs of Delayed Disclosures
Dark periods can impose significant costs on both investors and restating companies. According
to one analyst, ‘‘investors count on restatements to get a true sense of a company’s financial health,
notice trends, and create realistic projections of earnings and cash flows’’ (Johnson 2008). A lengthy
remediation process coupled with minimal regulatory filings and other disclosures may make
investors uncertain as to how to assess future cash flows and thereby accurately value a company. As
a result, stock prices typically decline following restatement announcements, particularly those
restatement announcements that fail to disclose the restatement’s impact on earnings (Leone 2008).
Additional costs exist as well, in that the failure to submit timely financial reports during a dark
period frequently is associated with SEC sanctions, penalties, and suspended stock trading. Thus, it
is in a company’s best interests to disclose remediated data as quickly as possible in order to
minimize the explicit costs of the restatement and to restore investors’ confidence in the firm’s
operations and financial reports. In fact, the timeliness of restatement disclosures may be more
important to investors than the timeliness of 10-Ks, given that the latter often are supplemented with
readily available alternative sources of financial information (e.g., analyst forecasts and earnings
announcements) between the end of a fiscal period and the annual filing date.
Hypotheses
The popular press suggests, ‘‘internal accountants and auditors pore over mistakes’’ during the
dark period to understand and quantify the accounting errors that exist (Johnson 2008). As such, the
length of the dark period is likely to be related to the investigative capabilities and familiarity of
these parties with the client’s underlying accounting systems and processes. An external auditor’s
accounting expertise may also help a client address problems related to restatements more quickly.
At a minimum, such experience and expertise could decrease the time that it takes the audit firm to
become comfortable with and willing to sign off on an estimate of the error that is being corrected.
Prior research finds that Big N auditors are associated with shorter audit reporting lags, measured as
3
Auditor involvement is likely to have increased after 2004 because firms were under no specific regulatory time
pressure to provide restatement announcements or quantitative details before the effective date of the four-day
rule. Audit committee involvement is likely to have increased after 2004 because while SOX AC requirements
were effective in July of 2003, the SEC did not require the stock exchanges to demand compliance until 2004
(large issuers) or 2005 (small/foreign issuers).
224 Schmidt and Wilkins
Auditing: A Journal of Practice & Theory
February 2013