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This paper describes how managers get reputational penalties simply because of announcing earnings restatements which have been on the increase in the recent years. The penalties are meant to act in accordance with the stated laws that tend to punish the persons who break the GAAP rules.
Managers have been known to indulge in such fraudulent activities since they believed that the law will not catch up with them in any way. However things have changed for the better in the current times and the numerous laws that have been set up have begun catching up with the offenders.
Recent reports from the GAO department have shown much improvement when compared to the previous years’ reports. The previous ones had reported high figures of violators in financial reporting fraud and earnings restatements. Therefore, a lot needs to be done so at to ensure that such persons are brought to book.
In the US, the Government Accounting Office (GAO) has reported major incidences of financial fraud and earnings restatements. For instance in the year 1997 to 1998, highest rates of fraud were reported unlike in the previous years and the GAO department was quick to establish why this occurred. In general, this drop in quality was of high importance to various parties including the practitioners and academics alike who are partly concerned with such events.
To them this could be avoided considerably if the acting manager’s action were monitored before things were out of control. More so, they believed that the internal controls that were present did not discipline the firm managers effectively and for that reason the proliferation of such earning restatements will still continue if measures are not employed. (Desai, et al., 2006 p 2)
In addition to that, blame could also be directed to other avenues since there were limited resources that could be used by the SEC in investigating the GAAP violations that went unnoticed. All these are serious crimes requiring strict penalties to the offenders.
Desai, et al. (2006) add that, the lack of strict measures as described above has encouraged the managers to do such violations since they are not intimidated by the law and this entails that the managers will continue doing that inclusive to other types of corporate frauds since they have managed to get away from previous manipulation earnings which they have accomplished.
For most companies the managers engage in the “blame game” when they realize that the authorities have discovered their fraudulent activities. They normally give excuses saying that they were not aware when such events were happening while in the real sense they were the drivers of that since they know how to doge their way out.
Such events should result to their dismissal until analysis is done with the available proof and penalties can be a little bit harsh depending on the magnitude of the crime. It is for this reason that previous investigations have seen numerous penalties being unleashed on such managers Agrawal et al., (1999).
Reputation penalty was the way forward for managers who were restated in 1997 and 1998 earnings and the same can also apply today since the frauds committed at that time are quite similar to those of now. Therefore, the penalty was meant to focus on management turnover and subsequent ex post, which was directed to the managerial labor market.
So before they arrived at this, numerous analyses were conducted so as to come up with the right and workable solution for managers who commit fraud in various companies. Afterwards, the high management turnover and subsequent ex post was found to be the ideal analysis since it could have a huge impact on managerial actions and incentives. (Desai, et al., 2006 p 3)
With respect to that, high management turnover was supposed to blend in with low rehiring rate for it to have influence on manager’s actions. This would only happen if the managerial labor market imposed adequate costs on the so called displaced managers. These costs could be in the form of power, prestige, and loss in income, so that the ex post settling up would provide incentives for managers and the whole deal of manipulations earnings would seize there and then. (Desai, et al., 2006).
Even with the strict penalties in the managerial labor market, some critics thought that the penalties imposed needed to be adjusted in order to make them stronger than they were. They wanted something that would scare off the managers who had the thought of engaging in the act of theft, leave alone doing the act itself.
For them, this was the only sure solution to this problem since the incidences of such behaviors were increasing day by day. They believed that the consequences that were inflicted on the managers in the previous years were generally weak since it did not act as a lesson to other managers in the public units.
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The relevant authorities were concerned with the formulation of samples and reports which were meant to monitor the progress of violators all round the country. The findings made the above mentioned critics conclude that the penalties were very weak. More of this was outlined in sample 64 GAAP, which showed the violators that were targeted by the SEC in the year 1987 and 1993. According to Desai, et al., (2006), the sample was very detailed meaning that it had captured all the essentials without omitting any part.
After thorough analysis, the SEC did not find any differences in the managerial turnover rate of the sample firms and that of size or even industry control firms. Similar investigations were also done regarding the consequences of corporate firms including financial reporting fraud, among others.
The investigation proved that there was no association between subsequent managerial turnover and fraud. This investigation had only covered a few years that is 1981 to 1992. It is after this finding that the authorities were able to establish that the monitoring system did not have proper mechanism for punishing the managers who engaged in such fraudulent activities. (Desai, et al., 2006 p 6)
According to Holmstrom & Kaplan (2001), managers who committed GAAP violations and were punished acted as a good lesson to managers who were intending to engage in such activities in future. In addition to this, dramatic changes were witnessed both in the internal and external monitoring systems, way before 1990.
For example, more institutional owners increased considerably and by the following year, such companies had doubled in numbers. More still, there was an increase in share holder activisms and more independent corporate boards were the order of the day.
Inline with the above changes, the same was also experienced in the forced turnover, whereby, higher frequencies were noted during 1971 through to 1994, and with respect to that, the highest figure was seen during 1989 to 1994 period, which was quite encouraging. Recent reports show that the same trend has continued to manifest itself while at the same time the rate of CEO getting dismissal letters also increased. To be specific, the number increased by 170 percent from 1995 to 2003. (Desai, et al., 2006 p 9)
In general, there has been a significant change for both the internal and external monitoring systems which have taken place over the last year given that the sample described above was conducted before 1998. The reviewed literature denotes that, changes in that order were tightened so as to punish the top management when fraudulent accounting was detected. Ideally, the top management level may cover a large number of employees meaning that a stringent approach in that respect would do justice to all.
As described above, fraudulent activities in any firm should be avoided since the law will always catch up with the culprits. Any activity that goes against a company’s policy in whatever angle, qualifies as a fraudulent activity. With respect to financial reporting fraud and earnings restatements, the issues were going on long before the GAO department reported the high rates as per their survey and this was happening right under the eyes of the managers who are supposed to monitor and report such cases.
This led to the harsh penalty introduction so as to punish the managers who are caught up in the act. Managers and those involved continue to be intimidated by this law forcing them to draw back from such activities. However, more needs to be done so as to ensure perfection in the departments which have seen a lot of wrong doing in the recent years.
Agrawal, A., Walkling, R. Florence, J. (1999). Executive careers and compensation surrounding takeover bids. Journal of Finance 49 (July): 985–1014.
Desai H, Hogan C., & Wilkins M. (2006). The Reputation Penalty for Aggressive Accounting: Earnings Restatements and Management Turnover. The Accounting Review Vol. 81, No. 1 pp. 83–112
Holmstrom, B. and Kaplan S. N. (2001). Corporate governance and merger activity in the United States: Making sense of 1980s and 1990s. Journal of Economic Perspectives 15 (spring): 121–144.