Effects of financial restatements on top management team dismissal

• Pages: 485-502
• DOI: https://doi.org/10.1108/CG-06-2019-0191
• Date: 18 March 2020
• Published date: 18 March 2020
• Author: Stefano Azzali,Tatiana Mazza
• Subject Matter: Corporate governance,Strategy

Effects of f‌inancial restatements on top

management team dismissal

Stefano Azzali and Tatiana Mazza

Abstract

Purpose –The purpose of this paper is to analyze the effects of financial restatements (FRs) on the

likelihood of the top management team (TMT) dismissal. It investigates the effects of types of FRs

[corrective note and reissuance of financial statement (RFS)], of FR severity and of FR related to

internationalfinancial reporting standards(IFRSs) easy or difficult-to-estimate.

Design/methodology/approach –The authors hand-collect:data about 96 FRs from the Italian public

oversight board documents; chief executive officer (CEO) name, chairman name, year of the financial

statement under investigation, total assets and operating income, from their financial statement. The

authorsuse multivariate regression to test the effects of FRs onthe probability of TMT dismissal.

Findings –The authors find that the RFS leads to a higher likelihood of chairman dismissal. A greater

magnitude of misrepresentation on income statements, and FRs,which decrease net income, increase

the likelihoodof CEO dismissal. Difficult-to-estimateIFRSs increases the likelihoodof CEO dismissal.

Originality/value –FRs are significant determinants of the CEO/chairman dismissal.The authors show

that FRs directlyinvolving shareholders (RFS) have negative consequenceson the chairman of the board

of directors, whilethe CEO is more affected by FRs that involve technical factors(FR severity or financial

statementassociated with difficult-to-estimateIFRSs).

Keywords Financial restatements, Chief executive off‌icer dismissal, Chairman dismissal,

Financial reporting

Paper type Research paper

1. Introduction

A financial restatement (FR) refers to the revision of a prior financial statement as required

by a public oversight board (POB)[1]. It is required whenever a financial statement is found

to contain one or more material misstatements[2]. FRs are bad news for investors, creditors,

analysts and auditors (Mao, 2018), and the literature finds that incentive compensation, firm

characteristics and auditorattributes are determinants of FRs (Fountaine and Phillips, 2018)

and that FRs can have several effects. They can:

䊏Decrease expected future earnings and stock prices.

䊏Increase the firm’s cost of equity capital (Hribar and Jenkins, 2004;Kasznik, 2004;

Kravet and Shevlin, 2010).

䊏Have a contagion effect on non-restating firms[3] in the same industry causing share

prices to decline (Gleason et al., 2008).

Most of the literature investigates the USA or China while Italian studies have focused on

type, severity and international financial reporting standard (IFRS) FRs, but to date, no

empirical studies have analyzedthe effects of FR on top management team (TMT) dismissal

taking into account of different types of FR [corrective note (CN) and reissuance of the

financial statement (RFS)], FR severity and FR from easy or difficult-to-estimate IFRS. We

expect FR to be negative for chief executive officers (CEO) and chairman of the board of

Stefano Azzali and

Tatiana Mazza are both

based at the Department of

Economics and

Management, University of

Parma, Parma, Italy.

Received 25 June 2019

Revised 6 December 2019

17 January 2020

24 January 2020

11 February 2020

Accepted 13 February 2020

This reserach has financially

been supported by the

Programme “FIL-Quota

Incentivante” of University of

Parma and co-sponsored by

Fondazione Cariparma.

DOI 10.1108/CG-06-2019-0191 VOL. 20 NO. 3 2020, pp. 485-502, ©Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 485

directors, given that a consequence of FR is often dismissal (Agrawal and Cooper, 2017;

Desai et al.,2006;Srinivasan, 2005).

CEO dismissal is defined as the ad hoc departure of the CEO, not part of a mandatory

retirement policy, and against her or his will (Fredrickson et al.,1988, p. 255). CEO

dismissal depends on organizational performance and on four main types of social and

political factors as follows: board expectations and attributions, board allegiances,

alternatives to the incumbent and the incumbent’s power (Fredrickson et al.,1988,

pp. 257-259). These factors affect CEO dismissal and interact with a number of objective

variables pertaining to the characteristics of the board, the organization, the industry, the

CEO and the preceding CEO (Fredrickson et al.,1988). This model of CEO dismissal is

based on upper echelons theory (UET) (Hambrick and Mason, 1984) and its updated

version (Abatecola and Cristofaro,2020), where organizational outcomes, strategic choices

and performances are partially predicted by TMT characteristics. CEO/chairman are the

main roles in a company and, together with the chieffinancial officer (CFO), audit committee

and auditors, they are mainly responsible for the company’s financial statement. Hennes

et al. (2008) investigate the effect of different types of restatement (errors vs irregularities)

on CEO/CFO turnover in the USA but to date, no studies have investigated the effects of FR

in Italy using the CEO/chairman dismissalmodel of Fredrickson et al. (1988).

The analysis of the effects of FR on TMT dismissal is important because neither the CEO

dismissal model nor UET directly considers the risks brought by FR. This research aims to

show that FR is a significant factor to be included in the CEO dismissal model linked to the

updated version of UET.

TMT dismissal and FR are linked because the chairman and CEO are chiefly responsible for the

company and, together with CFO, audit committee and auditors, for the financial statement.

Material misstatement in the financial statement increases the risks of FR and the likelihood of

manager dismissal. However, it is an empirical question of whether FR impact integrates the

CEO dismissal model used in prior literature. We analyze the effects of following two types of FR:

1. FR relating to non-compliance with financial reporting, which requires a CN to be

published on the internet site of the company.

2. FR requiring the RFS, which needs re-approval by shareholders.

Using a unique bank of data hand-collected directly from Commissione Nazionale per le

Societa

`e la Borsa (CONSOB), the Italian POB, whichincludes information on 96 FR (51 CN

and 45 RFS), our research aims to investigatethe effects on TMT dismissal of different types

of FR (CN and RFS), according to FR severity and according to whether FR is caused by

easy or difficult-to-estimateIFRS. Using logit regression models to compare companies with

and without FR, we first test the probability of TMT dismissal, separating the effect of CR

and RFS. We also analyze the effect of FR severity and of FR associated with difficult-to-

estimate IFRS on the probability of TMT dismissal.

The main results are that:

䊏FR increases the likelihood of chairman dismissal;

䊏The severity of the FR is a significant determinant of the probability of CEO dismissal.

The likelihood of CEO dismissal is significantly higher for more severe income

statement restatements and for restatements that decrease income, compared with

restatements that do not affect income; and

䊏The likelihood of CEO dismissal increases when FR is associated with more difficult-to-

estimate IFRS.

We contribute to the literature in several ways. First, we show that chairman dismissal is

more probable for RFS than for CN. This may reflect that RFS is more severe and requires

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