THE RELATIONSHIP BETWEEN FINANCIAL DISTRESS AND RESTATEMENT OF FINANCIAL STATEMENTS

Abstract

The present study examines the empirical relationship between the restatement of financial statements involving revenue recognition and cost/expense accounting and the probability of financial distress. The underlying motivation of the study is based on the U.S. General Accounting Office’s (GAO) report to the U.S. senate that revenue and cost/expense accounting issues are associated with more than 50% of its total reported restatement cases over the period from January 1997 to June 2002, which involved billions of dollars market capitalization loss for the restated firms. The present study demonstrates that, among other things, financial distress is a major economic factor that induced managers to engage in managing reported financial information by applying questionable revenue and expense accounting techniques over time. In subsequent periods, those companies restated their financial statements to revise the previously reported financial numbers when they appear to be back on the economic recovery track as revealed by their improving financial distress Z-scores.