Does late 10K filing impact companies’ financial reporting strategy? Evidence from discretionary accruals and real transaction management

• Author: Talal Al‐Hayale,Mahmud Hossain,Santanu Mitra
• Date: 01 May 2019
• DOI: http://doi.org/10.1111/jbfa.12369
• Published date: 01 May 2019

DOI: 10.1111/jbfa.12369

Does late 10K filing impact companies’ financial

reporting strategy? Evidence from discretionary

accruals and real transaction management

Santanu Mitra1Talal Al-Hayale2Mahmud Hossain3

1MikeIlitch School of Business, Wayne State

University, 2771 WoodwardAvenue, Detroit,

Michigan 48201, USA

2Odette School of Business, University of

Windsor, Windsor, Ontario N9B 3P4, Canada

3Dept. of Accounting, School of Business

Administration,American University of Sharjah,

Sharjah 2666, UAE

Correspondence

SantanuMitra, Mike Ilitch School of Business,

WayneState University,2771 Woodward

Avenue,Detroit, MI 48201, USA.

Email:smitra@wayne.edu

JELClassification: M40, M41

DATA

Datafor the study are obtained from publicly

availablesources as described in the text.

Abstract

The study investigates how late 10K filers adapt their financial

reporting strategy in the post-late filing period in their response to

bad publicity, negative market sentiment, and higher stakeholders’

scrutiny resulting from reporting delays. Both the level and change

regressions show that late 10K filers significantly reduce the use of

discretionary accruals from pre- to post-late filing year. However,

they simultaneously increase real transaction management over the

same time period. The trade-offs between the two earnings man-

agement techniques are more prominent when the late filers have

a strong incentive to meet or beat earnings benchmarks. Our pri-

mary results are robust when late filings are caused by accounting,

auditing, and internal control issues, and when the late filers cited

no meaningful reason for late 10K filings. It is further evident that

late filers with material internal control weaknesses and late filers

that subsequently restate their financial statements make relatively

higher trade-offs than the matched non-late filers. Finally,the trade-

offs between reduced accruals and increased real transaction man-

agement are stronger for the accelerated filers, and for the late filers

audited by Big 4 auditors.

KEYWORDS

auditor's scrutiny, big 4 auditors, discretionary accruals manage-

ment, earnings benchmarks, financial restatements, internal control

weaknesses,late 10K filing, professional community, real transaction

management, trade-offs

1INTRODUCTION

Timely filing of financial statements (e.g., 10K or 10Q)by Securities and Exchange Commission (SEC) registrants is crit-

ical for a well-functioning capital market, as investors and other stakeholdersrely on audited financial statements for

making credit, investment,and other economic decisions. Firms’ failure to submit their annual financial reports on time

leads to investor skepticism,significant adverse market reaction, and declined share prices (e.g., Bartov & Konchitchki,

J Bus Fin Acc. 2019;46:569–607. wileyonlinelibrary.com/journal/jbfa c

2019 John Wiley & Sons Ltd 569

570 MITRA ET AL.

2017;Impink, Lubberink, van Praag, & Veenman, 2012). Cao, Chen, and Higgs (2016) document that late 10K filers have

poor financial reporting quality as measured bydiscretionary accruals, and higher probability of financial restatements

in subsequent periods, but the adverse consequence of late filing is largely mitigated by Big 4 auditors. In this respect,

Wang, Raghunandan, and McEwen (2013) find that late 10K filing has negativeimplications for audit fees, resulting in

higher audit fees for the late filers.

Prior studies also suggest that a late 10K filing incident has other serious economic consequences, such as limiting

late filers’ ability to conduct certain types of registered securities’ offerings, violation of exchangelisting requirements,

and the probability of being delisted from stock exchangesand costly debt covenant violations (e.g., Gao, Gao, & Smith,

2011; Wang et al., 2013). We extendthis literature stream by examining late filers’ financial reporting strategy in the

period after late filing incident that is associated with heightened skepticism, bad publicity,and enhanced stakeholder

scrutiny.

Based on prior observations, we conjecture that a late filing incident poses a challenge to late filers to mitigate nega-

tive stakeholders’perception, auditors’ skepticism, and bad publicity about the quality of their reported financial infor-

mation. Such an incident is likely to havea profound effect on late filers’ financial reporting decisions regarding how to

manage and report earnings information in the post-late filing period. Earnings management literature demonstrates

that managers can manage earnings through two channels in their financial reporting process: managing accounting

accruals and real transactions in varying degrees.1The extent to which managers are able to apply these techniques

depends on the level of oversight and scrutiny that the firms are subject to, and the costs associated with the detec-

tion of earnings management. We argue that the extent to which late filers employ these two earnings management

techniques largely depends on reporting flexibility availableto firms in preparing financial statements in a constrained

environment immediately following late 10K filing incident as it leads auditors and professional community, such as

financial analysts, to more closely scrutinize the late filers’ operating, investing,and financial reporting decisions.

Extant literature documents that firms subject to enhanced oversight and scrutiny tend to reduce accruals man-

agement (AM). Instead, they manipulate real transactions at a higher level through their operating and investment

decisions (e.g., Cohen, Dey,& Lys, 2008; Cohen & Zarowin, 2010; Kothari, Mizik, & Roychowdhury,2016; Zhang, 2012)

because real transaction management (RTM) is less visible to outsiders and could be accomplished without violating

generally accepted accounting principles (GAAP).It is more challenging to investors to detect RTMthan accruals man-

agement (Kothari et al., 2016).

Another group of studies, however,suggests that the trade-offs between reduced AM and increased RTM may not

be automatic and easy to accomplish when a major, visible corporateevent such as a delay in filing 10K annual report

creates considerable skepticism and invites scrutiny from auditors and financial community,constraining managers’

accounting and operational flexibility.For example, Commerford, Hermanson, Houston, and Peters (2016) document

that auditors express concern about RTM and often change their audit procedures in response to the evidence of

RTM detected from preliminary risk assessments, analytical procedures, and discussions with management. Greiner,

Kohlbeck, and Smith (2017) find that aggressive income-increasing RTMsignificantly impacts auditors’ assessment of

client-specific risk, leading to enhanced auditor scrutiny and higher audit fees. Auditors consider real activity manipu-

lation seriously and spend considerable time and effort to reduce financial reporting and audit risk.2This is consistent

with Ettredge, Scholz, Smith, and Sun (2010) who suggest that auditors’ reaction to RTMis justified because firms with

higher levels of accumulated RTMare more likely to restate their financial statements in subsequent periods.

1Real transaction management (RTM)alters the execution of real transactions taking place during the year by such means as inflating sales, overproducing

inventories, or decreasing discretionary costs, for example,research and development, advertising, and maintenance expenditure. Accruals-based earnings

management(AM) is achieved by changing the accounting methods and estimates used when presenting a given transaction in the financial statements (Zhang,

2012).RTM occurs throughout the fiscal year as part of management's operating decisions, whereas most AM occurs toward the end of the accounting period.

Zhang (2012) provides evidence that managers use these two forms of earnings management as substitutes. Abernathy,Beyer, and Rapley (2014) find that

firmsuse income classification shifting techniques to boost core earnings when their ability to use other forms of earnings management is constrained.

2Greiner et al. (2017) and Commerford et al. (2016) find that auditors perform additional audit procedures around the inventory function in response to

an abnormal fluctuation in production costs, increase scrutiny around the audit of intangible assets and product development upon observing an abnormal

reductionin R&D expenditure, or dedicate additional hours auditing fixed assets and assessing their potential impact on revenue-generating capabilities after

observingadditional gains from asset sales.

MITRA ET AL.571

Kothari et al. (2016) further point out that the larger financial community, such as financial analysts and large

and sophisticated investors, spend considerable resources analyzing not only managers’ accruals choice but also

their operational and financial decisions. Major economic events, such as 10K filing delays, may potentially induce

auditors, institutional investors, and financial analysts to increase their firm-specific analysis and scrutiny. This is

likely to impose additional constraints on late filers’ ability to manage earnings, making trade-offs between earnings

management techniques more difficult in the post-late filing period. Thus, it is conceivable that though there is a

general pecking order for corporate earnings management, the trade-offs between earnings management techniques

are not easy for the late filers to accomplish as part of their reporting strategywhen they are under increased oversight

and scrutiny from the professional community. Rather,it is more likely that enhanced scrutiny and oversight would

severely restrict late filers’ flexibility to manage both accounting accruals and real transactions in the subsequent

fiscal period. In this case, we expect that overall earnings management will subside, and the trade-offs between

earnings management techniques by late filers will be at an inconsequential level in the post-late filing period. This

expectation leads us to consider the following empirical questions: What is late 10K filers’ financial reporting strategy

in periods of heightened scrutiny and skepticismfollowing the late filing incident? More specifically, are late 10K filers

able or willing to use opaque channels to manage earnings in the post-late filing period? In this study, we attempt to

answer these questions through our empirical analyses of late 10K filing incidents that took place between 2004 and

2013.

Prior studies use research settings in which the sample firms tend to use opaque forms of earnings management

and manipulate real activities as a proactive measure to avoid enhanced scrutiny and mitigate adverse stakeholder

reactions. Such studies relate to clawback adopters’ proactive action to make trade-offs between AM and RTM in a

post-adoption period (Chan, Chen, Chen, & Yu, 2015), real earnings management by firms’ disclosing material inter-

nal control weaknesses (ICW) under SOX Section 404 (Järvinen & Myllymäki, 2016; Lenard, Petruska, Alam, & Yu,

2016), trade-offs between two earnings management techniques by firms subject to higher-quality audits (Chi,Lisic, &

Pevzner,2011), and the role of real earnings management in firms’ overvaluation at the time of seasoned equity offer-

ings (Kothari et al., 2016).Recently, Garg (2018) finds that while Australian firms complying with internal control certi-

fication requirements (ICCR) for the first time generallyengage in higher earnings management than those havingcon-

tinuing disclosure from a voluntary period, they use more real activity management in place of accruals management

to improve perceived earnings quality.Garg's (2018) study is similar in nature to Järvinen and Myllymäki (2016) and

Lenard et al. (2016) in the US contextin that the firms disclosing material internal control weaknesses under SOX 404

are more likely to engage in real activity manipulation at a higher level.In a related study, Brown, Pott, and Wompener

(2014) find evidence of the positive effect of mandatory internal control and risk management reform on earnings-

based attributes of German companies. These studies, in general, provide evidence that regulations constrain certain

types of accounting flexibility and motivate managers to take proactive actions to improvestakeholders’ perceptions

about their financial reporting quality.

Our study differs from prior research as we examine US firms’ reporting response to an adverse corporate event

such as 10K filing delay that potentially creates bad publicity and enhanced skepticism, hurts firms’ reputations, and

invites increased scrutiny and oversight from auditors and other professional investors. In this situation, it is rather

unlikely that late filers have sufficient accounting and operational flexibility to maketrade-offs between two forms

of earnings management to improve perceived earnings quality in the post-late filing period. Furthermore,since RTM

hurts firms’ performance in the long run creating long-term valuation problems (Cohen & Zarowin, 2010), the late fil-

ers may not be willing to take short-sighted action and make trade-offsby increasing the level of RTM. Recently, Shi,

Sun, and Zhang (2018) also find that firms facing competitive market pressure refrainfrom managing real activities to

misreport financial results because RTMadversely affects firms’ competitiveness in the product market. In view of con-

flicting evidence,our investigation extends the late filing studies by investigating late filers’ financial reporting strategy

in the period following 10K filing delays.

We use a sample of 1,785 late 10K filers and 1,785 propensity-score-matched non-late filers for a 10-year period

from 2004 to 2013. Our analyses focus mainly on three yearssurrounding the late filing year, i.e., the year before (t−1),

the year of (t) and the year after the late filing year(t+1). The regression analyses show that though the late filers have