4. Earnings restatements and the efficiency of supply chain capital investments
4.2. Literature review and hypotheses
4.3.2. Empirical procedures
I use the predication error from Equation (2) which is estimated after excluding restating firms, as a measure of excess investment for suppliers in year t. My approach to examining the influence of misstatement information on suppliers’
investment decisions is to examine the behavior of excess investment through time relative to the misreporting period. I examine the mean level of excess investment over the three years preceding the misreporting period, the year or years during the misreporting period, and the three years following the misreporting period. This estimation assumes that the proxies for the investment opportunity set capture the suppliers’ optimal investment at each year, and thus excess investment that is significantly different from zero reflects deviations from optimal investment for the restating firms’ suppliers. I predict that there is significantly positive excess investment during the misreporting period.
4.3.3. Sample
I first obtain a preliminary sample of 919 restating firms that announced restatements from January 1, 1997 to June 30, 2002 as provided in Government Accounting Office Report (2002). 35 I require restating firms covered by CRSP and Compustat. To do so, I checked all of the company names after merging the GAO data with CRSP and Compustat (207 firms). Based on previous study, I then exclude financial firms (SIC codes between 6000 and 6999) and utilities (SIC codes between 4900 and 4999) (63 firms). I also exclude firms with multiple restatements (48 firms).
I next follow the approach of Fee and Thomas (2004) and Hertzel et al. (2008) to identify major suppliers of restating firms. This approach is based on the segment
35 Following Gleason et al. (2008) and Wilson (2008), I use restatement firm reported in GAO (2002) as our research sample. The database includes instances in which financial statements were not fairly presented in accordance with Generally Accepted Accounting Principles (GAO 2002). Restatements resulting from stock splits, mergers and acquisitions, or changes in accounting principles are not included in the report. During this period, the public concern on the reliability of financial reporting and corporate governance grew, leading to the passage of Sarbanes-Oxley Act in July 2002. Thus, there was no significant shift in the legal regime during our sample period.
sales information disclosure requirement. In accordance with the Statement of Financial Accounting Standards (SFAS) No. 131, firms are required to disclose the identity of any customer that contributes at least 10% to the firm’s total revenues.36 This customer information is available on Compustat segment files, but the database reports only the name of the customer. And, further adding to the difficulty, sometimes it reports only the abbreviated versions of the names. To link the customer name with company in the CRSP or Compustat database, I use the following procedure. First, for each firm I determine whether the customer is another company listed on the CRSP or Compustat file and I assign it the corresponding CRSP permno number. To do so, I use a text-matching program to generate a list of potential matches to the customer’s name to one of CRSP or Compustat firm. Subsequent to the text matching by computer, I hand-matched the customer to the corresponding permno number by visually inspecting customers’ name, segments, and industry information to ensure accuracy.37
Next, I use the resulting database following above procedure to identify my sample of restating firm suppliers, I identify all firms in the database that list a restating firm as a major customer in either of the three year prior to (and including) the restatement announcement year. My sample selection procedure results in a total of 88 restating firms that have at least one supplier.
For each restating firm with at least one supplier in our sample, I further confirm announcement date and the nature of the restatements. I obtain new reports form the ProQuest Newspaper database, Lexis-Nexis, and press release attached to 8-ks file
36 Statement of Financial Accounting Standards No. 14 required firms to report certain financial information for any industry segment that comprised more than 10% of consolidated sales or revenues between 1977 and 1997. Effective 1998, Statement of Financial Accounting Standards No. 131 now governs required segment disclosures.
37 While some discretion is involved in visually inspecting customer abbreviation with firm identities, I am conservative in conducting visual inspection that could reduces the sample size but ensures all matches are certain.
with the SEC. Consistent with prior work (e.g., Hennes, et al. 2009), I exclude 9 technical restatements that do not imply an improper accounting in the original filing (e.g., restatements for merges and change in principle)38. I also eliminate interim restatements that are viewed as less severe than restatement of audited annual reports (4 firms). Finally, to provide the most powerful test of hypotheses, I only focus on restatements that result from aggressive accounting practice. Thus, I drop firms that make income-decreasing restatements (6 firms). Following these screens, my final sample of restating firms contains 70 earnings restatements and I identify a total 229 individual suppliers. The distribution of restating firms and suppliers are presented in Table 4.1. The distribution of these samples over time is reported in Panel A of Table 4.1.
[Insert Table 4.1 here]
Panel B of Table 4.1 reports summary information on the sample distribution by industry. Industries are as defined in Beneish et al. (2008). Panel B indicates that restating firms are widely distributed among industries, with some clustering of firms in durable manufacturers, computers, and retail industry. I hand collect from SEC filings the fiscal period affected by the restatement. About 15% of restating firms restate single quarter’s financial statement. About 63% of the restating firms restate four or fewer quarters, 21% restate five to eight quarters, and 24 % the remaining restate nine or more quarters.
4.4. Empirical results 4.4.1. Descriptive statistics
Table 4.2 presents summary statistics for the supplier firm. Descriptive statistics
38 The GAO database includes restatement following the adoption of SAB No. 101 “Revenue Recognition in Financial Statements (SEC 1999). Restatements prompted by adoption of SAB No. 101 are excluded (6 firms) and the issuance of various EITF Consensuses. .
are presented in Panel A, and correlations are presented in Panel B. At the median, firms invest 32.7 percent of net property, plant, and equipment (NPPE). The inter-quartiles ranges indicate significant cross-sectional variation in these amounts.
Specifically, at the quartiles, investment ranges from 16.7 percent to 66.7 percent of
NPPE. The mean (median) Q of suppliers is 2.89 (1.51), consistent with unrecognized
assets causing the market value of assets to exceed the book value of assets. Median cash flow from operation is positive. The mean (median) asset growth is 0.189 (0.126). The mean (median) excess investment (EXINV) is 0.112 (0.071).[Insert Table 4.2 here]
Panel B of Table 4.2 reports Pearson correlations. Correlations are significantly different from zero. Suppliers’ Investment is positively correlated with Q; suppliers firms with greater growth opportunities tend to invest more. Investment is also positively correlated with profitable, as measured by cash flows, and with asset growth.
4.4.2 Primary results
Table 4.3 reports multivariate regression results using the Q model of investment, as described in Equation (1) and Equation (2). Panel A shows summary statistic for the investment model regressions, and Panel B presents excess investment through event time for restating firms and suppliers.
[Insert Table 4.3 here]
Panel A shows summary statistics from 576 separate industry-year regression-mean coefficient estimates and adjusted R2 and Fama and Macbeth (1973) t-statistics. Panel A model 1 indicates that investment is positively associated with Q and positively associated with cash flows (CF). The results from the estimation of Equation (2) indicate investments are also significantly positively related to asset
growth and lagged investment. I also find that significant differences in the relationship between investment and Q across the distribution of Q. The incremental coefficients indicate that the magnitude of the relationship is greatest in the fourth quartile of Q and lowest when Q is the smallest. These results are consistent with the findings in McNichols and Stubben (2008).
In Panel B of Table 4.3, the first column reveals that excess investment to the restating firm is positive and increasing through the second year of the manipulation period, indicating the restating firms over-invest during the misreporting period.
Excess investment is significantly positive one year before the misreporting period, but it is greatest during the fist two years of the misreporting period. My results presented for the restating firm are similar to findings in the work of McNichols and Stubben (2008). The results suggest that restating firms overstated their accounting earnings over-invest during the misreporting period.
To test whether restating firm manipulating their reported earnings induce their suppliers to over-invest, I provide results of excess investment for suppliers. The second column reports the results for suppliers. I find evidence of over-investment during the misreporting period for suppliers, which is consistent with H1. Specifically, suppliers over-invest during the first years of the misreporting period. Excess investment is positive and increasing with a peak in the first year of the misreporting period.
Consistent with H2, excess investment is no longer positive after the restatement announcement year. It is negative but not significant. Investments of suppliers are then significantly lower then misreporting period. Overall, I find evidence of significant over-investment during the misreporting period, and that over-investment ends as the misreporting ends.
To examine how severity of earnings restatement interacts with suppliers’
investment decisions, I test suppliers’ excess investments conditioning on whether restatement firms’ abnormal returns are less than or greater than median. Based on prior research (e.g., Wilson 2008), I define that the more severe restatements are those for which the three-day cumulative abnormal returns surrounding the restatement announcement date is below the median CAR (i.e., more negative) for the restating firms.
The analyses for suppliers’ excess investments are shown in Table 4.4.This reports excess investment separately for restatements that result in more negative market reactions and less negative market reaction. I find evidence that supplier over-investments during the misreporting period are clearly more prominent when there restating firms have a severely negative stock price reaction to earnings restatement announcement. Suppliers in the first two year of the misreporting period have larger magnitudes of excess investment for the subsample of restatement sample in which restating firms have abnormal returns are less or equal to median (0.050, t=2.09) (0.056, t= 2.40). This compares to a significant average excess investment of -0.039 in the fist year of misreporting period for the subsample with restatement abnormal returns are greater than or equal to median.
[Insert Table 4.4 here]
It is interesting to note that significant over-investment before the misreporting period occurs only in the subsample of restating firm with more negative stock price effects at the time of earning restatement announcement. The more over-investment for suppliers in the presence of more negative restating firms’ abnormal returns is consistent with that restatements yield more negative wealth effect for the restating firms have more significant misstated financial information and so that suppliers will make more inefficiency investment decisions during the misstated period. Consistent
with H2, in both cases I find that supplier excess investment is no longer significantly positive after the misreporting period.
Table 4.5 presents the investment of sample firms relative to that of control firms based on past growth and excess investment. Comparing investment of suppliers to that of control firms matched on asset growth the year before the misreporting period, I no longer find evidence of supplier over-investment before the misreporting period.
This suggests that suppliers’ investment is not significantly greater than that of firms with similar growth in the pre-misreporting period. Thus, this result indicates that greater suppliers’ investment is likely due to growth expectations. However, I find that suppliers invest significantly more than the matched firms with similar growth during the second year of misreporting period (4.6 percent of NPPE), which is consistent with H1. This finding indicates that greater suppliers’ investment is not due to growth expectations during the misreporting period. Furthermore, restating firms’
suppliers invest less than growth-matched firms after the misreporting period; these differences are not statistically significant. That is, I find no evidence of over-investment for suppliers subsequent to the restatement.
[Insert Table 4.5 here]
I find similar results when controlling for excess investment the year before the misreporting period. The results indicate that restating firms’ suppliers invest slightly more than control firms leading up to the misreporting period, and they generally invest more than control firms during the first year of the misstatement period (5.4 percent of NPPE), which is consistent with H1. Investment of suppliers is then lower than that of control firms after the restatement announcements. Consistent with H2, in both cases I find that supplier excess investment is no longer significantly positive after the misreporting period.
Table 4.6 presents the investment of suppliers based on types of earnings restatements. I find evidence that supplier over-investments during the misreporting period are clearly more prominent when restatements involve accounting fraud.
Suppliers in the first two year of the misreporting period have larger magnitudes of excess investment for fraud firms’ suppliers (0.113, t=3.19) (0.74, t=2.37). In addition, I find supplier over-investments during the misreporting period are clearly more prominent when restatements involve revenue recognition errors. However, I do not find similar results for restatements involving cost or expense errors.
[Insert Table 4.6 here]
Overall, the empirical results suggest that earnings restatements inducing over-investments by the restating firms will spillover to their suppliers. This is because with a positive correlation in economic activities between the restating firm and suppliers, over-investment by the restating firms implies a less efficient use of factors of production, which will increases the demand for inputs, thereby leading to supplier over-investment.
4.5. Summary
This paper examines whether restating firms misreporting their financial results induce their suppliers to make suboptimal investment decisions. To test this investment inefficiency hypothesis, this paper first estimates investment efficiency for major suppliers during the misreporting period. Based on prior research (e.g., Richardson 2006; Biddle et al. 2008), the inefficiency of suppliers’ investments is measured as the deviation of Tobin’s q from their optimal level. The findings indicate that restating firms’ suppliers over-invest substantially during the misreporting period.
I find significantly greater investment than would be expected based on investment fundamentals. Additional test using matching control firms suggest that supplier
invest more than peer firms that their major customers did not misreport their reported financial results. Overall, the empirical results suggest that earnings restatements inducing over-investments by the restating firms will spillover to their suppliers. This is because with a positive correlation in economic activities between the restating firm and suppliers, over-investment by the restating firms implies a less efficient use of factors of production, which will increases the demand for inputs, thereby leading to supplier over-investment.
Table 4.1 Sample distribution Panel A: Distribution by Year
Restating firms Suppliers
Year Count Median
Count is the number of restating firms and their suppliers. Median length is the median number of years of restating firms’ misreporting period. Industries are defined in
Table 4.2
Sample summary statistics Panel A: Descriptive Statistics
Variable N Mean Q1 Median Q3 Std Dev.
INV
229 0.643 0.167 0.327 0.667 0.987Q
213 2.896 1.020 1.501 3.011 3.764CF
223 -0.616 -0.512 0.217 0.858 6.616GROWTH 226 0.189 -0.032
0.126 0.455 0.615EXINV
203 0.112 -0.073 0.071 0.253 0.683Panel B: Pearson Correlation Matrix
INV Q CF GROWTH
Q
0.270***CF
0.275*** 0.142**GROWTH 0.314
*** 0.387*** 0.125**EXINV
0.788*** -0.118*** 0.077* -0.205***Variable Definitions: INV = suppliers’ capital expenditures scaled by beginning-of-year net property, plant, and equipment; Q= suppliers’ Tobin’s Q (market to book value of asset) at beginning of year.
CF= suppliers’ cash flow from operations scaled by beginning-of-year property, plant, and equipment;
GROWTH= suppliers’ natural log of total assets at end of prior year divided by total assets tow years prior; and EXINV= suppliers’ excess investment, measured as the residual from and industry-year regression of INV onto Q and CF.
Table 4.3
Excess investment through event time Panel A: Determinants of Investment (N=576)
(1) (2)
Variable Mean Estimate FM t-stat Mean Estimate FM t-stat
Q
t-1 0.11 16.98*** 0.15 10.10***Q_Quartile2
t-10.02 2.10**
Q_Quartile3
t-10.04 4.39***
Q_Quartile4
t-10.09 7.63***
CF
t 0.04 7.02*** 0.02 3.07***GROWTH
t-1 0.06 3.08***INVt
t-1 0.28 86.10***Adjusted R2 0.49 0.67
Panel B: Excess Investment for restating firms and suppliers
Restating firms Suppliers
Event Year N Mean t-value N Mean t-value
-3 53 0.038 1.52 133 0.019 0.32
-2 55 0.046 1.61 159 0.029 0.73
-1 58 0.059 2.04 181 0.043 1.21
M1 68 0.105 4.39 203 0.102 2.09
M2 36 0.063 3.40 124 0.083 1.60
M3 16 0.051 1.08 48 0.061 1.54
1 59 -0.033 -0.70 193 -0.011 -0.53
2 57 -0.005 -0.12 175 0.012 0.58
3 58 0.001 0.24 169 0.063 1.79
Panel A reports summary statistics from industry-year regression of investment. Mean Estimate is the mean of 576 separate coefficient estimates, and FM t-stat is the Fama-MacBeth t-statistic. Panel B reports the mean of excess investment (EXINV) through event time for restating firms and suppliers, based on Equation (2). Year -1 (Year -2, Year -3) is the first (second, third) year before the misreporting year. M1 (M2, M3) represents the first (second, third) year of the misreporting period.
Year 1 (Year 2, Year 3) is the first (second, third) year following the restatement announcement.
Table 4.4
Excess investment through event time-by level of severity of restatements Low CAR Market Reaction Higher CAR Market Reaction Event Year N Mean t-value N Mean t-value
-3 67 0.034 1.80 66 0.019 0.41
-2 81 0.016 0.45 78 0.025 1.73
-1 89 0.028 1.11 92 0.040 1.93
M1 107 0.039 1.96 96 0.050 2.09
M2 62 0.027 0.76 62 0.056 2.40
M3 23 0.005 0.16 25 0.027 1.20
1 92 0.001 0.11 101 -0.016 -0.75
2 85 0.054 1.29 90 0.021 0.89
3 88 0.056 1.33 81 0.028 1.14
Table 4 reports the mean of excess investment (EXINV) through event time for restating firms and suppliers conditioning on whether restatement firms’ abnormal returns are less than or greater than median. M1 (M2, M3) represents the first (second, third) year of the misreporting period. Year -1 (Year -2, Year -3) is the first (second, third) year before the misreporting year. M1 (M2, M3) represents the first (second, third) year of the misreporting period. Year 1 (Year 2, Year 3) is the first (second, third) year following the restatement announcement.
Table 4.5
Mean investment through event time-relative to control firms
Growth Adjusted EXINV Investment Adjusted EXINV Event Year N Mean t-value N Mean t-value
-3 98 -0.001 -0.24 98 0.007 0.47
-2 109 0.015 0.73 109 0.019 0.62
-1 161 0.026 0.97 161 0.039 1.73
M1 181 0.037 1.54 181 0.054 2.23
M2 115 0.046 2.10 115 0.040 1.50
M3 42 0.031 0.98 42 0.021 1.33
1 188 -0.028 -1.48 188 -0.017 -0.45
2 177 0.019 0.77 177 0.021 1.25
3 124 0.025 1.32 124 0.037 1.43
Table 5 reports the mean of excess investment (EXINV) through event time for restating firms and suppliers, based on Equation (2). M1 (M2, M3) represents the first (second, third) year of the misreporting period. Missing data for control firms reduces the effective sample sizes. Growth adjusted EXINV is the mean investment of each sample firm’s investment less that of a control firm matched on asset growth, size, and industry, in event year t-1. Investment adjusted is the mean investment of each supplier’s investment less that of a control firm matched on excess investment, size, and industry, in event year t-1. Year -1 (Year -2, Year -3) is the first (second, third) year before the misreporting year.
M1 (M2, M3) represents the first (second, third) year of the misreporting period. Year 1 (Year 2, Year 3) is the first (second, third) year following the restatement announcement.
Table 4.6
Excess investment through event time-by the types of earnings restatements Fraud
restatements
Revenue restatements
Cost restatements Event Year N Mean t-value N Mean t-value N Mean t-value
-3 52 0.054 1.75 75 0.019 1.51 6 0.025 1.53 -2 64 0.036 1.31 86 0.005 0.23 9 0.012 0.97 -1 72 0.068 1.83 99 0.040 1.61 10 0.019 0.41 M1 75 0.113 3.19 107 0.055 1.87 21 0.030 1.62 M2 37 0.074 2.37 47 0.041 1.66 40 0.026 1.44 M3 11 0.045 1.55 25 0.031 1.28 12 0.029 1.51 1 72 -0.036 -1.71 97 -0.016 -0.75 24 0.000 0.15 2 71 -0.021 -0.79 95 0.018 1.07 9 0.001 0.65 3 68 0.000 0.31 94 0.000 0.29 7 0.013 0.84
Table 4 reports the mean of excess investment (EXINV) through event time for restating firms and suppliers conditioning on whether restatement firms’ abnormal returns are less than or greater than median. M1 (M2, M3) represents the first (second, third) year of the misreporting period. Year -1 (Year -2, Year -3) is the first (second, third) year before the misreporting year. M1 (M2, M3) represents the first (second, third) year of the misreporting period. Year 1 (Year 2, Year 3) is the first (second, third) year following the restatement announcement.
5. Conclusions
This thesis extends prior research on earnings restatements by examining the effects of earnings restatements on valuation and investment decisions of restating firms’ suppliers. First, this paper hypothesizes and finds that earnings restatements that adversely affect stock price of the restating firms also induce their supplier stock price decline. The declines in stock price seem to reflect investors’ future prospect concerns and accounting quality concerns about suppliers. Second, I hypothesize that earnings restatements contain information about the value of relationship-specific investments by suppliers. This information causes suppliers to revise their belief about the value of relationship-specific investments, and therefore affects their subsequent relationship-specific investment decisions. Consistent with my prediction, I find that changes in suppliers’ relationship-specific investments after restatement announcements are related to information in the restatements. Finally, I predict and find that a restating firm misreporting financial results induces its suppliers to make excess investments during the misreporting period, while excess investment is no longer positive after the restatement announcement.
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