Investigation of the Impact of Earnings Quality on Restatement of Financial Statements

Changes in accounting principle and accounting errors are two broad scenarios that require the restatement of prior financial statements. Of course, not all restatements reflect manipulations. However, since 1998 the frequency of financial restatements increase. This event coincides with a major move by the SEC to limit earnings manipulations, and with the Stock market crash, which flushed out many reporting dishonesties. Many of the restating firms faced securities class action lawsuits, management and auditors replacement. These results suggest that many of the restatements involved more than technical accounting issues. Restatements frequently call into question the credibility of a firm’s prior financial reports, and are often accompanied by claims of securities fraud. Restatements cause investors and other external users to re-evaluate the firm’s future earnings. Also, Restatements lead to lose confidence in the quality of reported earnings. (Frieder and Shanthikumar, 2008). In other words it is expected that low quality of reported earnings lead to financial restatement in future years. Therefore, the main objective of this study is to investigate the impact of earnings quality on restatement of listed companies in Tehran Stock Exchange (TSE). Research Hypotheses Based on the theoretical literature and the conducted studies, research hypotheses were developed as follows. H1: There is a significant relationship between earnings quality and occurrence of restatement. H2: There is a significant relationship between earnings quality and magnitude of restatement. The research methodology is a quantitative research that uses the scientific method and empirical evidence, and based on hypotheses and research designs is done. The empirical data was collected from a panel consisting of 103 Iranian companies listed in the TSE, over the seven-year period of 2004 to 2010. Magnitude of restatement is measured using the amount of net income restatement. Accruals quality, earnings predictability and earnings smoothing are selected as earnings quality proxies. Logistic and multiple linear regression analysis were conducted to test the research hypotheses. The results of the analysis of regression models show that there is a negative relationship between proxies of earnings quality (accruals quality, earnings predictability and earnings smoothing) and occurrence of restatement. But, only the relationship between accruals quality and restatement occurrence is statistically significant. Also, there is a significant negative relationship between earnings quality proxies and magnitude of restatement. The additional results of our study show that leverage not only positively influenced the occurrence of restatement, but also positively related to magnitude of restatement. In addition, profitability negatively related to restatement magnitude, but there is no relationship between profitability and occurrence of restatement. However, our results show that firm size has no relationship with restatement occurrence and magnitude.