I recently was schooled about the difference between “Little R” restatements versus “Big R” restatements when it comes to public companies and errors identified by auditors in past financial statements. When a company is off by more than 5% in their revenue statements, the Securities & Exchange Commission (SEC) requires that it go back and reissue the financials. This is considered a “Big R” restatement in contrast to a “Little R,” which is below the 5% rule of thumb.

Papa John’s recently came under scrutiny for not reissuing financials after “years’ worth of accounting errors” were found last spring. Now The Wall Street Journal reports there are reasons why it’s in companies’ best interest not to reissue prior financial statements, thanks to a study by the University of Arizona, Duke University, and Indiana University entitled, “The Last Chance to Improve Financial Reporting Reliability: Evidence from Recorded and Waived Audit Adjustments.” That study looked at data from 1,681 unique audit clients (chosen for inspection by the Public Company Accounting Oversight Board [PCAOB] between 2005 and 2014).

When companies do restate financials, their share price falls. Investors don’t like mistakes. Preeti Choudhary, a co-author of the study and an associate professor at the University of Arizona, said, “The significant share price movement suggests that managers and investors disagree about the importance of the errors.”

Another reason for avoiding a restatement is because of its impact on executive compensation. When “Big R” restatements occur, companies can “clawback” compensation. Although the SEC has the power to influence companies when it deems they have a duty to restate their financials, this power is infrequently exercised, according to a separate study, “The Materiality of Accounting Errors: Evidence from SEC Comment Letters” by researchers at Virginia Tech, the University of Notre Dame, and the University of Iowa.

Similarly, IMA® (Institute of Management Accountants) has conducted research on “earnings management” or financial reporting practices, asking 122 managers at publicly traded companies how public perception influences their decision to engage in aggressive (income-increasing) earnings management. Among the key findings:

  • Managers engage in more aggressive (income-increasing) earnings management when they believe such behavior will not be revealed publicly.
  • The prospect of being included on a corporate watch list changes managers’ accounting choices. When managers fear inclusion on a watch list, they are less likely to engage in aggressive (income-increasing) earnings management and more likely to engage in conservative (income-decreasing) earnings management.
  • Managers generally view earnings management as unethical (particularly income-increasing earnings management), but frequently engage in such behavior despite these beliefs.
  • Managers give considerable thought to how their aggressive accounting choices might be perceived by others (such as investors, regulators, and auditors).

Strategic Finance magazine contributors Erin L. Hamilton, CPA, Rina M. Hirsch, CPA, Uday S. Murthy, and Jason T. Rasso, CFE, elaborate more on this study’s results, making the distinction between “bad” earnings management and “good” earnings management:

“The only difference separating ‘bad’ earnings ?management—which is undertaken to hide true operating performance and mislead financial statement users—from ‘good’ earnings management—which is undertaken to manage the business effectively and create value for shareholders—is the intent of management when making financial reporting decisions. Because managerial intent is often unknown to financial statement users, there’s somewhat of a ‘knowledge gap’ that exists between the managers who know the purpose of their accounting decisions and the users of the statements who lack insight into the goals underlying reporting decisions.”

Clearly, companies’ willingness to be fully transparent is based on a range of factors, not all of which investors may be aware of. Share price, executive compensation, and reputation all play a role in managers’ willingness to restate financials when there are errors or when management engages in aggressive accounting practices.

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