Oct. 2006, Vol.2, No.10 (Serial No.17)
Journal of Modern Accounting and Auditing, ISSN1548-6583, USA
Accounting Restatement: A Comparison between China and USA
WANG Xia *
(Renmin University of China, Beijing 100872, China)
Abstract: This paper compares the accounting restatement between American listed companies and Chinese
ones. We find that there are some difference significantly existed in four aspects: institutional background,
characteristics of restatement, marketing reactions of restatement events and the effects of corporate governance
of restating companies. We find that Chinese case is unlike the prior results of U.S. firms, and there are no
significant returns associated with corrections announcements because the corrections in China are announced in
earnings releases. Consistent with prior literature where U.S. data are used, corporate governance in Chinese
capital market can at least partly explain why accounting restatements have become common.
Key words: accounting restatement; institutional background; characteristics; market reaction; corporate
governance
In America, accounting restatement has become an increasingly common phenomenon in financial reporting.
Restatements clearly signal that the firm’s prior financial statements are not credible and are of relatively lower
“quality”. A restatement can cause investors to reevaluate their expectations for future prospects of the firm, either
because amended historical results trigger a reassessment of expected future cash flows or because the restatement
calls the credibility of management into question. Prior research has shown that restatements of financial
statements result in a substantial loss of market value. For example, the former Chairman of Securities and
Exchange Commission (SEC) testified before a Senate Subcommittee that, “in recent years, countless investors
have suffered significant losses as market capitalizations have dropped by billions of dollars due to restatements
of audited financial statements” (Levitt, 2000).
However, there is also showing a similar phenomenon increasingly in the developing capital market like
China recent years. This trend and its potential impact have caught the attention of accounting professionals,
regulators and investors. In this paper, we compare the accounting restatement between China and America in the
following aspects: the institutional background; the characteristics of restatement; the market reaction to the
accounting restatement and the corporate governance of the restated firms.
1. A Comparison of Institutional Background
In America, according to APB opinion No.20 (Accounting Changes), when firms find errors such as “result
from mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts
that existed at the time the financial statements were prepared” in previously issued financial statements, they
should restate the previous financial statements. If a company restates its previously filed annual (quarterly) report,
it files an amended annual (quarterly) report, 10K/A (10Q/A). Both 10K/As and 10Q/As carry the newly restated
WANG Xia, PhD in Accounting of Tsinghua University, lecturer of School of Business, Renmin University of China; research
fields: quality of accounting information, corporate governance.
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Accounting Restatement: A Comparison between China and USA
numbers and usually the originally reported ones as well. These filings override the original 10Ks and 10Qs. As to
restatement of unfilled quarterly or year-end results, since the original results have not been filed with the SEC,
the 10K or 10Q filed later will carry the corrected number.
In China, according to Accounting Standards for Business Enterprises: Changes in Accounting Polices and
Accounting Estimates, and Corrections of Accounting Errors (which became operative as from 1 January, l999,
revised 2001), accounting errors are errors in measurement, recognition or recording for accounting purposes.
Significant accounting errors are accounting errors discovered by an enterprise, which would cause accounting
statements previously issued to be no longer reliable. Accounting errors discovered in the current period should be
dealt with in accordance with the fo1lowing principles: (a) accounting errors relating to current period and
discovered in the current period should be adjusted against relevant items in the current period; (b) insignificant
accounting errors discovered in the current period that affect the profit or loss arising in prior periods should be
directly reflected in the net profit or loss for the current period together with an adjustment to any other relevant
items. If there is no effect on the profit or loss, any other relevant items of the current period affected should be
adjusted; and (c) significant accounting errors discovered in the current period that affect the profit or loss arising
in prior periods should be adjusted to the opening balance of retained earnings. The opening balance of other
related items in the accounting statements should also be adjusted. If there is no effect on the profit or loss, the
opening balance of related items in the accounting statements should be adjusted. So in accordance with the CAS,
significant accounting errors should be dealt with the retrospective application, and not need to restate the prior
financial statement like a public firm of U.S. does except to restate the retained earnings and related financial
items in the current statements. However, this status will be changed. On Feb. 2006, Ministry of Finance issues
the “new” Accounting Standards for Business Enterprises which require the companies to restate the financial
statement when the accounting errors are found.
2. A Comparison of the Characteristics of Restatement
From a study prepared and submitted to the U.S. Congress by the U.S. General Accounting Office (GAO,
2002), we find that it lists 919 accounting restatements by 845 public companies during January 1, 1997 to June
30, 2002. W.R. Baber et al (2006)handcollect additional restatement announcements during the post-GAO period
from July 2002 to December 2004. This effort yields additional 55 firms that misstate financial reports disclosed
during July 1, 2002 to December 31, 2004. We also handcollect the announcement of correction of accounting
errors in the notes of financial reporting from January 1, 1999 to December 31, 2004, and we find there are total
894 listed companies that correct the accounting errors of prior financial statement.
Figure 1a shows the trend of initial sample restatements of U. S. firms from 1997 to 2004. During the
eight-year period, 974 firms restated their earnings, in which the number of firms restating their earnings in 2001
is the highest. Figure 1b presents the results of our handcollect work, which demonstrates that there are 894 firms
corrected the accounting errors in their prior financial statements. Compared with figure 1a, the similarity we find
is that the number of restatements increases from 2001 and decreases sharply from 2003. The potential reason of
the change we guess is that the regulators have expressed great concern over restatements. In America, the
increasing number of restatement helped motivate the U.S. Securities and Exchange Commission’s (SEC)
earnings management and initiative formation of the Public Oversight Board (POB) Panel on Audit Effectiveness.
It also influenced the SECs auditor independence rule-making on non-audit services provided to audit clients, a
11
Accounting Restatement: A Comparison between China and USA
General Accounting Office (GAO, 2002) probe of restatements, and certain provisions in the Sarbanes-Oxley Act
of 2002. In China, China Securities Regulatory Commission (CSRC) also issued a series of rules to reduce the
number of restatements, such as “a notification of former improving the disclosure information quality of listed
firms”, which require the listed companies to disclose the information of restatement in temporary bulletin, not in
the notes of financial statement as usual. Besides this, just like what is mentioned in preamble, “new” Accounting
Standards for Business Enterprises requires the companies to restate the financial statement from 2007.
250
225
201
200
174
Quantit
y
150
125
102
92
100
55
50
0
1997
1998
Figure 1a
1999
2000
Period
2001
30/06/2002
30/06
/2002-2004
Restatements of American companies by year 1997~2004
282
300
252
250
190
200
Quantity
150
128
100
50
21
21
1999
2000
0
2001
2002
2003
2004
Period
Figure 1b
Corrections of accounting errors of Chinese companies by year 1999~2004
Restatements of financials have different characteristics because of prompters and reasons. S. Demirkan
(2006) divided the firms into categories based on the reasons for the restatement. He shows the frequency of each
type of error. The categories he uses included revenue recognition, restructuring charges, in-process research and
development, cost/expense, loan-loss, reclassification, related party transaction, securities related, tax related,
unspecified, and other items. Consistent with WU (2002) and GAO (2002), he finds that revenue recognition
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Accounting Restatement: A Comparison between China and USA
dominates any other single reason for restatements. The majority of the restatement is initiated by the firm, the
SEC, auditors and other outsiders initiated the remainder of the restatements.
Unlike the American firms, Chinese companies did not report the party who initiated restatements. We
investigate the reason for the restatement and find that the largest category relates to tax related, the second largest
category relates to costs or expenses, which can be decomposed into either the understatement of various
operating costs or the overstatement of current or long-term assets. The remaining categories cover restatements
for reclassification, revenue recognition, depreciation and reserve, pure errors, and no stated reason.
3. A Comparison of Market Reaction to Accounting Restatement
The most attractive research field is the stock-return behavior around earnings restatement announcements.
Lots of American scholars did much work on this. They all found a strongly negative short-term market reaction
to restatement announcements. For example, using a sample of 403 restatements announced from 1995 to1999,
Palmrose et al. (2004) documented economically and statistically significant mean (median) market reaction to
restatement announcements of -9.2 % (-4.6%) abnormal return over a two day event window. They found that
more negative returns were associated with restatements involving fraud, affecting more accounts, decreasing
reported income and attributed to auditors or management (but not the Securities and Exchange Commission).
These results are consistent with both diminished company prospects and increased risk/uncertainty.
Table 1 presents summary statistics for cumulative abnormal return. Prior research has shown that
restatements of financial statements result in a substantial loss of market value, with abnormal returns estimates
ranging from -4% to -12%, depending on the sample examined. This evidence supports the notion that
restatements as a whole are evidence of a serious corporate failure.
Table 1
Summary of cumulative abnormal returns (CARs) for prior studies surrounding restatement announcements
Cumulative
author
Sample period
number
windows
abnormal return
Dechow et al.(1996)
1981-1992
105
-1,1
-6%
Truner et al.(2001)
1997-1999
223
0,1
-12%
Wu(2002)
1997-2000
255
-5,5
-11%
Anderson
et.al(2002)
1997-1999
329
-3,3
-3.8%
GAO(2002)
1997-2002
689
-1,1
-10%
Palmrose et
al.(2004)
1995-1999
403
0,1
-9%
S.Demirkan(2006)
1997-2002
275
-1,0
-3.7%
William R.Baber et
al.(2006)
1997-2002
204
-1,1
-7.0%
We also examine the determinants of market reactions to corrections announcements of Chinese listed
companies. Because our investigation period is before 2004, about all the restatements are announced in the notes
of financial reports going with earnings releases. We find that no significant returns are associated with
corrections announcements because the corrections are announced in earnings releases just as what Palmrose et al.
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Accounting Restatement: A Comparison between China and USA
(2004) document that returns for the new no-earnings subsamples are significantly more negative than the
earnings release group. We divide the firms into two subsamples following the income-increasing restatements
and income-decreasing ones. Our analysis indicates that the amount of income-decreasing restatements is larger
than that of income-decreasing ones. The market reaction for all income-increasing restatements is 4%,
significantly positive. But the market reaction for all income-decreasing restatements is negative, not significantly.
We add an earnings surprise variable to control for concurrent earnings news effects. The result shows that the
correction test variable coefficients are insignificant but direct to restatements.
4. Corporate Governance and Accounting Restatement
Several plausible explanations have been offered to explain why such harmful accounting restatements have
become common. Basing on the prior studies, William R. Baber’s (2006) Comparisons of 204 restatement firms
with 1,617 non-restatement firms indicate that most governance mechanisms frequently advanced by governance
experts and regulators-as examples, board and audit committee independence, CEO-chair separation, board size,
equity compensation structure of the CEO, and audit committees with independent financial experts—fail to
explain the incidence of financial restatement. They do find, however, that the probability of a restatement varies
directly with external governance mechanisms-specifically the statutory regulations and corporate charter
provisions-that increase the cost of corporate takeover and otherwise restrict or discourage shareholder
participation in the governance process.
In china, similar to prior studies of accounting restatements, we presume that weak corporate governance is
at least partially responsible for financial reporting errors (GAO, 2002; Abbott, Parker, and Peters 2003; Argawal
and Chadha 2005; Srinivasan 2005). We investigate cross-sectional associations between the probability of
financial restatements and characteristics of the corporate governance. We find that financial restatements are
more likely when firms have weaker profitability, a state control shareholder, diffuse ownership, higher leverage,
smaller size and turnover manager. The restated companies with turnover manager indicate that accounting
restatements are likely to be used as an earnings management tool. New managers restate prior earning and related
financial items like “big bath”.
5. Conclusion
In this study, we compare the accounting restatement between American listed companies and Chinese ones.
We find that there are some difference significantly existed in four aspects: institutional background,
characteristics of restatement, market reactions of restatement events, and the effects of corporate governance of
restating companies. Using Chinese data, we find that unlike the prior results by using U.S. firms, there are no
significant returns associated with corrections announcements because the corrections are announced in earnings
releases. Consistent with prior literature where U.S. data are used, corporate governance in Chinese capital market
can at least partly explain why accounting restatements have become common.
References:
[1] Abbott, L., S. Parker, G. Peters.(2003). Audit Committee Characteristics and Restatements[J]. Auditing, a Journal of Practice
and Theory, 23 (1): 69-87.
(to be continued to Page 27)
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