The value of restatement to fraud prediction
Abstract
A financial report restatement reflects errors in the previous financial statement, and thus it increases investors’ doubt about the credibility of the financial statement. The primary objective of this paper is to examine whether restatement announcements imply increased fraud risks in Chinese firms in the context that up to one quarter of listed companies have restated their financial reports in China, and explore the implications of the content, severity and reasons for restatements with respect to fraud. In this paper, firms with financial restatements prove to be more likely to be labeled as fraudulent by regulators in China. Second, the following results also are revealed: (1) financial statements, except balance sheet restatements, provide insights into the revelation of fraudulent behaviors, (2) the severity of restatements is positively correlated with future fraud disclosures, and (3) restatements due to negligence are positively correlated with future fraud occurrences. These results imply that restatement announcements and their different characteristics provide important information for detecting financial statement fraud.
Keyword : restatement, fraud, innocent error, negligence, severity of restatement, content of restatement, reasons of restatements, propensity score matching method, fraud risk
How to Cite
Qiu, S., He, H.-Q., & Luo, Y.- sheng. (2019). The value of restatement to fraud prediction. Journal of Business Economics and Management, 20(6), 1210-1237. https://doi.org/10.3846/jbem.2019.10489
This work is licensed under a Creative Commons Attribution 4.0 International License.
References
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Bartus, T. (2005). Estimation of marginal effects using margeff. Stata Journal, 5(3), 309-329. https://doi.org/10.1177/1536867X0500500303
Baucus, M. (1994). Pressure, opportunity and predisposition: A multivariate model of corporate illegality. Journal of Management, 20(4), 699-721. https://doi.org/10.1016/0149-2063(94)90026-4
BenYoussef, N., & Breton, G. (2016). Restatement announcements: sincerity analysis through information manipulation theory. Retrieved from https://ssrn.com/abstract=1985680
BenYoussef, N., & Khan, S. (2018). Timing of earnings restatements: CEO equity compensation and market reaction. Accounting and Finance, 58(2), 341-365. https://doi.org/10.1111/acfi.12220
China securities regulatory commission. (2012). Guidelines for the industry classification of listed companies. Retrieved from http://www.csrc.gov.cn/pub/newsite/flb/flfg/bmgf/zh/gfxwjtj/201310/t20131016_236281.html
Christensen, J. (2010). Accounting errors and errors of accounting. Accounting Review, 85(6), 1827-1838. https://doi.org/10.2308/accr.2010.85.6.1827
Chung, J., & Mccracken, S. (2014). Understanding the restatement process. Accounting Perspectives, 13(4), 253-281. https://doi.org/10.1111/1911-3838.12036
Corona, C., & Randhawa, R. S. (2018). The value of confession: admitting mistakes to build reputation. The Accounting Review, 93(3), 133-161. https://doi.org/10.2308/accr-51893
Cuadrado-Ballesteros, B., Garcia-Sanchez, I. M., & Ferrero, J. M. (2016). How are corporate disclosures related to the cost of capital? The fundamental role of information asymmetry. Management Decision, 54(7), 1669-1701. https://doi.org/10.1108/MD-10-2015-0454
Demirkan, S., & Platt, H. D. (2018). Differential investors’ response to restatement announcements: an empirical investigation. Journal of Economics and Financial Analysis, 2(2), 29-59.
Donelson, D. C., Ege, M. S., & McInnis, J. M. (2017). Internal control weaknesses and financial reporting fraud. Auditing: A Journal of Practice & Theory, 36(3), 45-69. https://doi.org/10.2308/ajpt-51608
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Erickson, M., Hanlon, M., & Maydew, E. L. (2006). Is there a link between executive equity incentives and accounting fraud? Journal of Accounting Research, 44(1), 113-143. https://doi.org/10.1111/j.1475-679X.2006.00194.x
Fang, J., Lobo, G. J., Zhang, Y., & Zhao, Y. (2018). Auditing related party transactions: evidence from audit opinions and restatements. Auditing: A Journal of Practice & Theory, 37(2), 73-106. https://doi.org/10.2308/ajpt-51768
Fang, V. W., Huang, A. H., & Wang, W. (2017). Imperfect accounting and reporting bias. Journal of Accounting Research, 55(4), 919-962. https://doi.org/10.1111/1475-679X.12170
Firth, M., Rui, O. M., & Wu, W. (2011). Cooking the books: recipes and costs of falsified financial statements in China. Journal of Corporate Finance, 17(2), 371-390. https://doi.org/10.1016/j.jcorpfin.2010.09.002
He, L., Sarath, B., & Wans, N. (2019). Material weakness disclosures and restatement announcements: The joint and order effects. Journal of Business Finance & Accounting, 46(1-2), 68-104. https://doi.org/10.1111/jbfa.12363
Hennes, K. M., Leone, A. J., & Miller, B. P. (2008). The importance of distinguishing errors from irregularities in restatement research: the case of restatements and CEO/CFO turnover. The Accounting Review, 83(6), 1487-1519. https://doi.org/10.2308/accr.2008.83.6.1487
Hirschey, M., Smith, K. R., & Wilson, W. M. (2015). The timeliness of restatement disclosures and financial reporting credibility. Journal of Business Finance and Accounting, 42(7-8), 826-859. https://doi.org/10.1111/jbfa.12125
Hong, W. Z., Wang, X. X., Ping, H. Q., & Information, S. O. (2014). Research on the financial report fraud detection of listed companies based on logistic regression model. Chinese Journal of Management Science, 22(11), 351-356.
Ji, A. E., Kumar, K. R., Pei, H., & Xue, Y. (2019) Does the market value auditors’ industry specializations? Evidence from the contagion effects of restatements. Accounting Horizons, 33(1), 125-152. https://doi.org/10.2308/acch-52350
Jiang, Y. B., Cui, G., & Wang, Y. W. (2010). The trend and characteristics of Financial Statement Restatements: 2004–2008[J]. Journal of Accounting and Economics, 24(2), 17-27.
Kim, Y. J., Baik, B., & Cho, S. (2016). Detecting financial misstatements with fraud intention using multi-class cost-sensitive learning. Expert Systems with Applications, 62, 32-43. https://doi.org/10.1016/j.eswa.2016.06.016
Land, J. K. (2010). CEO turnover around earnings restatements and fraud. Pacific Accounting Review, 22(3), 180-198. https://doi.org/10.1108/01140581011091666
Lee, T. A., Ingram, R. W., & Howard, T. P. (1999). The difference between earnings and operating cash flow as an indicator of financial reporting fraud. Contemporary Accounting Research, 16(4), 749-786. https://doi.org/10.1111/j.1911-3846.1999.tb00603.x
Li, Q., & Yan, S. G. (2018). Comparative study of logistic regression accounting fraud identification model and accounting fraud index. Journal of Northeast Normal University (Philosophy and Social Sciences), 294(4), 181-187.
Liou, F. (2008). Fraudulent financial reporting detection and business failure prediction models: a comparison. Managerial Auditing Journal, 23(7), 650-662. https://doi.org/10.1108/02686900810890625
Ma, C., Du, H., & Zhang, J. (2018). Chinese accounting restatement and the timeliness of annual report. Applied Economics, 50(50), 5436-5453. https://doi.org/10.1080/00036846.2018.1486995
Murphy, P. R., & Dacin, M. T. (2011). Psychological pathways to fraud: understanding and preventing fraud in organizations. Journal of Business Ethics, 101(4), 601-618. https://doi.org/10.1007/s10551-011-0741-0
Office USGA. (2003). Financial statement restatements: trends, market impacts, regulatory responses, and remaining challenges. Government Accountability Office Reports. Retrieved from https://www.gao.gov/assets/240/236067.pdf
Palmrose, Z. V., Richardson, V. J., & Scholz, S. (2004). Determinants of market reactions to restatement announcements. Journal of Accounting & Economics, 37(1), 59-89. https://doi.org/10.1016/j.jacceco.2003.06.003
Perols, J., Bowen, R., Zimmermann, C., & Samba, B. (2017). Finding needles in a haystack: using data analytics to improve fraud prediction. The Accounting Review, 92(2), 221-245. https://doi.org/10.2308/accr-51562
Pfarrer, M. D., Smith, K. G., Bartol, K. M., Khanin, D. M., & Zhang, X. (2008). Coming forward: the effects of social and regulatory forces on the voluntary restatement of earnings subsequent to wrongdoing. Organization Science, 19(3), 386-403. https://doi.org/10.1287/orsc.1070.0323
Plumlee, M., & Yohn, T. L. (2015). An examination of managements’ regulatory filing choices surrounding restatements. Journal of Management Accounting Research, 27(2), 121-144. https://doi.org/10.2308/jmar-50744
Schmidt, J. J., & Wilkins, M. S. (2013). Bringing darkness to light: the influence of auditor quality and audit committee expertise on the timeliness of financial statement restatement disclosures. Auditing: A Journal of Practice & Theory, 32(1), 221-244. https://doi.org/10.2308/ajpt-50307
Scholz, S. (2013). Financial restatement trends in the United States: 2003–2013. Washington, DC: Center for Audit Quality. Retrieved from https://www.thecaq.org/financial-restatement-trends-united-states-2003-2012
Securities and Exchange Commission (SEC). (2014). Implementing Dodd-Frank Wall Street reform and consumer protection act – pending action. Washington DC: SEC. Retrieved from http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml
Shipman, J. E., Swanquist, Q. T., & Whited, R. L. (2016). Propensity score matching in accounting research. The Accounting Review, 92(1), 213-224. https://doi.org/10.2308/accr-51449
Singer, Z., & Zhang, J. (2018). Auditor tenure and the timeliness of misstatement discovery. The Accounting Review, 93(2), 315-338. https://doi.org/10.2308/accr-51871
Srinivasan, S., Wahid, A. S., & Yu, G. (2014). Admitting mistakes: home country effect on the reliability of restatement reporting. The Accounting Review, 90(3), 1201-1240. https://doi.org/10.2308/accr-50887
Tan, C. E., & Young, S. M. (2015). An analysis of “Little r” restatements. Accounting Horizons, 29(3), 667-693. https://doi.org/10.2308/acch-51104
Trompeter, G. M., Carpenter, T. D., Desai, N., Jones, K. L., & Riley, R. A. (2013). A synthesis of fraud-related research. Auditing: A Journal of Practice & Theory, 32(Supplement 1), 287-321. https://doi.org/10.2308/ajpt-50360
Wang, T. Y. (2011). Corporate securities fraud: Insights from a new empirical framework. The Journal of Law, Economics & Organization, 29(3), 535-568. https://doi.org/10.1093/jleo/ewr009
Wei, Z. H., Li, C. Q., & Chen, T. Y. (2010). Determinants of restatement announcements: evidence from China. Journal of Business Economics, 222(4), 75-82.
Wang, X., & Wu, M. (2011). The quality of financial reporting in China: An examination from an accounting restatement perspective. China Journal of Accounting Research, 4(4), 167-196. https://doi.org/10.1016/j.cjar.2011.09.001
Xin, Q., Zhou, J., & Hu, F. (2018). The economic consequences of financial fraud: evidence from the product market in China. China Journal of Accounting Studies, 6(1), 1-23. https://doi.org/10.1080/21697213.2018.1480005
Zhang, H., Huang, H. J., & Habib, A. (2018). The effect of tournament incentives on financial restatements: evidence from China. The International Journal of Accounting, 53(2), 118-135. https://doi.org/10.1016/j.intacc.2018.05.002
Zhang, H. H., & Zhang, L. Y. (2017). Managerial tournament incentive and financial fraud: evidence from Chinese listed companies. Business Management Journal, 39(4), 176-194.
Ahmed, K., & Goodwin, J. (2007). An empirical investigation of earnings restatements by Australian firms. Accounting and Finance, 47(1), 1-22. https://doi.org/10.1111/j.1467-629X.2006.00196.x
Badertscher, B. A., & Burks, J. J. (2011). Accounting restatements and the timeliness of disclosures. Accounting Horizons, 25(4), 609-629. https://doi.org/10.2308/acch-50026
Bartus, T. (2005). Estimation of marginal effects using margeff. Stata Journal, 5(3), 309-329. https://doi.org/10.1177/1536867X0500500303
Baucus, M. (1994). Pressure, opportunity and predisposition: A multivariate model of corporate illegality. Journal of Management, 20(4), 699-721. https://doi.org/10.1016/0149-2063(94)90026-4
BenYoussef, N., & Breton, G. (2016). Restatement announcements: sincerity analysis through information manipulation theory. Retrieved from https://ssrn.com/abstract=1985680
BenYoussef, N., & Khan, S. (2018). Timing of earnings restatements: CEO equity compensation and market reaction. Accounting and Finance, 58(2), 341-365. https://doi.org/10.1111/acfi.12220
China securities regulatory commission. (2012). Guidelines for the industry classification of listed companies. Retrieved from http://www.csrc.gov.cn/pub/newsite/flb/flfg/bmgf/zh/gfxwjtj/201310/t20131016_236281.html
Christensen, J. (2010). Accounting errors and errors of accounting. Accounting Review, 85(6), 1827-1838. https://doi.org/10.2308/accr.2010.85.6.1827
Chung, J., & Mccracken, S. (2014). Understanding the restatement process. Accounting Perspectives, 13(4), 253-281. https://doi.org/10.1111/1911-3838.12036
Corona, C., & Randhawa, R. S. (2018). The value of confession: admitting mistakes to build reputation. The Accounting Review, 93(3), 133-161. https://doi.org/10.2308/accr-51893
Cuadrado-Ballesteros, B., Garcia-Sanchez, I. M., & Ferrero, J. M. (2016). How are corporate disclosures related to the cost of capital? The fundamental role of information asymmetry. Management Decision, 54(7), 1669-1701. https://doi.org/10.1108/MD-10-2015-0454
Demirkan, S., & Platt, H. D. (2018). Differential investors’ response to restatement announcements: an empirical investigation. Journal of Economics and Financial Analysis, 2(2), 29-59.
Donelson, D. C., Ege, M. S., & McInnis, J. M. (2017). Internal control weaknesses and financial reporting fraud. Auditing: A Journal of Practice & Theory, 36(3), 45-69. https://doi.org/10.2308/ajpt-51608
Dorminey, J., Fleming, A. S., Kranacher, M. J., & Riley Jr, R. A. (2012). The evolution of fraud theory. Issues in Accounting Education, 27(2), 555-579. https://doi.org/10.2308/iace-50131
Erickson, M., Hanlon, M., & Maydew, E. L. (2006). Is there a link between executive equity incentives and accounting fraud? Journal of Accounting Research, 44(1), 113-143. https://doi.org/10.1111/j.1475-679X.2006.00194.x
Fang, J., Lobo, G. J., Zhang, Y., & Zhao, Y. (2018). Auditing related party transactions: evidence from audit opinions and restatements. Auditing: A Journal of Practice & Theory, 37(2), 73-106. https://doi.org/10.2308/ajpt-51768
Fang, V. W., Huang, A. H., & Wang, W. (2017). Imperfect accounting and reporting bias. Journal of Accounting Research, 55(4), 919-962. https://doi.org/10.1111/1475-679X.12170
Firth, M., Rui, O. M., & Wu, W. (2011). Cooking the books: recipes and costs of falsified financial statements in China. Journal of Corporate Finance, 17(2), 371-390. https://doi.org/10.1016/j.jcorpfin.2010.09.002
He, L., Sarath, B., & Wans, N. (2019). Material weakness disclosures and restatement announcements: The joint and order effects. Journal of Business Finance & Accounting, 46(1-2), 68-104. https://doi.org/10.1111/jbfa.12363
Hennes, K. M., Leone, A. J., & Miller, B. P. (2008). The importance of distinguishing errors from irregularities in restatement research: the case of restatements and CEO/CFO turnover. The Accounting Review, 83(6), 1487-1519. https://doi.org/10.2308/accr.2008.83.6.1487
Hirschey, M., Smith, K. R., & Wilson, W. M. (2015). The timeliness of restatement disclosures and financial reporting credibility. Journal of Business Finance and Accounting, 42(7-8), 826-859. https://doi.org/10.1111/jbfa.12125
Hong, W. Z., Wang, X. X., Ping, H. Q., & Information, S. O. (2014). Research on the financial report fraud detection of listed companies based on logistic regression model. Chinese Journal of Management Science, 22(11), 351-356.
Ji, A. E., Kumar, K. R., Pei, H., & Xue, Y. (2019) Does the market value auditors’ industry specializations? Evidence from the contagion effects of restatements. Accounting Horizons, 33(1), 125-152. https://doi.org/10.2308/acch-52350
Jiang, Y. B., Cui, G., & Wang, Y. W. (2010). The trend and characteristics of Financial Statement Restatements: 2004–2008[J]. Journal of Accounting and Economics, 24(2), 17-27.
Kim, Y. J., Baik, B., & Cho, S. (2016). Detecting financial misstatements with fraud intention using multi-class cost-sensitive learning. Expert Systems with Applications, 62, 32-43. https://doi.org/10.1016/j.eswa.2016.06.016
Land, J. K. (2010). CEO turnover around earnings restatements and fraud. Pacific Accounting Review, 22(3), 180-198. https://doi.org/10.1108/01140581011091666
Lee, T. A., Ingram, R. W., & Howard, T. P. (1999). The difference between earnings and operating cash flow as an indicator of financial reporting fraud. Contemporary Accounting Research, 16(4), 749-786. https://doi.org/10.1111/j.1911-3846.1999.tb00603.x
Li, Q., & Yan, S. G. (2018). Comparative study of logistic regression accounting fraud identification model and accounting fraud index. Journal of Northeast Normal University (Philosophy and Social Sciences), 294(4), 181-187.
Liou, F. (2008). Fraudulent financial reporting detection and business failure prediction models: a comparison. Managerial Auditing Journal, 23(7), 650-662. https://doi.org/10.1108/02686900810890625
Ma, C., Du, H., & Zhang, J. (2018). Chinese accounting restatement and the timeliness of annual report. Applied Economics, 50(50), 5436-5453. https://doi.org/10.1080/00036846.2018.1486995
Murphy, P. R., & Dacin, M. T. (2011). Psychological pathways to fraud: understanding and preventing fraud in organizations. Journal of Business Ethics, 101(4), 601-618. https://doi.org/10.1007/s10551-011-0741-0
Office USGA. (2003). Financial statement restatements: trends, market impacts, regulatory responses, and remaining challenges. Government Accountability Office Reports. Retrieved from https://www.gao.gov/assets/240/236067.pdf
Palmrose, Z. V., Richardson, V. J., & Scholz, S. (2004). Determinants of market reactions to restatement announcements. Journal of Accounting & Economics, 37(1), 59-89. https://doi.org/10.1016/j.jacceco.2003.06.003
Perols, J., Bowen, R., Zimmermann, C., & Samba, B. (2017). Finding needles in a haystack: using data analytics to improve fraud prediction. The Accounting Review, 92(2), 221-245. https://doi.org/10.2308/accr-51562
Pfarrer, M. D., Smith, K. G., Bartol, K. M., Khanin, D. M., & Zhang, X. (2008). Coming forward: the effects of social and regulatory forces on the voluntary restatement of earnings subsequent to wrongdoing. Organization Science, 19(3), 386-403. https://doi.org/10.1287/orsc.1070.0323
Plumlee, M., & Yohn, T. L. (2015). An examination of managements’ regulatory filing choices surrounding restatements. Journal of Management Accounting Research, 27(2), 121-144. https://doi.org/10.2308/jmar-50744
Schmidt, J. J., & Wilkins, M. S. (2013). Bringing darkness to light: the influence of auditor quality and audit committee expertise on the timeliness of financial statement restatement disclosures. Auditing: A Journal of Practice & Theory, 32(1), 221-244. https://doi.org/10.2308/ajpt-50307
Scholz, S. (2013). Financial restatement trends in the United States: 2003–2013. Washington, DC: Center for Audit Quality. Retrieved from https://www.thecaq.org/financial-restatement-trends-united-states-2003-2012
Securities and Exchange Commission (SEC). (2014). Implementing Dodd-Frank Wall Street reform and consumer protection act – pending action. Washington DC: SEC. Retrieved from http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml
Shipman, J. E., Swanquist, Q. T., & Whited, R. L. (2016). Propensity score matching in accounting research. The Accounting Review, 92(1), 213-224. https://doi.org/10.2308/accr-51449
Singer, Z., & Zhang, J. (2018). Auditor tenure and the timeliness of misstatement discovery. The Accounting Review, 93(2), 315-338. https://doi.org/10.2308/accr-51871
Srinivasan, S., Wahid, A. S., & Yu, G. (2014). Admitting mistakes: home country effect on the reliability of restatement reporting. The Accounting Review, 90(3), 1201-1240. https://doi.org/10.2308/accr-50887
Tan, C. E., & Young, S. M. (2015). An analysis of “Little r” restatements. Accounting Horizons, 29(3), 667-693. https://doi.org/10.2308/acch-51104
Trompeter, G. M., Carpenter, T. D., Desai, N., Jones, K. L., & Riley, R. A. (2013). A synthesis of fraud-related research. Auditing: A Journal of Practice & Theory, 32(Supplement 1), 287-321. https://doi.org/10.2308/ajpt-50360
Wang, T. Y. (2011). Corporate securities fraud: Insights from a new empirical framework. The Journal of Law, Economics & Organization, 29(3), 535-568. https://doi.org/10.1093/jleo/ewr009
Wei, Z. H., Li, C. Q., & Chen, T. Y. (2010). Determinants of restatement announcements: evidence from China. Journal of Business Economics, 222(4), 75-82.
Wang, X., & Wu, M. (2011). The quality of financial reporting in China: An examination from an accounting restatement perspective. China Journal of Accounting Research, 4(4), 167-196. https://doi.org/10.1016/j.cjar.2011.09.001
Xin, Q., Zhou, J., & Hu, F. (2018). The economic consequences of financial fraud: evidence from the product market in China. China Journal of Accounting Studies, 6(1), 1-23. https://doi.org/10.1080/21697213.2018.1480005
Zhang, H., Huang, H. J., & Habib, A. (2018). The effect of tournament incentives on financial restatements: evidence from China. The International Journal of Accounting, 53(2), 118-135. https://doi.org/10.1016/j.intacc.2018.05.002
Zhang, H. H., & Zhang, L. Y. (2017). Managerial tournament incentive and financial fraud: evidence from Chinese listed companies. Business Management Journal, 39(4), 176-194.