Can Management Turnover Restore the Financial Statement Credibility of Restating Firms? Further Evidence

• DOI: http://doi.org/10.1111/jbfa.12081
• Published date: 01 September 2014
• Date: 01 September 2014

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(7) & (8), 893–925, September/October 2014, 0306-686X

doi: 10.1111/jbfa.12081

Can Management Turnover Restore

the Financial Statement Credibility

of Restating Firms? Further Evidence

MAI DAO,HUA-WEI HUANG,KEN Y. CHEN AND TING-CHIAO HUANG∗

Abstract: This paper investigates the association between management turnover following

financial restatements and the probability of subsequent restatements. We find that restating

firms that replace management (CEO and/or CFO) are more likely to restate their financial

statements again. We also find that subsequent restatements are mainly attributable to the new

management. Overall, our results suggest that management turnover following restatements

may not be an effective mechanism to remediate financial restatements, but the change to a new

management results in a greater possibility of lower earnings quality (i.e., higher probability of

subsequent financial restatements and accruals-based earnings management). Our study sup-

ports prior literature’s findings that the change in the top management leads to organizational

instability and higher accounting information risk. Our findings have implications for internal

decisionmaking with regard to top executive replacement.

Keywords: management turnover, restatement, accruals quality, CEO, CFO

1. INTRODUCTION

This study investigates whether management turnover (including turnover of chief

executive officer (CEO), and chief financial officer (CFO)) immediately following

a financial restatement can help firms to avoid subsequent restatements. Financial

restatements have been a topic of interest among US and international regulators,

investors and academia (Desai et al., 2006; Archambeault et al., 2008) since misstated

financial statements are regarded as one of the major factors that have reduced

investor confidence in corporate financial reporting (SEC, 2002; Archambeault

∗The first author is at the College of Business and Innovation, The University of Toledo, OH, USA. The

second and fourth authors are at College of Management, National Cheng Kung University, Taiwan, ROC.

The third author is at Department of Accounting, National Taiwan University, Taipei, Taiwan, ROC. We

appreciate the insightful comments received from the Editor and the anonymous referees. Hua-Wei Huang

gratefully acknowledges the financial support of the National Science Council, Taiwan, ROC (Project No.

NSC 100-2410-H-006-102). (Paper received August 2012, revised version accepted June 2014).

Address for correspondence: Hua-Wei Huang, College of Management, National Cheng Kung University,1

University Road, Tainan City, Taiwan, ROC.

e-mail: hwawei7@yahoo.com.tw

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et al., 2008; Wilson, 2008; Chen et al., 2014), threatened organizational legitimacy1

(Arthaud-Day et al., 2006; Feldmann et al., 2009), and had a number of other costly

consequences. The extant empirical evidence shows that the market reacts negatively

and significantly to restatement announcements (Palmrose et al., 2004; Xu et al.,

2006; Kravet and Shevlin, 2010), and that restating firms are charged higher audit

fees (Feldmann et al., 2009), face higher capital costs (Hribar and Jenkins, 2004; Park

and Wu, 2009), and have higher litigation risk (Palmrose and Scholz, 2004). To avoid

future loss of reputation and to restore investor confidence, restating firms commonly

replace their CEOs and/or CFOs.

On the one hand, CEO and/or CFO turnover is considered an effective solution

for firms with financial reporting problems and other forms of organizational distress

(e.g., Daily and Dalton, 1995; Agrawal et al., 1999; Arthaud-Day et al., 2006; Feldmann

et al., 2009). Since CEOs and CFOs are responsible for the financial reporting

process, CEO/CFO turnover is believed to be an appropriate strategy to improve

firm performance, restore organizational legitimacy and regain investor confidence

in fraudulent and/or distressed firms (Schwartz and Menon, 1985; Daily and Dalton,

1995; Agrawal et al., 1999; Feldmann et al., 2009). On the other hand, management

turnover may lead to organizational instability and ambiguity due to changes in

policies and strategies, as well as altering or breaking existing formal and informal

corporate relationships (Grusky, 1960; Schwartz and Menon, 1985; Kesner and Dalton,

1994). Prior research also finds that operating problems lead to managers being

distracted from fully addressing weaknesses in financial reporting (Files et al., 2014).

Moreover, the new executives have the incentive to manage earnings to blame the

old management for poor performance (i.e., adopting income-decreasing accruals

in the year of management replacement, and adopting income-increasing accruals

in the following years), or to “window-dress” earnings to avoid underperformance

and the likelihood of termination (Pourciau, 1993; Peltier-Rivest, 1999; Wang and

Chou, 2011). In addition, management turnover may influence corporate culture

with regard to making financial reporting decisions (Kraatz and Moore, 2002; Hayes

et al., 2006), and deteriorate firms’ future performance due to employees’ concerns

over job security, status and power under the new leadership (Kesner and Dalton,

1994). Consequently, issues such as organizational instability, distractions resulting

from operational problems, earnings management and employees’ fears can result in a

greater risk of financial misstatements in firms with changes in executive management.

Prior research focuses on the causes and consequences of management turnover.2

Generally, previous studies find that poor firm performance, fraud and restatements

are associated with a higher likelihood of changes in executive management (e.g.,

Agrawal et al., 1999; Arthaud-Day et al., 2006; Desai et al., 2006), whereas the

consequences of management turnover remain unclear in the literature. For example,

some studies find that such management replacements result in an improvement of

firm performance (e.g., Denis and Denis, 1995; Huson et al., 2004), while others

conclude that these changes decrease firm performance (e.g., Grusky, 1960; Carroll,

1984; Kesner and Dalton, 1994). Empirical evidence indicates that firm performance

1 Organizational legitimacy refers to “a generalized perception or assumption that the actions of an entity are

desirable, proper, or appropriate within some socially constructed systems of norms, values, beliefs, and definitions”

(Suchman, 1995).

2 This study is limited to analysis of CEO and/or CFO turnover since CEOs and CFOs have direct

responsibility for both firms’ performance and the financial reporting process (Arthaud-Day et al., 2006).

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may deteriorate when firms replace the managers as scapegoats, or when changes in

management lead employees to fear the loss of job security, status and power (Kesner

and Dalton, 1994). Prior research also shows that management turnover may not

have any impact on firm performance and internal control quality unless the newly

hired CEO and/or CFO has significantly better qualifications (Li et al., 2010). To

date, no study has investigated whether management turnover has any impact on

financial reporting quality. In the current study, we fill this gap in the literature by

investigating the association between management turnover following a restatement

and the likelihood of subsequent restatements to see whether such change can restore

firms’ financial credibility.

Using a sample of 1,485 firm–year observations that filed financial restatements

in 2004 and 2005, we examine whether firms replacing management after an initial

restatement are more likely to experience subsequent restatements than those without

management turnover. Our results suggest that management turnover may not help

firms to remediate their financial reporting problems and restore their financial

credibility; instead, it is the change to a new management that leads to a higher

probability of firms having lower earnings quality. In particular, restating firms with

management turnover have a higher likelihood of subsequent restatements (ascribed

to the new management) than firms that retain their existing managers. Moreover,

we document that restating firms with management turnover are more likely to

restate financial statements subsequently due to SEC investigation, and are more

likely to engage in aggressive accruals-based earnings management. The results are

consistent with Ettredge et al.’s (2010) finding that balance sheet bloat (i.e., earnings

management) is likely to be higher in restating firms than in other firms.

Our findings support the perception that management turnover leads to orga-

nizational instability (Grusky, 1960), and that the new management is distracted

from improving financial reports by other operating problems (Files et al., 2014).

The results also support the argument that the new management would suffer

from pressure due to high expectations, and thus are likely to engage in earnings

manipulations (Krieger and Ang, 2013). According to Krieger and Ang (2013), the

new management is under high expectations on the level of firm performance from

investors, analysts and other stakeholders and under great pressure on meeting these

performance expectations. With the fear of disappointing stakeholders’ expectations

and being removed from the position in the subsequent years, the new management

has the tendency to engage in earnings management activities.

Our paper contributes to the financial restatement and management turnover

literature in the following ways. First, prior studies have primarily investigated the

common practice of firms with financial reporting problems (herein, financial re-

statements) attempting to resolve the problem through changing their CEO and/or

CFO (input perspective of management turnover). However, our study focuses on the

output perspective of management turnover; that is, we examine the consequences of

top management changes following financial restatements. Our results demonstrate

that management replacement is not an effective deterrent of restatement reoccur-

rence, which contrasts with the notion that changing the CEO or CFO can fix a

firm’s financial reporting problems. We argue that organizational instability following

management turnover may distract managers from addressing financial reporting

misstatements. We also argue that the new management faces considerable pressure

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