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How Do Restatements Begin? Evidence of Earnings Management Preceding Restated Financial Reports

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  • Michael Ettredge
  • Susan Scholz
  • Kevin R. Smith
  • Lili Sun

Abstract

Most earnings restatements are blamed on error, or misunderstanding of GAAP, but suspicion persists that many of these restatements are instead due to intentional earnings management. We analyze balance sheet bloat, or unusually high levels of working capital account balances, for evidence of sustained, income-increasing earnings management "prior" to initial non-GAAP financial reports. We establish a pattern of systematically increasing balance sheet bloat for firms later issuing clearly fraudulent financial reports. Next, we compare bloat for apparently non-fraud restatements to fraud and control samples. We find non-fraud restatement companies' bloat is higher than control companies for two years preceding the initial misstated financial report. But, these firms accumulate less balance sheet bloat than companies with restatements clearly involving fraud. This suggests meaningful, but not pervasive, earnings management underlying even apparently non-fraudulent restatements. We extend our analysis to discretionary accruals and real activity earnings management. Copyright (c) 2010 Blackwell Publishing Ltd.

Suggested Citation

  • Michael Ettredge & Susan Scholz & Kevin R. Smith & Lili Sun, 2010. "How Do Restatements Begin? Evidence of Earnings Management Preceding Restated Financial Reports," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 37(3-4), pages 332-355.
  • Handle: RePEc:bla:jbfnac:v:37:y:2010-04:i:3-4:p:332-355
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    References listed on IDEAS

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    Cited by:

    1. Lennox, Clive & Li, Bing, 2014. "Accounting misstatements following lawsuits against auditors," Journal of Accounting and Economics, Elsevier, vol. 57(1), pages 58-75.
    2. Lucie Courteau & Jennifer L. Kao & Yao Tian, 2013. "Does Accrual Management Impair the Performance of Earnings-Based Valuation Models?," BEMPS - Bozen Economics & Management Paper Series BEMPS12, Faculty of Economics and Management at the Free University of Bozen.
    3. Nan-Ting Kuo & Cheng-Few Lee, 2016. "A potential benefit of increasing book–tax conformity: evidence from the reduction in audit fees," Review of Accounting Studies, Springer, vol. 21(4), pages 1287-1326, December.
    4. Pelucio-Grecco, Marta Cristina & Geron, Cecília Moraes Santostaso & Grecco, Gerson Begas & Lima, João Paulo Cavalcante, 2014. "The effect of IFRS on earnings management in Brazilian non-financial public companies," Emerging Markets Review, Elsevier, vol. 21(C), pages 42-66.
    5. Jan Barton, 2010. ""Discussion of" How Do Restatements Begin? Evidence of Earnings Management Preceding Restated Financial Reports," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 37(3-4), pages 356-368.
    6. repec:eee:reveco:v:49:y:2017:i:c:p:437-452 is not listed on IDEAS
    7. Mai Dao & Hua-Wei Huang & Ken Y. Chen & Ting-Chiao Huang, 2014. "Can Management Turnover Restore the Financial Statement Credibility of Restating Firms? Further Evidence," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 41(7-8), pages 893-925, September.

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