The Reputational Penalty for Aggressive Accounting : Earnings Restatements and Management Turnover

In this paper, we investigate the reputational penalties to managers of firms announcing earnings restatements. More specifically, we examine management turnover and the subsequent employment of displaced managers at firms announcing earnings restatements during 1997 or 1998. In contrast to prior research (Beneish 1999 and Agrawal et al. 1999), which does not find increased turnover following GAAP violations or revelation of corporate fraud, we find that 60% of restating firms experience a turnover in at least one top manager within 24 months of the restatement compared to 35% among age-, size- and industry-matched firms. Moreover, the subsequent employment prospects of the displaced managers of restatement firms are poorer than those of the displaced managers of control firms. Our results hold after controlling for firm performance, bankruptcy and other determinants of management turnover, and suggest that both corporate boards and the external labor market impose significant penalties on managers for violating GAAP. Also, in light of resource constraints at the SEC, our findings are encouraging as they suggest that private penalties for GAAP violations are severe and may serve as partial substitutes for public enforcement of GAAP violations