Tax Refunds on Overstated Earnings: A Valuation Puzzle

• Author: Alan Reinstein,Katrina L. Mantzke,Natalie Tatiana Churyk,James M. Johnson
• DOI: http://doi.org/10.1002/jcaf.22004
• Date: 01 November 2014
• Published date: 01 November 2014

45

© 2014 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22004

f

e

a

t

u

r

e

a

r

t

i

c

l

e

Natalie Tatiana Churyk , Katrina L. Mantzke , James M. Johnson , and Alan Reinstein

Tax Refunds on Overstated Earnings:

A Valuation Puzzle

INTRODUCTION AND

LITERATURE REVIEW

The number of

financial state-

ment restatements

practically doubled

from 1998 to 2002

(Huron Consulting

Group, 2002). About

37% of such restate-

ments relate to revenue

recognition, most of

which result in an

original overstatement

of earnings. Many

researchers are inves-

tigating these restate-

ments to provide a

clearer picture of this financial

reporting phenomenon.

One line of restatement

research examines restatements

relative to external auditors and

governance. Dechow, Sloan,

and Sweeny (1996) examined

firms with issued Securities

and Exchange Commission

(SEC) Accounting and Audit-

ing Enforcement Releases

(AAERs), finding that firms

with overstatements need less

external financing. They also

found that overstatements are

associated with founder CEOs,

chairs, CEOs, insider boards of

directors, and the need for an

audit committee. They found a

9% drop in stock price around

the earnings restatement. Bon-

ner, Palmrose, and Young (1998)

also examined firms with issued

SEC AAERs in sampling 260

companies from 1982 to 1995.

Findings indicate a higher prob-

ability of litigation for auditors

in instances where they fail to

detect common frauds or when

restatements occur from ficti-

tious transactions. For a sample

of 88 firms from 1991 to 1999,

Abbot, Parker, and

Peters (2004) found

a negative associa-

tion between earn-

ings restatements

and audit committee

independence, audit

committee financial

expertise, and audit

committee size.

Lev, Ryan,

and Wu’s (2008)

study of 1,032

U.S.-listed firms

1997–2002 earnings

restatements from

amended Form

10-Q/A (quarterly)

or Form 10-K/A

(annual) found that restate-

ments, which eliminate or

shorten histories of earnings

growth or positive earnings, have

significantly more adverse effects

for investor valuations and the

likelihood of lawsuits than other

restatements. Peterson (2012)

found that revenue recogni-

tion complexity increases the

probability of revenue restate-

ments, which result from both

intentional and unintentional

misreporting. This complexity

also moderates the consequences

of restatement—lower incidence

The number of financial statement restatements

practically doubled from 1998 to 2002 (Huron

Consulting Group, 2002). Approximately 37% of

these restatements are related to revenue recog-

nition, with most of these resulting in an original

overstatement of earnings. From 2000 to 2009,

the Securities and Exchange Commission (SEC),

on average, issued 200 Accounting and Auditing

Enforcement Releases (AAERs) each year (see

SEC.gov). Most AAERs lead to restatements. While

prior literature focused on the negative conse-

quences to firms from reporting a restatement, the

authors’ study looks for a mitigating effect from

reporting good news along with the bad.

© 2014 Wiley Periodicals, Inc.