Conditional and unconditional conservatism following a financial reporting failure: An empirical study

The quality of financial reporting has come under increased scrutiny in recent years because of high-profile financial reporting failures, such as Enron and WorldCom, and the significant increase in the number of financial restatements. While most of the attention following these financial reporting failures has focused on the capital market consequences and the negative impact on investor confidence, very little analysis has adopted a contracting perspective. As accounting information is often used in contracts, the reliability and quality of the accounting information plays a critical role. A financial reporting failure casts doubt on the quality of the financial information, and consequently, leads to greater contracting uncertainty. I posit one means of restoring credibility of the accounting numbers following a financial reporting failure is to take a more conservative approach in reporting firm performance. Therefore, this study investigates whether firms report more conservatively following a financial restatement in order to restore the trust and confidence of the contracting parties and to protect the interests of the contracting parties.;I specifically examine whether firms report more conservatively in the three years following a restatement announcement, and whether an increase in conservatism is related to the extent of debt and compensation contracts. I then examine various corporate governance variables as possible explanations for an increase in conservatism following a restatement. I find restating firms significantly increase conditional conservatism in the three year period following the restatement announcement year. In addition, I find that both the level and change in conditional conservatism following a restatement is greater for firms where debt and compensation contracting are more important. These results are consistent with the contracting explanation of conservatism provided in Watts (2003). Lastly, I find little support for corporate governance variables as explanations for the increase in conservatism.