Voluntary vs. Forced Financial Restatements: The Role of Board Independence

Using a sample of companies that restated their earnings over the period 1997–2002, this study finds that the probability of voluntary as opposed to forced restatements is positively related to the independence of both the board of directors and the audit committee. Following both voluntary and forced earnings restatements, companies increase the proportion of independent directors on both the board and the audit committee; three years after restatements, both types of restating companies attain similar levels of director independence. Moreover, the study finds comparable postrestatement long-run stock performance for all restating and matched companies, which suggests that postrestatement enhancements to internal control systems help restore companies’ blemished reputations. This article reports the results of our investigation of the role of corporate governance in monitoring earnings manipulation in which we examined the independence of boards of directors and audit committees in companies that restated their earnings. Extant empirical evidence on board independence and the incidence of accounting irregularities is mixed. Our investigation of 187 restatements from 1997 to 2002 finds that director independence is not associated with a lower incidence of earnings restatements. Companies that make voluntary restatements, however, have greater board and audit committee independence than do companies forced to restate earnings by the U.S. SEC and other external agencies. Moreover, the probability of voluntary restatements is positively related to board and audit committee independence. Our results also show that restating companies, especially those forced to restate, increase the independence of their boards and audit committees after restatements. And long-run stock performance after both voluntary and forced restatements is similar to that of matched companies. Our findings point to the importance of independent boards of directors and audit committees in improving the accuracy of financial reporting. Although director independence does not ensure a lower incidence of earnings restatements, it increases the probability that a company will initiate a restatement instead of waiting for outsiders to force it to restate. These findings are relevant to the current controversy surrounding the rising number of restatements since 2001 and support the requirements for greater board and audit committee independence mandated by the Sarbanes–Oxley Act and the rules of major exchanges. Our findings suggest that greater director independence is associated with more efficient internal monitoring of financial reporting and results in a greater number of voluntary restatements. Consequently, the recent increase in restatements may indicate that the corporate governance laws enacted in this decade have taken root rather than the contrary, as some observers believe. The restating companies in our sample responded to the significant cost imposed on them by financial markets by making reputation-enhancing changes to their internal monitoring systems, changes that are evidenced by the increase in the independence of their boards and audit committees. The incentive that restating companies have to maintain their reputations with investors in the capital markets ensures that the negative impact of restatements is short-lived. Our results indicate comparable postrestatement long-run stock performance for all restating and matched companies, which suggests that postrestatement enhancements to internal control systems help restore both blemished reputations and investor confidence. Thus, concerns that the current increase in restatements will erode investor confidence may be unwarranted.