Impact of post-restatement actions taken by a firm on non-professional investors' credibility perceptions

Journal of Business Ethics 80 (1):61 - 76 (2008)
The frequency of earnings restatements has been increasing over the last decade. Restating previous earnings erodes perceived trustworthiness and competence of management, giving firms strong incentives to take actions to enhance perceived credibility of future financial reports [Farber, D. B.: 2005, The Accounting Review 80(2), 539–561.]. Using an experimental case, we examine the ability of post-restatement actions taken by a firm to positively influence non-professional investors’ perceptions of management’s financial reporting credibility. Our examination considers credibility judgments following two types of restatements – those resulting from fraud in which the character, ethics, and values of an organization may be called into question [cf. Copeland, Jr., J. E.: 2005, Accounting Horizons 19(1), 35–43.], and those resulting from non-fraud (i.e., aggressive accounting). Based on the information in the experimental case, non-professional investors take the role of potential equity investors and make a judgment about management’s financial reporting credibility after reviewing a set of post-restatement actions taken by a firm. The possible actions include changes in four corporate governance mechanisms (i.e., internal audit function, external audit firm, board of directors, CFO) and a buyback of company stock. Our results provide an important contribution to the literature by demonstrating that among non-professional investors, perceptions of management’s financial reporting credibility are affected both by the post-restatement action taken and the nature of the restatement. These results offer insight into the formation of a key credibility judgment made by non-professional investors following a trust-destroying event, an earnings restatement.
Keywords corporate governance  credibility  restatements  trust
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