scispace - formally typeset

Journal ArticleDOI

Equity and debt issuance by firms violating GAAP

01 Oct 2012-Accounting and Finance (Blackwell Publishing Ltd)-Vol. 52, pp 77-108

Abstract: We examine security issuance in restated periods by firms that misreport financial statements and find that only a small per cent of such firms issues securities in the restated period. Investors are misled by mistakes made by firms issuing equity more so than other restating firms at the initial announcement of misreported earnings, but are not misled by mistakes made by debt-issuing firms. Equity-issuing firms that manage earnings to beat analyst expectations experience abnormally high returns in the restated period prior to security issuance. Firms that restated more reports and have higher pre-mistake returns are more likely to issue equity. High leverage, firm size and number of restated periods are positively associated with the likelihood of debt issuance by restating firms.
Topics: Earnings (51%)

Content maybe subject to copyright    Report

"*2:&,%.*6&23*48"*2:&,%.*6&23*48
*(*4",/--/.3"*2:&,%*(*4",/--/.3"*2:&,%
53*.&33"$5,485#,*$"4*/.3 )"2,&3/,".$)//,/'53*.&33

15*48".%%&#4*335".$&#8:2-36*/,"4*.(15*48".%%&#4*335".$&#8:2-36*/,"4*.(
"43*"28."","6&*"2%/3
"*2:&,%.*6&23*48
+#"2%/3'"*2:&,%&%5
"4",*8"!"*"43
/,,/74)*3".%"%%*4*/.",7/2+3"4)4403%*(*4",$/--/.3'"*2:&,%&%5#53*.&33'"$5,4805#3
/082*()4*,&8,"$+7&,,
)*3*3"02&02*.4/'"."24*$,&"$$&04&%'/205#,*$"4*/.*.
$$/5.4*.(".%*.".$
&)&
%&:.*4*6&6&23*/.*3"6"*,"#,&"4777*.4&23$*&.$&7*,&8$/-
&0/3*4/28*4"4*/.&0/3*4/28*4"4*/.
","6&*"2%/3"43*"28."".%!"*"43"4",*8"15*48".%%&#4*335".$&#8:2-36*/,"4*.(

53*.&33"$5,485#,*$"4*/.3

)4403%*(*4",$/--/.3'"*2:&,%&%5#53*.&33'"$5,4805#3
5#,*3)&%*4"4*/.
"2%/3"43*"28."",&6&*".%"4",*8"!"*"4315*48".%%&#4*335".$&#8:2-36*/,"4*.(
)*3*4&-)"3#&&."$$&04&%'/2*.$,53*/.*.*(*4",/--/.3"*2:&,%#8"."54)/2*9&%"%-*.*342"4/2/'
*(*4",/--/.3"*2:&,%4*3#2/5()44/8/5#8*(*4",/--/.3"*2:&,%7*4)0&2-*33*/.'2/-4)&2*()43
)/,%&23".%*302/4&$4&%#8$/082*()4".%/22&,"4&%2*()43 /5"2&'2&&4/53&4)*3*4&-*.".87"84)"4*3 /5"2&'2&&4/53&4)*3*4&-*.".87"84)"4*3
0&2-*44&%#84)&$/082*()4".%2&,"4&%2*()43,&(*3,"4*/.4)"4"00,*&34/8/5253&/2/4)&253&38/5.&&%4//#4"*.0&2-*44&%#84)&$/082*()4".%2&,"4&%2*()43,&(*3,"4*/.4)"4"00,*&34/8/5253&/2/4)&253&38/5.&&%4//#4"*.
0&2-*33*/.'2/-4)&2*()43)/,%&23%*2&$4,85.,&33"%%*4*/.",2*()43"2&*.%*$"4&%#8"2&"4*6&/--/.3,*$&.3&0&2-*33*/.'2/-4)&2*()43)/,%&23%*2&$4,85.,&33"%%*4*/.",2*()43"2&*.%*$"4&%#8"2&"4*6&/--/.3,*$&.3&
*.4)&2&$/2%".%/2/.4)&7/2+*43&,'*.4)&2&$/2%".%/2/.4)&7/2+*43&,'/2-/2&*.'/2-"4*/.0,&"3&$/.4"$4%*(*4",$/--/.3'"*2:&,%&%5

Equity and Debt Issuance by Firms Violating GAAP
Abstract
We examine security issuance in restated periods by firms that misreport financial
statements and find that only a small percent of such firms issues securities in the restated
period. Investors are misled by mistakes made by firms issuing equity more so than other
restating firms at the initial announcement of misreported earnings, but are not misled by
mistakes made by debt-issuing firms. Equity-issuing firms that manage earnings to beat
analyst expectations experience abnormally high returns in the restated period prior to
security issuance. Firms that restated more reports and have higher pre-mistake returns
are more likely to issue equity. High leverage, firm size and number of restated periods
are positively associated with the likelihood of debt issuance by restating firms.
1

1. Introduction
We study equity and debt issuance in restated periods by firms that violate
Generally Accepted Accounting Principals (GAAP).
1
Prior literature suggests that one of
the reasons firms violate GAAP is to reduce the cost of security issuance (Dechow,
Sloan, and Sweeny (1996), Richardson, Tuna and Wu (2003), Burns and Kedia (2006),
Efendi, Srivastava and Swanson (2006)). These studies find that firms that restate
financial statements or are subject to Securities and Exchange Commission (SEC)
enforcement actions for financial reporting violations (AAERs) raise more capital than
control firms during violation periods. They also find that security issuance in the
violation period increases the likelihood of a restatement or an AAER. They interpret
these results as evidence that firms manage earnings to issue securities at better prices.
However, these results are weak evidence to suggest that restating firms violate
GAAP in order to issue securities at inflated prices. For example, it is plausible that when
equity and debt issuance is motivated by other considerations, it results in higher scrutiny
of the firm’s accounting by managers, auditors, the SEC and other market participants
and thus increases the likelihood of a restatement or an AAER. Another explanation for
high security issuance in the restated period is the successful market timing by
management. Above mentioned studies also find that firms restating financial statements
experience abnormally high performance prior to the first restated year. Therefore,
abnormally high firm performance prior to misreporting can be driving both security
issuance and the likelihood of misreporting. In fact, Efendi, Srivastava and Swanson
(2006) find that security issuance does not explain the likelihood of a restatement when
1
Restated period is defined as the period between the beginning of the first restated year or quarter and the
date of restatement announcement.
2

the pre-misstatement price run up is included as an explanatory variable. This result is
consistent with Jensen’s (2005) theory of overvalued equity which suggests that
overpricing leads to value destructive behavior, such as earnings management.
Furthermore, none of these papers test whether erroneous accounting prior to security
issuance is associated with misvaluation in the restated period.
The main contribution of this paper is that it goes beyond the analysis of the
frequency of security issuance in the restated period and tests whether restating firms
experience abnormally high performance in the period after GAAP violation but before
security issuance, and whether this performance is related to the magnitude of accounting
misrepresentation relative to expectations. This paper is also the first to examine which
restating firms are more likely to issue equity and debt.
We analyze 446 US firms that restated financial statements due to violations of
GAAP during the period from January 1, 1996 to June 30, 2002. A sample of restating
firms provides a unique setting for studying the impact of the quality of financial
information on security issuance because ex post one observes the date and the nature of
mistakes in financial statements and the date of the correction of those mistakes. We read
restatement announcements to determine which financial reports were restated and the
impact of restatement on net income. Our research design allows us to directly test
whether overstatement of reported earnings is associated with investors over optimism
about firm prospects prior to equity and debt issuance. Unlike prior studies that examined
security issuance by restating firms (Burns and Kedia (2006), Efendi, Srivastava and
Swanson (2006)), we focus on actual security issuance rather than balance sheet proxies.
3

We find that only a small percent of restating firms issues securities in the restated
period: 15% of restating firms issue equity and 6% issue debt in the restated period,
compared with 9% of control firms issuing equity and 4% issuing debt.
2
The difference
between the frequencies of security issuance is statistically significant. Although the
percent of restating firms issuing securities is higher than the percent of control firms
issuing securities, the number of issuances in the restated period is small to argue that
security issuance is the dominant reason for violating GAAP - only 20% of firms issue
either equity or debt. Therefore, 80% of restating firms were not motivated by security
issuance to violate GAAP. Moreover, not all restating firms that issue equity manage
earnings upward. Nineteen percent of equity issuing firms and twenty one percent of debt
issuing firms understate net income prior to the issuance. If the firm understates net
income prior to security issuance, it will not obtain financing at more favorable terms.
Therefore, security issuance could not be a rational motivation for downward earnings
management. Overall, the results suggest that there is no strong connection between the
act of restatement and security issuance.
If some firms violate GAAP to reduce financing costs, then we should observe
positive association between abnormal return at the announcement of earnings and the
mistake, adjusted for expected earnings. We test this proposition by examining whether
investors are misled by mistakes in reported earnings prior to equity and debt issuance.
Following Bardos, Golec and Harding (2011) we decompose reported earnings into
correctly stated component and mistake and examine abnormal returns at the initial
2
Control firms are found among all firms that did not restate their earnings during the period January 1,
1995 to June 30, 2002 in the same two digit SIC code as restating firms that are the closest in size (market
value) and book-to-market, measured one fiscal year prior to the announcement of restatement, and have
sufficient data to calculate returns one year prior to mistake and one year subsequent to restatement.
4

Citations
More filters

Journal ArticleDOI
Po-Chang Chen1Institutions (1)
Abstract: This study investigates whether banks respond to financial misreporting as the borrowing firms release misstated financial reports, i.e., in the misreporting period. Drawing upon finance theory that recognizes banks' superior information access and processing abilities, this study predicts and finds that banks adjust loan contract terms in response to the ongoing misreporting. Compared with loans issued in the prior period, loans issued in the misreporting period have higher interest spread, are more likely to be secured by collateral, and have more restrictive covenants. Further analyses show that banks acquire indirect, rather than direct, information about the misreporting and that they do not fully adjust loan pricing until after the restatement announcement. Together, these findings suggest that banks make timely, but insufficient, adjustments during the misreporting period. Nevertheless, banks' early reactions appear to be unique, as equity investors do not respond to the ongoing misreport...

31 citations


Journal ArticleDOI
Abstract: We provide a comprehensive overview of the findings regarding the causes of financial restatements in the US. Acknowledging that restatements may derive from intentional and unintentional misreporting, we assign the findings to one of three pillars: i) expected benefits, ii) expected costs and iii) executive characteristics. Assuming that managers are rational decision-makers, the likelihood of misreporting increases in expected benefits and decreases in expected costs. While expected benefits reflect executives’ desire to maximize private benefits through compensation contracts, expected costs refer to the likelihood that misreporting will be revealed through internal or external controls. Given that efficiency of internal and external controls derives from the ability to avoid both, intentional and unintentional misreporting, we also review literature that investigates less severe restatements. We support the existing research by enhancing the understanding of restatements in light of severe and less severe restatements, identifying research gaps and organizing fragmented findings into a larger picture. Ultimately, our survey might inform regulatory bodies, auditors, standard setters and executives regarding restatements of financial statements.

13 citations


Cites background from "Equity and debt issuance by firms v..."

  • ...Bardos and Zaiats (2012) extend Electronic copy available at: https://ssrn.com/abstract=3231740 - 9 - this research and show that equity-issuing restatement firms experience abnormally high returns in misstated periods, suggesting that these firms misled investors before the equity issuance....

    [...]

  • ...Debt-issuing restatement firms, in contrast, exhibit no abnormal performance prior to debt issuance (Bardos and Zaiats 2012)....

    [...]

  • ...Since only 20% of restatement firms issue equity or debt during the misstated period, Bardos and Zaiats (2012) argue that security issuance is not the dominant reason for misreporting and conclude that only a few equity-issuing restatement firms obtain financing at better terms....

    [...]


Journal ArticleDOI
Abstract: Purpose This study investigates the occurrence of pre-merger earnings management for a sample of 197 stock- and cash-financed UK acquirers between 1990 and 2009. We also examine the earnings management behavior around the change in the Corporate Governance Code in 2003 based on the Higgs recommendations. Design/methodology/approach Mean and median accrual and real-based manipulation are examined in the period before the announcement of a merger and acquisition. These are compared across stock and cash acquirers as well as before and after the implementation of the Higgs recommendations. We also run logistic regressions to examine accrual and real-based manipulation across stock and cash acquirers after controlling for variables that may impact the acquisition type. Findings We find some evidence of upward pre-merger accrual-based earnings management by stock-financed acquirers, which is in line with the findings of Botsari and Meeks (2008). Furthermore, we do not find significant changes in the post-Higgs...

7 citations


Journal ArticleDOI
Abstract: We re-examine the effect of financial restatements on the cost of equity vis-a-vis litigation risk. Specifically, we study the effect of litigation on post-restatement financing costs and whether market anticipates litigation before restatement announcement as evident from its effect on financing costs. In a sample of 91 restatements, although we find that the cost of equity increases subsequent to a financial restatement for all restating firms, the increase is substantially greater for firms facing litigation as a result of the restatement. We also find that investors do not adjust for the cost of equity before the announcement of a financial restatement for firms facing post-restatement litigation. Overall, our findings suggest that most of the increase in the cost of equity after restatement is concentrated in sued sub-sample and that the cost of equity is an important channel through which litigation associated with financial restatement is priced. The economic effect of post-restatement litigation i...

5 citations


Cites background from "Equity and debt issuance by firms v..."

  • ...A sizeable stream of literature has sought to understand the economic effects of financial restatements by publicly traded corporations (Palmrose et al., 2004; Bardos and Zaiats, 2012)....

    [...]

  • ...Accordingly, Desai et al. (2006), Agrawal and Cooper (2007) and Burks (2010) find high turnover among top management (e....

    [...]


Journal ArticleDOI
01 Jun 2019-
Abstract: Muhammad Akhtar 1*, Irfan Ahmed 2, Sajid Gul 3, Najam us Sahar 4 1 Assistant Professor at the FAST School of Managment, National University of Computer & Emerging Sciences, Islamabad, Pakistan 2 Lecturer, FMS, Riphah International University, Islamabad, Pakistan 3 Assistant Professor and HoD at the FMS, Mohi-Ud-Din Islamic University Azad Jammu & Kashmir, Mirpur, Azad Kashmir 4 Assistant Professor at the FMS, Riphah International University, Islamabad, Pakistan

3 citations


Cites methods from "Equity and debt issuance by firms v..."

  • ...Management uses creative accounting techniques to inflate the value of securities (Bardos & Zaiats 2012)....

    [...]


References
More filters

Journal ArticleDOI
Mitchell A. Petersen1Institutions (1)
Abstract: In both corporate finance and asset pricing empirical work, researchers are often confronted with panel data. In these data sets, the residuals may be correlated across firms and across time, and OLS standard errors can be biased. Historically, the two literatures have used different solutions to this problem. Corporate finance has relied on clustered standard errors, while asset pricing has used the Fama-MacBeth procedure to estimate standard errors. This paper examines the different methods used in the literature and explains when the different methods yield the same (and correct) standard errors and when they diverge. The intent is to provide intuition as to why the different approaches sometimes give different answers and give researchers guidance for their use.

6,753 citations


Journal ArticleDOI
Abstract: This study tests whether firms that would benefit from import relief (eg, tariff increases and quota reductions) attempt to decrease earnings through earnings management during import relief investigations by the United States International Trade Commission (ITC) The import relief determination made by the ITC is based on several factors that are specified in the federal trade acts, including the profitability of the industry Explicit use of accounting numbers in import relief regulation provides incentives for managers to manage earnings in order to increase the likelihood of obtaining import relief and/or increase the amount of relief granted While studies of earnings management typically examine situations in which all contracting parties have incentives to "perfectly" monitor (adjust) accounting numbers for such manipulation, import relief investigations provide a specific motive for earnings management that is not

6,720 citations


Journal ArticleDOI
Abstract: Accounting theorists have generally evaluated the usefulness of accounting practices by the extent of their agreement with a particular analytic model. The model may consist of only a few assertions or it may be a rigorously developed argument. In each case, the method of evaluation has been to compare existing practices with the more preferable practices implied by the model or with some standard which the model implies all practices should possess. The shortcoming of this method is that it ignores a significant source of knowledge of the world, namely, the extent to which the predictions of the model conform to observed behavior. It is not enough to defend an analytical inquiry on the basis that its assumptions are empirically supportable, for how is one to know that a theory embraces all of the relevant supportable assumptions? And how does one explain the predictive powers of propositions which are based on unverifiable assumptions such as the maximization of utility functions? Further, how is one to resolve differences between propositions which arise from considering different aspects of the world? The limitations of a completely analytical approach to usefulness are illustrated by the argument that income numbers cannot be defined substantively, that they lack "meaning" and are therefore of doubtful utility.' The argument stems in part from the patchwork development of account-

5,689 citations


"Equity and debt issuance by firms v..." refers background in this paper

  • ...A well-established result in the literature is that earnings announcement returns are positively related to unexpected earnings (Ball and Brown, 1968; Collins and Kothari, 1989)....

    [...]


Posted Content
Abstract: This paper evaluates alternative models for detecting earnings management. The paper restricts itself to models that assume the construct being managed is discretionary accruals, since such models are commonly used in the extant accounting literature. Existing models range from simple models in which discretionary accruals are measured as total accruals, to more sophisticated models that separate total accruals into a discretionary and a non-discretionary component. Prior to this paper, there had been no systematic evidence bearing on the relative performance of these alternative models at detecting earnings management. This paper evaluates the relative performance of the competing models by comparing the specification and power of commonly used test statistics across the measures of discretionary accruals generated by each model. The specification of the test statistics is evaluated by examining the frequency with which they generate type I errors for a random sample of firm-years and for samples of firm-years with extreme financial performance. We focus on samples with extreme financial performance because the stimuli investigated in previous research are frequently correlated with financial performance. The first sample of firms are targeted by the Securities and Exchange Commission for allegedly overstating annual earnings and the second sample is created by artificially introducing earnings management into a random sample of firms.

5,652 citations


"Equity and debt issuance by firms v..." refers background in this paper

  • ...However, market model-adjusted abnormal returns are not statistically different from zero for this period....

    [...]

  • ...However, DNI/Assets is considerably less skewed....

    [...]

  • ...However, as the true value of earnings is revealed, investors devalue firms that manage earnings....

    [...]

  • ...However, accrual management is a more common practice, which does not impose the large costs of financial misrepresentation that are associated with restatements....

    [...]

  • ...However, as investors learn the true value of earnings, they revalue firms that manage earnings downwards....

    [...]


Journal Article
Abstract: This paper evaluates alternative accrual-based models for detecting earnings management. The evaluation compares the specification and power of commonly used test statistics across the measures of discretionary accruals generated by the models and provides the following major insights. First, all of the models appear well specified when applied to a random sample of firm-years. Second, the models all generate tests of low power for earnings management of economically plausible magnitudes (e.g., one to five percent of total assets). Third, all models reject the null hypothesis of no earnings management at rates exceeding the specified test-levels when applied to samples of firms with extreme financial performance. This result highlights the importance of controlling for financial performance when investigating earnings management stimuli that are correlated with financial performance. Finally, a modified version of the model developed by Jones (1991) exhibits the most power in detecting earnings management.

4,078 citations


Performance
Metrics
No. of citations received by the Paper in previous years
YearCitations
20192
20171
20161
20141
20121