Labor market penalties from past earnings restatements: Enhancements to current earnings credibility?

Abstract

Purpose

Experts contend that knowledge of the personal labor market penalties (loss of employment and future wealth) incurred by past chief executive officers (CEOs) forced to restate their firms' earnings may induce current CEOs to refrain from fraudulent disclosures. Because of the increased incidence of earnings restatements and the importance of augmenting investor trust, this paper aims to examine empirically nonprofessional investors' impressions of managerial earnings restatement penalties as fraud deterrents.

Design/methodology/approach

The restatement penalties were explored in an experimental setting with nonprofessional investors as subjects. Using an experimental case as a basis, the study compared subjects' predictions of the probability that a CEO would fraudulently report a particular transaction under two general conditions: the absence of a specific fraud deterrent; and the presence of two potential deterrents, earnings restatement penalties and CEO financial statement certifications.

Findings

Statistical analyses revealed that investors viewed the earnings restatement penalties as fraud deterrents, providing a level of protection comparable to that offered by financial statement certifications, a mandated practice originally intended to deter fraud. These results suggest that investors' awareness of past restatement penalties could help to enhance the credibility of currently reported earnings.

Originality/value

The investigation of this topic makes two contributions to existing research. First, it provides empirical evidence concerning a potential fraud deterrent (earnings restatement penalties) previously unexamined in prior studies. Second, it represents a new area of inquiry in earnings restatement research, both in topic (the perceived deterrence qualities of restatement penalties) and in method (empirical research vs traditional archival studies).

Citation

Steven Flynn, R. (2010), "Labor market penalties from past earnings restatements: Enhancements to current earnings credibility?", Management Research Review, Vol. 33 No. 3, pp. 269-277. https://doi.org/10.1108/01409171011030417