OCTOBER 2004

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The Ramifications of Restatements

Outside directors face job market penalties from financial reporting failures

Research by Suraj Srinivasan

Outside board members fear the legal and financial consequences they may face as a result of financial reporting failures. However, recent research suggests that outside directors of companies issuing earnings restatements are more likely to suffer a blow to their reputations and employability. When companies restate earnings, outside directors tend to lose board positions with both the restating companies and other companies. The losses are more severe for audit committee members and when the restatements are severe.

For outside directors, sitting on a company's board bestows a number of benefits, including boosting the director's reputation as an expert monitor. Their board membership is a signal that they are successful managers and attractive candidates to serve on the boards of other firms as well. Serving as an outside director brings prestige and opportunities for networking and ongoing learning. Taken together, these nonfinancial rewards are seen by many outside directors as more attractive than monetary incentives.

Previous research has suggested that managers and directors with positive reputations are rewarded with additional board positions and benefits. Directors who are seen as being ineffective tend to lose board positions and their affiliated perks. Until now, little has been known about the impact of financial reporting failure on outside board members. In particular, do outside directors of firms which are forced to restate their earnings face a risk of legal liability or loss of board positions?

In the study, "Consequences of Financial Reporting Failure for Outside Directors: Evidence from Accounting Restatements," University of Chicago Graduate School of Business professor Suraj Srinivasan examines the impact of accounting restatements on more than 2,000 outside directors.

"Over the past few years, it has been suggested that insiders and affiliated directors are not the best people to monitor managers," says Srinivasan. "The current thinking is that the board and especially the audit committee should be primarily comprised of people who are truly independent of the company's management."

In a climate of increased financial reporting scandals, independent directors are expected to be part of the solution to corporate governance problems. If better corporate governance is supposed to be the result of having independent directors, what are the consequences for these directors when monitoring fails?

Three Types of Restatements

A firm's earnings restatements can decrease reported income or increase reported income. In the former, restatements are seen as evidence that firms tried aggressive accounting practices.

"The earnings number could be wrong because of genuinely mistaken assumptions," notes Srinivasan. "Or, as suspected in some cases, it could be wrong because of deliberate managerial intent."

By contrast, income-increasing restatements are often not viewed in such a negative light, despite the fact that these restatements are still accounting failures. A third type of restatement, the technical restatement, does not imply improper accounting. Such a restatement can result from routine actions, such as new accounting rules.

Srinivasan used data from the General Accounting Office, tracking companies that announced restatements between 1997 and 2000. Of the 304 companies studied, 201 announced income-decreasing restatements. Fifty-one issued income-increasing restatements, and another 52 issued technical restatements.

Srinivasan focused on the first type of restatement, in which the assessment of the company's profitability was better in the original earnings statement than what it turns out to be in the restatement.

Restatements from these companies represented highly significant events. Among income-decreasing companies, the average cumulative amount of net income restated was $39.5 million. On average, companies lost close to 10 percent of their value upon announcement of their income-decreasing restatements.

Srinivasan looked at the most significant failures. In examining the income-decreasing companies, he noted that restatements were followed by a host of reactions, including legal challenges and corporate governance changes. The Securities and Exchange Commission (SEC) issued an Accounting and Auditing Enforcement release against more than half of the companies. Additionally, in more than half of the companies, the CEOs resigned. In nearly half, the auditors changed.

By comparison, income-increasing companies in his study experienced fewer lawsuits, less SEC enforcement action, and less CEO turnover and auditor change. Firms announcing technical restatements suffered no litigation or SEC action. They also had lower rates of CEO and auditor turnover than either of the other two groups.

Impact on Directors

For companies that issued income-decreasing restatements, Srinivasan found more than half of the outside directors left those boards within three years. Most of the turnover occurred in the first two years. That percentage was almost twice that of the turnover in companies releasing income-increasing restatements, and nearly three times that of companies issuing technical restatements.

Among companies issuing income-decreasing restatements, the turnover of outside directors was greater among those releasing annual restatements rather than interim restatements.

"Longer-duration restatements have greater consequences and are more severe," says Srinivasan.

Srinivasan next looked at how the fate of directors in income-decreasing companies was impacted by the severity of restatements. He measured severity by examining both the number of quarters in which earnings were restated and the value of the restatement. Under both measures, the likelihood of director turnover increased with the severity of restatement.

The likelihood that audit committee members would leave increased with the severity of the income-decreasing restatement. This likelihood was also greater for audit committee members than for other outside directors, which presumably reflected damage to their reputations as skillful monitors of financial reporting, writes Srinivasan. Director departure was more likely when accompanied by CEO change. It was also more probable when higher percentages of company shares were owned by board members.

Director turnover in income-decreasing cases was also more likely for older directors, but less likely for those with longer tenure and who held more directorships at other companies.

Comparing these findings against companies issuing income-increasing and technical restatements, Srinivasan found that with income-increasing restatements, there is a much more subdued impact than in income-decreasing restatements. In technical restatements, there is no impact.

Loss of Other Board Positions

Turning to board positions in other companies, Srinivasan examined whether other companies and the stock market paid attention to monitoring failures. He found evidence suggesting that they did. Directors, especially audit committee members, of companies with income-decreasing restatements faced a loss of directorships at other companies as well.

Predictably, the decline in other directorships was greater for directors in companies making annual income-decreasing restatements than in those making interim restatements. The loss of board positions in other companies increased with the severity of the income-decreasing restatement, and impacted audit committee members more than other directors. Overall, audit committee directors seem to suffer greater reputational harm than other directors. The decline in other directorships was slightly greater for older directors and for those who left restating companies. If directors were CEOs of public companies, the loss was slightly lessened.

Srinivasan then compared these findings with the fate of directors of companies issuing income-increasing and technical restatements. For these directors, the decline in holding other directorships was much less severe. There was no significant change in opportunities for directors in companies issuing technical restatements.

Srinivasan next studied the issue of legal and stock market driven penalties that might be borne by outside directors. He analyzed data from the Stanford Securities Class Action Clearinghouse regarding lawsuits initiated against outside directors. The results indicate that even in the income-decreasing group, only about six percent of outside directors were named in lawsuits.

"There is a big fear that directors will face legal liability," he says. "Even though there is little financial liability due to directors and officers insurance, there is still a nuisance factor associated with lawsuits. However, even this nuisance cost seems to be limited to a very small percentage of directors."

Did investors use restatements as a reason to perceive poor monitoring by directors, punishing the stocks of other companies on whose boards the same directors served?

Srinivasan examined the stock price reaction of companies that shared directors with restating companies, and found the answer was yes. Evidence suggests investors revise their valuation of companies when their directors are associated with restating companies.

Overall, the study serves as a contrast between the legal costs and labor market costs for outside directors.

"It appears that there are very few legal costs, but there seem to be costs in loss of directorship opportunities," says Srinivasan. "In some sense, this is a contrast between what the legal system does and what the labor market does. And the labor market costs certainly seem to be evident."

Srinivasan suggests that future research might examine whether such penalties increase during periods in which the market pays greater attention to corporate governance issues.

Finally, Srinivasan intends to examine whether director turnover is forced rather than voluntary by examining characteristics of other firms in which directors lose board positions.

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Suraj Srinivasan is assistant professor of accounting at the University of Chicago Graduate School of Business.

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