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.
