Right But Worse

Why restated earnings are sometimes less useful than the originals

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When companies announce they're "restating" their earnings, the typical investor may think, "So, the last time you lied and now you're being forced to tell the truth."

That's because earnings restatements usually happen when auditors or regulators spot accounting errors or irregularities and order the financial statements to be redone.

But not all restatements are nefarious, and the restated financial reports don't always improve their practical value. In some cases, the revisions make them less informative, according to a report by a research team that included Mendoza College's Brad Badertscher, assistant professor of accountancy.

Writing in the Journal of Accounting and Economics, Badertscher and his co-authors say context is the key in interpreting a restatement. If the eyebrow-raising accounting enabled a company to meet or beat Wall Street estimates of its earnings—always good news for a company's stock price—the firm was most likely up to no good, they say. The proof was in the restated earnings they studied.

In cases where the original report helped the company meet or beat estimated earnings, the restated earnings turned out to be a much more accurate predictor of the company's future cash flows. (In finance, firms are "valued" or priced by the market based on future cash flows.)

However, the researchers also examined restatements in which the originally reported
numbers did not help the company meet or beat Wall Street estimates. In those cases, the recalculations actually reduced the report's usefulness in predicting future cash flows.

Badertscher says this second kind of restatement-triggering report—one that gains a company nothing—can result from a sincere effort on the part of a company to paint the most accurate picture possible of its financial condition.

What happens is that Generally Accepted Accounting Principles (GAAP)—the accounting principles, standards and procedures that companies use to compile their financial statements—allow accountants discretion in how they calculate elements of a financial report. Badertscher says sometimes in trying to craft an accurate report, a company will believe it is adhering to GAAP, only to have regulators rule, after the fact, that it strayed outside the boundaries.

An example would be in how a company estimates its bad debts as an expense going forward. The SEC requires this estimate be based on what the company has experienced in the past, he says.

"I could say the economy is turning around and my customers are going to pay their bills now, whereas historically, they haven't," he says. That insight could make the report more accurate, but it could also trigger a restatement, he says. For that reason, this paper is likely to add fuel to a current debate in the accounting world.

According to the paper, at least some companies appear to be bending the rules only to make their reports more accurate. And at least sometimes regulators are demanding strict obedience to rules even if it potentially makes reports less accurate. The research team doesn't comment on this issue in its paper, but Badertscher says the team's findings lend support to those who argue for a switch to the alternate International Financial Reporting Standards (IFRS), which are more principles-based than GAAP and allow accountants to exercise more discretion.

The researchers also discovered that they aren't the only ones able to draw a distinction between restatements ordered under different circumstances. Apparently the stock market can, too.

Studying the movement of stock prices following restatements, they found that investors punish companies that appear to have been fudging numbers in order to meet or beat earnings estimates. But the market is more or less indifferent to companies that have restatements demanded of them for reports that gained them nothing.

The accounting professors' article, "Discretionary Accounting Choices and the Predictive Ability of Accruals with Respect to Future Cash Flows," by Badertscher, Dan Collins of the University of Iowa and Thomas Lys of Northwestern University, appears in the January-February 2012 issue of the Journal of Accounting and Economics.