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#e Reputational Penalty for Aggressive
Accounting: Earnings Restatements and
Management Turnover
Hemang Desai
Chris E. Hogan
Michael S. Wilkins
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83
THE ACCOUNTING REVIEW
Vol. 81, No. 1
2006
pp. 83–112
The Reputational Penalty for Aggressive
Accounting: Earnings Restatements and
Management Turnover
Hemang Desai
Southern Methodist University
Chris E. Hogan
Southern Methodist University
Michael S. Wilkins
Texas A&M University
ABSTRACT: In this paper we investigate the reputational penalties to managers of firms
announcing earnings restatements. More specifically, we examine management turn-
over and the subsequent employment of displaced managers at firms announcing
earnings restatements during 1997 or 1998. In contrast to prior research (Beneish 1999;
Agrawal et al. 1999), which does not find increased turnover following GAAP violations
or revelation of corporate fraud, we find that 60 percent of restating firms experience
a turnover of at least one top manager within 24 months of the restatement compared
to 35 percent among age-, size-, and industry-matched firms. Moreover, the subse-
quent employment prospects of the displaced managers of restatement firms are
poorer than those of the displaced managers of control firms. Our results hold after
controlling for firm performance, bankruptcy, and other determinants of management
turnover, and suggest that both corporate boards and the external labor market impose
significant penalties on managers for violating GAAP. Also, in light of resource con-
straints at the SEC, our findings are encouraging as they suggest that private penalties
for GAAP violations are severe and may serve as partial substitutes for public enforce-
ment of GAAP violations.
Keywords: restatements; reputational penalty; management turnover; aggressive
accounting.
Data Availability: The data used in this study are available from public sources iden-
tified in the text.
We thank two anonymous referees, James Brickley, Joe Carcello, Michelle Diaz, Patricia Dechow (editor), Neil
Fargher, Kathleen Farrell, Zhaoyang Gu, Doug Hanna, Prem Jain, Simi Kedia, Mary Lea McAnally, Jody Magliolo,
Paul Simko, Lynn Rees, Greg Sommers, Rex Thompson, Brett Trueman, Catherine Usoff, Kumar Venkataraman,
Michael Vetsuypens, David Williams, Joanna Wu, the participants at the 2004 AAA Annual Meeting and 2004
FMA meeting for comments and discussions, and James John, Janet McDonald, Jenna Moscovic, Hari Pothineni,
and Kun Wang for research assistance.
Editor’s note: This paper was accepted by Patricia Dechow, Editor.
Submitted November 2003
Accepted June 2005
84 Desai, Hogan, and Wilkins
The Accounting Review, January 2006
I. INTRODUCTION
I
n recent years the incidence of earnings restatements and financial reporting fraud has
increased dramatically (GAO-03-138, U.S. Government Accounting Office [GAO]
2002a; Wu 2002). The erosion in the quality of earnings and financial reporting as
evidenced by the proliferation of earnings restatements has caused concern among academ-
ics, practitioners, and regulators alike. Of particular concern is the extent to which man-
agers’ actions can be adequately monitored, given (1) the widely held belief that internal
control mechanisms do not discipline firm managers effectively (Jensen 1993) and (2) the
fact that the SEC has significant resource limitations that prohibit it from adequately in-
vestigating all alleged GAAP violations (GAO-02-302, GAO 2002b).
1
In short, these factors
in combination with the dearth of evidence from prior research about adverse consequences
to managers for violating GAAP (Beneish 1999) and committing other types of corporate
fraud (Agrawal et al. 1999) have led to a popular perception that managers often ‘‘get
away’’ with earnings manipulation (Abelson 1996).
In this paper, we investigate the reputational penalties to the managers of firms that
restated their earnings in 1997 or 1998. Our measure of reputational penalty is management
turnover and subsequent ex post settling up in the managerial labor market. Such an analysis
is important because high management turnover coupled with a low rehire rate could influ-
ence managerial actions and incentives, ex ante. That is, if the managerial labor market
imposes significant costs on the displaced managers in the form of a loss in income, power,
prestige, and/or reputation following a restatement, then such an ex post settling up can
provide incentives for managers to avoid manipulating earnings. Stated differently, the pen-
alties implicit in the managerial labor market may help to reduce the regulatory costs
associated with monitoring and enforcing strict adherence to GAAP.
While previous research has provided strong evidence on the incentives that exist for
firms to engage in earnings manipulation (e.g., Kedia 2003; Erickson et al. 2003; Richardson
et al. 2003; Beneish 1999; Dechow et al. 1996), the evidence on the consequences of
earnings manipulation for managers is weak. In a sample of 64 GAAP violators that were
targeted by the SEC for enforcement actions between 1987 and 1993, Beneish (1999) does
not find a significant difference in the managerial turnover rate between sample firms and
size-, age-, and industry-matched control firms. Similarly, Agrawal et al.’s (1999) investi-
gation of the consequences of corporate fraud (which includes financial reporting fraud)
does not document a significant association between fraud and subsequent managerial turn-
over over the period 1981–1992. Findings such as these contribute to the belief that man-
agement does not suffer consequences following the revelation of fraud; that is, the mon-
itoring mechanisms do not impose sufficient discipline on managers.
In this paper, we re-examine the consequences to managers for committing GAAP
violations. Our analysis is important for at least two reasons. First, there were significant
changes in both internal and external monitoring mechanisms in the U.S. during the 1990s
(Holmstrom and Kaplan 2001). For example, the influence of institutional owners increased
dramatically, as their ownership of U.S. companies nearly doubled from 1980 to 1996
(Gompers and Metric 2001). There was also a large increase in shareholder activism in the
1990s (Gillan and Starks 2000), along with a trend toward smaller, more independent
corporate boards (Yermack 1996). Consistent with these changes, Huson et al. (2001) show
1
The report issued by the GAO (GAO 2002b) finds that the SEC’s workload as measured by open and pending
cases has increased 65 percent and 77 percent, respectively, from 1991 to 2000, while the staff-years dedicated
to these investigations have increased only 16 percent. Because the SEC is unable to address every violation, it
prioritizes the cases it will pursue (Feroz et al. 1991).
The Reputational Penalty for Aggressive Accounting 85
The Accounting Review, January 2006
that the frequency of forced turnovers has increased during the 1971–1994 period and was
highest over the 1989–1994 period. Similarly, a recent Booz Allen Hamilton study suggests
that this trend has continued, as the rate of CEO dismissals in the largest 2,500 public
companies increased by 170 percent from 1995 to 2003 (Lucier et al. 2004). Although the
data point to an increase in the frequency of forced turnovers in the 1990s, the empirical
evidence on the relation between performance and forced turnover has remained relatively
stable over time (Huson et al. 2001). In spite of this fact, it is difficult to ignore the
significant changes in the internal and external monitoring mechanisms that have occurred
over the last few years. Given that our sample covers a later time period (1997–98) relative
to prior studies, we are able to test whether the recent increased focus on corporate gov-
ernance results in boards being more likely to punish top management when aggressive
accounting or fraud is revealed.
The second reason that our study is important relates to the power of tests in previous
research. Prior studies have provided evidence consistent with ex post settling up in the
labor market for directors of firms committing GAAP violations (Gerety and Lehn 1997;
Srinivasan 2005) with no corresponding evidence for top managers of firms in similar
situations. The fact that there seem to be significant consequences for individuals who are
only tangentially involved in a firm’s daily operations (i.e., directors) but no such conse-
quences for those who are directly responsible for whatever GAAP violations arise (i.e.,
top managers) is somewhat surprising. One potential reason for the lack of evidence is that
the samples employed in management turnover studies tend to be rather small. For example,
although the initial sample of Agrawal et al. (1999) consists of 103 firms, data restrictions
reduce their usable sample to between 50 and 74. Moreover, given that they examine a
general set of corporate fraud, their sample of accounting fraud incidents is even smaller.
Similarly, Beneish’s (1999) sample size is 64 firms, of which 29 firms file for bankruptcy
within four years of the issuance of an Accounting and Auditing Enforcement Release
(AAER). Thus, his sample size for the analysis of employment losses for nonbankrupt firms
is only 35, limiting the inferences that may be drawn from his findings. This is not to say
that previous research on the relationship between accounting problems and managerial
turnover is flawed. However, because we are able to investigate this relationship in a period
from which many more observations can be drawn (due to the increasing number of ac-
counting violations over time), our tests are more powerful than those employed by previous
researchers.
In contrast to Beneish (1999) and Agrawal et al. (1999), our results show that earnings
restatements are very costly for the managers of restating firms. We examine a sample of
146 firms that announced restatements in 1997 or 1998.
2
We end our sample in 1998 to
permit a sufficiently long window to track both the turnover and the subsequent employ-
ment. 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 percent of the
firms. The corresponding rate of turnover among industry-, size-, and age-matched control
firms is 35 percent. The significant difference in turnover persists even after controlling for
other factors associated with management turnover, such as performance, bankruptcy, and
governance characteristics. Moreover, our analysis shows that the prospects of subsequent
employment are significantly poorer for displaced managers of sample firms relative to their
displaced counterparts at control firms. Even among managers who get rehired at one of
2
Our sample period precedes Enron’s and other high-profile restatement announcements. Thus, the reputational
penalties in the time period we examine may be understated relative to the recent time period as anecdotal
evidence seems to indicate that Boards are under greater pressure to respond to aggressive accounting behavior.
86 Desai, Hogan, and Wilkins
The Accounting Review, January 2006
the top three positions at a public firm, our results suggest that in contrast to the control
firm managers, the sample firm managers suffer deterioration in the quality of new em-
ployment relative to their previous employment. Given that the mean age of managers in
our sample is less than 50, these results suggest that, on average, managers of restatement
firms suffer significant losses in reputation and very likely personal wealth.
The fact that there are significant negative personal consequences for failing to adhere
to GAAP or for aggressive interpretation of GAAP mitigates some of the widespread con-
cern that insufficient disciplinary mechanisms have allowed managers to get away with
earnings manipulation. Our findings show that once earnings manipulation is discovered, a
majority of the managers face discipline from the board and from the external labor market.
We maintain that an increased awareness of the penalties imposed, coupled with recent
regulatory and legal actions, have the potential to influence managerial actions ex ante,
thereby reducing the incidence of aggressive accounting or outright fraud.
The remainder of the paper is organized as follows. Section II discusses prior literature
on management incentives, internal control systems, and management turnover. Section III
discusses the sample of restatement firms and control firms and provides descriptive statis-
tics on operating performance and governance characteristics prior to the restatement an-
nouncement for both groups. Section IV reports univariate and multivariate analyses of
management turnover and rehire rates for restatement and control firms. Section V provides
concluding remarks.
II. MANAGEMENT INCENTIVES, INTERNAL CONTROL, AND TURNOVER
Recent press reports suggest that incentive structures—in particular equity-based com-
pensation plans including stock and option grants—that were originally viewed as a way
to align managements’ incentives with those of shareholders may actually prompt managers
to use aggressive accounting or outright fraud to inflate stock prices (Byrne 2002). Studies
have documented a greater incidence of insider selling (Beneish 1999) and stock option
grants and exercises before the announcement of GAAP violations or restatements (Kedia
2003). Erickson et al. (2003) and Richardson et al. (2003) also show that stock-based
compensation comprises a much larger fraction of CEO pay at restating firms relative to
control firms. Murphy (1999) provides evidence that the use of stock option compensation
has increased dramatically during the 1990s, suggesting that incentives to misstate earnings
have increased (see also, Efendi et al. 2004; Bartov and Mohanram 2005). In addition to
personal incentives, capital market incentives such as the need to maintain positive earnings
surprises and the need for external financing are also greater for firms restating their earn-
ings and/or violating GAAP (Richardson et al. 2003; Dechow et al. 1996).
What seems to have been lacking at firms such as these is an effective system of internal
control, including corporate governance mechanisms designed to detect fraud, curtail ag-
gressive accounting, and discipline managers who engage in such activities. However, it is
not obvious that the optimal level of earnings management or even fraud necessarily be
zero nor that every revelation of earnings management or fraud should be followed by
management turnover. It is extremely costly both for a firm to design an internal control
mechanism that eliminates such behavior and to replace a top manager (Agrawal et al.
1999). If, however, the revelation of fraud or aggressive accounting results in a large decline
in firm value (say, due to a large penalty imposed by the capital market), then it may benefit
the firm to effect the change. This would explain why boards are prone to replacing man-
agers following poor performance or financial distress (Coughlan and Schmidt 1985; Warner
et al. 1988; Weisbach 1988; Gilson 1989; Gilson and Vetsuypens 1993). Also, a large
decline in market value upon the announcement of the restatement suggests that the market
