MD&A Disclosure of Critical Accounting Policies and Financial Reporting Risk: Evidence From Restatements

Abstract

In this study, I examine whether management discloses areas with higher financial reporting risk as critical accounting policies (CAPs) and how investors react to restatements of areas previously disclosed as CAPs. Through CAPs, management annually discloses the accounting policies that it views as most crucial to the portrayal of the firm’s financial condition and results and require its most difficult, subjective, and/or complex judgments. I find that CAPs covering four areas are predictive of subsequent restatements: revenue, derivatives, accruals and short-term liabilities, and capitalization of expenditures. In tests of investor reactions to restatements, I find that cumulative abnormal returns to restatements are more severe (negative) when the areas restated were previously disclosed as CAPs. Collectively, these findings support that management discloses area-specific financial reporting risk through CAPs in some, but not all, areas and that investors view restatements of CAP areas as more egregious than restatements of non-CAP areas.