A
Closer Look at Financial Statement Restatements
Analyzing the Reasons Behind the Trend
By
Lynn E. Turner and Thomas R. Weirich
DECEMBER
2006 - Financial restatements reached new heights in 2005,
and the first nine months of 2006 restatements are ahead
of last year. Just when the number of erroneous financial
reports by publicly traded companies seemed to have peaked,
they have continued to climb. The results show why investors
can’t afford a return to pre-Enron securities regulation.
This
article analyzes financial statement restatements during
2005 and the first nine months of 2006 obtained from a comprehensive
analysis of nearly 25,000 company filings with the SEC.
The article highlights the main causes of restatements,
comments on restatements and securities litigation, and
looks at the restatement rates of particular auditing firms.
The
authors’ research focused on restatements filed to
correct accounting errors and, therefore, did not include
restatements for changes in accounting principles (e.g.,
GAAP-to-GAAP changes, changes in estimates, or mandated
adoptions of new accounting pronouncements). It also excluded
restatements filed to add new discussion, to make minor
wording changes, or to correct typographical errors. Because
SFAS 154, Accounting Changes and Error Corrections,
took effect for companies with fiscal years beginning after
December 15, 2005, this study relied on the definition of
an accounting error in Accounting Principles Board (APB)
Opinion 20, Accounting Changes, where paragraph
13 states: “Errors in financial statements result
from mathematical mistakes, mistakes in the application
of accounting principles, or oversight or misuses of facts
that existed at the time the financial statements were prepared.
A change from an accounting principle that is not generally
accepted to one that is generally accepted is a correction
of an error.”
When
restatements were identified, they were counted based on
the underlying error or set of errors that drove the restatements,
not the number of filings. Therefore, multiple filings that
a company made to correct the same underlying error were
counted as a single restatement.
Number
of Restatements Reaches New Heights
Exhibit
1 presents a restatements scorecard for 2005. Companies
with U.S.-listed securities filed 1,295 financial restatements,
nearly double the previous year’s mark. This represents
about one restatement for every 12 public companies (up
from one for every 23 in 2004). Of these restatements, 100
were by foreign companies. The burden of these errors falls
on investors, who rely on management to get the numbers
right the first time.
These
restatements aren’t just about revising subjective
judgments or complying with esoteric, complex accounting
pronouncements. In hundreds of instances, they stem from
basic misapplications of simple rules or critical breakdowns
in corporate controls and competencies. On
the plus side, thanks to renewed urgency by auditors and
their regulators, investors at least are getting better
accounting on the next go-around. For that, investors can
thank the renewed public-policy focus on the need to maintain
strong internal controls.
The
volume of restatements in 2005 likely would have been even
higher had U.S. regulators not agreed to extend Sarbanes-Oxley
Act (SOX) section 404 compliance deadlines into 2007 for
smaller companies with stock market values of less than
$75 million. According to the authors’ findings, the
smallest companies are where strong internal controls arguably
are needed most, because they are where the risk of restatement
is the highest. Furthermore, companies audited by the smallest
accounting firms restated six times more often than other
companies—a trend that begs for more frequent inspections
of these firms by the Public Company Accounting Oversight
Board (PCAOB).
Finally,
the authors also examined 2005’s surge in “stealth
restatements”— companies that corrected material
errors but with minimum publicity, by quietly including
“fixes” in their quarterly and annual reports,
rather than using the 8-K disclosure form that the SEC created
expressly for announcing restatements. This should trouble
any reasonable investor and demands the immediate attention
of regulators. Exhibit
2 presents key findings from the study.
In
2005, 1,195 U.S. public companies filed financial restatements
to correct errors, as defined under generally accepted accounting
principles (GAAP), which increased 95% from year-earlier
results. By comparison, from 1997 to 2004, the number of
restatements grew at a 27% compounded annual rate. Exhibit
3 presents a historical view of the constant increase
in restatements by U.S. public companies from 1997 to 2005.
As of September 30, 2006, 1,042 U.S. public companies had
restated, and 88 foreign private issuers, for a total of
1,130.
The
restatements that concern investors most are the ones that
cause a company’s sales, income, liquidity, or financial
position to look dramatically different from the company’s
previous reports. Not all restatements do this; however,
it is better for a company to get its numbers right than
to leave them wrong. While many corporate executives may
have been slow to realize this, it has become more difficult
for them to avoid it. And while investors may appreciate
candor, the frequency with which companies have been incorrectly
preparing their financial reports is no less disturbing.
On a per-capita basis, restatements also climbed sharply
in 2005, when the number of restatements, as a percentage
of all U.S. public companies, was 8.5%, up from 4.5% in
2004.
From
1997 to 2005, U.S. public companies filed 3,642 restatements
to correct accounting errors. That’s about 30% of
all U.S. public companies over the past nine years. (The
30% figure is an estimate by Glass Lewis & Co. based
on 3,642 restatements over a nine-year period and a weighted
average of 11,333 U.S. public companies. Some companies
restated multiple times. From 2003 to 2005, 320 restatements
were by companies making at least a second restatement.
Comparable data for 1997 to 2002 were not available.) When
so many companies produce inaccurate financial statements,
the quality of information that investors rely upon to make
capital-allocation decisions is seriously called into question.
Financial
reporting errors are most likely to be unearthed when companies’
independent accounting firms conduct their year-end audits.
That helps explain why in 2005 March and April saw more
restatements than in any other months. Of the 385 restatements
filed in March and April 2005, 152 centered on faulty lease-accounting
practices, primarily at restaurant companies and retailers.
During these two months, 231 restatements were filed by
companies that disclosed problems with their internal controls.
Exhibit
4 presents restatements by year, with year-to-date numbers
as of September 30, for 2003 through 2006. Restatements
for the first three quarters of 2006 are larger than the
first three quarters of 2005. This is most surprising in
light of the hundreds of leasing restatements during the
same time period of 2005. If the trend continues, there
could be as many as 1,500 restatements by year end 2006.
Restatements
and SOX Section 404
Companies’
ability to produce accurate financial statements depends
on the soundness of their internal controls over financial
reporting. SOX section 404 requires that companies hire
independent auditors to test the effectiveness of their
internal controls and report their findings to investors.
The first wave of these reports came in early 2005 when
companies with calendar fiscal years filed their 2004 annual
reports.
Executives’
complaints about these reports notwithstanding, requiring
companies to have sound internal controls is nothing new.
The Foreign Corrupt Practices Act of 1977 mandated that
all public companies “devise and maintain a system
of internal accounting controls sufficient to provide assurances
that transactions are recorded as necessary to permit preparation
of financial statements in conformity with generally accepted
accounting principles” [U.S. Code Title 15, Commerce
and Trade, Chapter 2B-1, Securities Investor Protection,
section 78m(b)(2)].
Furthermore,
since August 2002, SOX section 302, “Corporate Responsibility
for Financial Reports,” requires top officers of all
public companies to evaluate the effectiveness of their
companies’ internal control systems and to include
their conclusions in annual and quarterly reports. For approximately
the first two years, the vast majority of corporate executives
certified that their controls were free of any material
weaknesses. As we now know, many of these companies’
controls did have major weaknesses. Not until independent
accounting firms began to perform their own internal control
audits did investors learn the extent of these problems.
Often, the problems they discovered were serious enough
to cause major errors on the companies’ financial
statements, leaving management with no choice but to restate
their previously issued financial reports.
The
recent rise of restatements is the inevitable by-product
of the financial housecleaning that was necessary to restore
investor confidence in the wake of Enron, WorldCom, Tyco,
Adelphia, and other corporate scandals. After more than
1,800 restatements during the past two years, the good news
is that the major housecleaning may be nearly finished,
although it may be years before annual restatement totals
return to pre-2000 levels.
To
some degree, the rise in restatements also may signal a
culture shift among corporate managers, directors, and auditors.
It has been more than eight years since then– SEC
Chairman Arthur Levitt delivered his landmark “Numbers
Game” speech, where he warned that the proliferation
of earnings-management gimmicks had eroded the quality of
corporate earnings and, thus, the quality of financial reporting.
“Management
may be giving way to manipulation; integrity may be losing
out to illusion,” he said, calling upon corporate
managers and Wall Street analysts “to embrace nothing
less than a cultural change.” Today it appears at
least some of the financial community has begun making that
change, albeit belatedly.
Implications
for smaller companies. Now that the major
stock-market indexes have rebounded, the reform pendulum
has begun to swing the other way. Over the past year or
so, there have been a number of proposals and actions to
scale back SOX requirements. In September 2005, the SEC
for the third time postponed the deadline for non-accelerated
filers (smaller companies) to comply with section 404, pushing
it into mid-2007. In most cases, shareholders of these companies
won’t receive an independent auditor’s report
on the effectiveness of internal controls until early 2008—nearly
six years after Congress passed SOX.
From
the beginning, section 404 has drawn fierce criticism from
a relatively small, but persistent, group of corporate executives
whose chief complaint has been the cost of compliance. No
doubt, complying with section 404 costs money. Nor is there
doubt, however, that section 404 is working—and that
the costs of ignoring weak internal controls would be far
greater. Yet smaller companies are where most of the problems
historically have existed.
The
results of this study indicate that restatements occur twice
as often at smaller companies as they do at larger companies.
Coinciding with this, material weaknesses are twice as prevalent
at smaller companies as they are at larger companies. [Based
on material-weakness rate by market capitalization (sources:
Glass Lewis; FactSet).] In 2005, the material-weakness rate
for companies with market capitalizations under $250 million
was 10.2% and the rate by companies with market capitalizations
of $2.5 billion or more was 4.7%.] This should not be surprising,
given that many small-business issuers do not have designated
CFOs. According to a February 2006 report by SME Capital
Markets, 251 of the 881 companies that filed Form SB-2 registrations
in 2005 did not name a CFO. Others said they relied on part-time
CFOs.
The
need for effective internal controls at small companies
cannot be overstated. In their research, the authors routinely
found companies disclosing material weaknesses due to a
lack of qualified accounting personnel. In such cases, companies
often explain that their accounting departments couldn’t
keep up with their operations’ rapid growth. In effect,
small companies often grow faster than their internal-control
systems can handle.
Restatements
and material weaknesses in internal controls. PCAOB
Auditing Standard (AS) 2, paragraph 10, defines a “material
weakness” in internal controls as a deficiency that
results in “more than a remote likelihood” that
an error in a company’s financial statements will
not be caught. Clearly, without the internal control reviews
mandated by section 404, many previously undetected weaknesses
would have remained undetected. Section 404 reviews have
disclosed thousands of material weaknesses, many of which
were directly responsible for financial-reporting errors.
As Exhibit
5 shows, more than half of all restatements in 2005
were by companies that disclosed at least one material weakness.
(Except where noted, all references to restatements refer
only to restatements by U.S. public companies.) Of the 640
restatements last year by companies with disclosed material
weaknesses, 42 were by companies that restated twice in
2005. That leaves 598 companies with disclosed material
weaknesses that restated in 2005.
Analysis
reveals that before late 2004 most restatements were by
companies that had not disclosed control weaknesses. This
trend shifted during the fourth quarter of 2004, when section
404 work began in earnest. Over the past five quarters (fourth
quarter 2004 and all four quarters of 2005), most restatements
have been submitted by companies that also disclosed material
weaknesses.
Another
view is that nearly half of 2005’s restatements were
made by companies that have not disclosed material weaknesses.
Hence the question: If these companies’ internal controls
really had no weaknesses, why did the companies have errors
that required restatements? Recall that PCAOB AS 2 defined
a material weakness as a deficiency in internal controls
that creates “more than a remote likelihood”
that a material misstatement in the financial statements
will go undetected. If a company restated, then a material
misstatement did in fact go undetected, indicating
the company’s internal controls must have had at least
one weakness.
Often,
however, companies get lucky and their weaknesses do not
lead to misstatements. By this logic, there should be more
companies reporting material weaknesses than restating financials.
However, only 640 of the 1,195 restatements in 2005 by U.S.
public companies were made by companies that disclosed material
weaknesses. Sometimes companies that disclosed the existence
of material weaknesses did so belatedly. That is, they first
told investors their controls were effective. Then they
found errors on their financials and restated, at which
point they realized that they must have material weaknesses
after all. In these cases, at the same time they filed their
restatements, the companies disclosed that their internal
controls actually were ineffective.
Some
prominent executives and policymakers have complained that
the major accounting firms have been going overboard in
forcing companies to report material weaknesses. The facts,
however, indicate otherwise. If anything, it appears the
auditors may have been cutting companies some slack. The
authors’ research and analysis found 566 companies
that, since SOX section 404 took effect in November 2004,
have: 1) restated their financials, and 2) not disclosed
any material weaknesses.
Most
companies that have restated but did not disclose material
weaknesses were nonaccelerated filers. (The authors’
research found 388 of these companies since November 2004.)
They were not required to have their internal controls audited
independently. Under SOX section 302, which took effect
in 2002, these companies’ executives were required
to disclose any material weaknesses they found on their
own. The authors suspect they would have found many more
had they known their outside auditors would be conducting
their own independent assessments.
Additional
restatement drivers. Today, every accounting
firm that audits more than 100 U.S.-listed companies must
submit to annual inspections by the PCAOB. These inspections
have helped foster a new culture of accountability at these
firms. Not long ago, companies often could count on their
outside auditors to help them rationalize aggressive—or
even simply wrong—accounting practices. Now, audit
firms know the PCAOB will be second-guessing any work that
appears substandard.
For
example, as part of its inaugural inspections of the Big
Four, PCAOB inspections forced at least 20 companies to
restate their 2003 balance sheets to correct improper debt
classifications (“Accounting Overseer Hits the Books,”
The Wall Street Journal, September 10, 2004). Since
then, PCAOB inspection reports have routinely singled out
audit firms for failing to catch material errors that eventually
required restatements.
As
executive compensation packages continue to soar (up 15%
in 2004), and senior officers’ pay remains tied to
hitting short-term profit targets, there are strong motives
for managing earnings to meet the expectations of analysts
and investors. At the same time, with the creation of the
PCAOB in 2002, the auditing profession is more highly regulated
than ever. These two trends may help explain last year’s
historic surge in restatements. Not only do companies continue
to give investors bad numbers, but auditors appear to be
catching them more frequently, albeit after the fact.
Over
time, as companies continue to improve their internal controls,
one would expect the number of restatements to eventually
decline; perhaps such a trend will be apparent as soon as
the 2006 filings are completed. Nevertheless, some executives
will try to cook their companies’ books no matter
how many rules and laws are passed. As such, financial irregularities
will never be eliminated completely.
Restatements,
by error category. Investors are more concerned
about some restatements than others. Investors may care
little if, for example, a company misclassified a short-term
certificate of deposit as “other current assets”
rather than “cash and cash equivalents.” But
they will probably be less forgiving of a revenue-recognition
error that overstates sales by 50%. Similarly, a restatement
that shifts past sales into future periods may not have
the same stock-market impact as a restatement that eliminates
a large portion of past sales. The authors’ study
classified restatements into 12 categories (see Exhibit
6).
The
authors’ review of last year’s 1,195 restatements
by U.S. public companies identified 1,796 separately categorized
errors. Exhibit
7 shows the number of restatements related to each error
category. Expense-recognition errors accounted for nearly
450 restatements, or 25% of all reported errors. This was
the most common type of error identified.
More
than half of 2005’s expense-recognition errors stemmed
from improper lease-accounting practices (see “Increased
Clarity in Accounting for Operating Leases,” on page
24 of this issue). In 2005, 249 companies filed restated
financials to correct their accounting for leases. Many
of these companies also had misclassified items on their
cash-flow statements. Even without the wave of lease-accounting
fixes, improper expense recognition still would have been
a leading cause of restatements in 2005.
The
next most commonly restated items were financial-statement
misclassifications, followed by equity-related errors. These
comprised 18% and 13% of all identified errors, respectively.
Historically,
restatements for revenue recognition have resulted in larger
drops in market capitalization than any other type of restatements.
(See the May 31, 2001, speech by SEC Chief Accountant Lynn
E. Turner at USC’s SEC Financial Reporting Institute.)
Furthermore, at least before the Enron scandal, revenue
overstatements were involved in more than 50% of all accounting
frauds. [Fraudulent Financial Reporting—1987–1997:
An Analysis of U.S. Public Companies, sponsored by
the Committee of Sponsoring Organizations (COSO) of the
Treadway Commission, March 1999.] In 2005 the number of
restatements correcting revenue-recognition errors increased
to 160, from 122 a year earlier. While revenue-recognition
errors remained a leading cause of restatements, other categories
grew at much faster rates in 2005; nine of the 12 error
categories jumped 65% or more from their 2004 levels.
Frequently
cited equity-related errors included inappropriate valuations
for stock-based compensation and improper accounting for
warrants and convertible debt. Restatements in the equity-error
category rose 77% in 2005, fueled by an increase in errors
related to stock options and convertible instruments. Errors
in other comprehensive income (OCI) jumped 198%, the highest
percentage increase of any category in 2005. Improper hedge-accounting
practices, primarily at financial institutions and service
companies, led to 57 of the 122 OCI-related restatements.
Restatements
related to acquisitions and investments more than doubled
in 2005. Common errors included improper purchase accounting
for business combinations. Some companies used the equity
method of accounting for investments that they should have
consolidated, and vice versa.
From
January to September 2006, 145 (17%) of the restatements
were for misclassifications with 100 related to cash flow
misclassifications and 28 related to hedge accounting. Interestingly,
the January 1 through September 30, 2006, review showed
an increase in equity-type restatements, with 179 restatements
(21%). These appear to have been driven by convertible-debt
errors where companies have had to restate the proportions
they allocated to debt and equity. Smaller companies continue
to restate more often than larger companies. Approximately
two-thirds of the 2006 restatements so far were made by
companies with a market capitalization of less than $100
million.
Lease-accounting
restatements. After 2005’s wave of lease-accounting
restatements, one lesson should be drilled into the minds
of accountants: Just because everybody’s doing it
doesn’t make it right. In a February 2005 open letter
to the AICPA, then–SEC Chief Accountant Donald Nicolaisen
noted the large number of companies improperly accounting
for lease transactions. The letter, which Mr. Nicolaisen
issued at the request of the accounting profession, laid
out the SEC staff’s view on the correct way to do
things—a view that FASB happened to share. As it turned
out, hundreds of companies simply hadn’t been following
GAAP.
The
infractions centered on fairly black-and-white violations
of well-established accounting rules. (SFAS 13, Accounting
for Leases, was issued in 1976, and FASB Technical
Bulletin 85-3, Accounting for Operating Leases with
Scheduled Rent Increases, issued in 1985, clarifies
the misapplied rules.) Typically, the violations—most
of which occurred in the restaurant and retail industries—had
the effect of understating rental expenses or improperly
keeping lease obligations off the balance sheet. These violations,
which had gone on for decades, ultimately led to 249 restatements
in 2005 to correct improper lease accounting.
This
may sound familiar, because in 1999, FASB Staff Accounting
Bulletin (SAB) 99, Materiality, debunked the widely
held but incorrect notion that companies could let accounting
misstatements slide as long as they fell below certain quantitative
benchmarks. (Some accountants used to call this the 5% rule
of thumb.) Some companies made one-time adjustments in the
fourth quarter of 2004 to correct their lease accounting
but avoided restatements by citing immateriality.
Hedge-accounting
restatements. Almost a year to the day after
the lease-accounting restatement frenzy began, a new but
familiar wave of restatements took its place. After an initial
surge in March, hedge-accounting restatements started to
roll in one after another. Perhaps it was the highly publicized
hedge-accounting woes at Fannie Mae that prompted both Fannie
Mae’s auditor at the time, KPMG, and other companies
to reassess their own practices. Whatever the case, by year
end, 57 companies had restated due to hedge-accounting errors.
Because the outbreak of hedge-accounting restatements started
in late 2005, this issue will probably continue well into
the 2006 financial statements.
The
57 hedge-accounting restatements does not include restatements
by federal home-loan banks that do not file reports with
the SEC, although some of these banks also restated in the
wake of irregularities at Fannie Mae and its government-chartered
cousin, Freddie Mac.
As
with the lease-accounting restatements, the hedge-accounting
problems stemmed from companies abiding by a supposed industry
norm, notwithstanding that the norm ran counter to GAAP
requirements. Once one company has been scolded publicly,
everybody else doing the same thing has to face up to the
fact that their accounting isn’t GAAP either. Then
they, too, must restate.
Stock-option
restatements. The adoption of SFAS 123(R),
Share-Based Payment, prompted many companies to
review their accounting for stock options and other stock-based
compensation. As a result, dozens of companies restated
their financial statements, even if only their footnote
disclosures. Auditors and corporate managers in the past
may not have given footnotes their full attention in the
past, but they must be audited too. Over the past few years
especially, investors began relying heavily on companies’
stock-option footnotes, because they knew the expenses disclosed
there would be harbingers of things to come once SFAS 123(R)
took effect. The authors’ analysis found 71 stock-options-related
restatements in 2005, compared to 39 in 2004.
“Stealth”
Restatements
One
of Wall Street’s biggest open secrets is that, increasingly,
companies are keeping their restatements under the radar
by making it difficult for shareholders to find out about
them. As a result, many investors perusing companies’
financial reports are surprised to discover restatements
that the companies never previously announced; that is,
if the investors discover them at all. The authors call
these “stealth” restatements.
“Stealth”
means that companies restated: 1) without filing an amended
quarterly or annual report; 2) without first announcing
the restatement in a press release, filed on Form 8-K Item
4.02; and 3) without citing the restatement as the reason
for a late quarterly or annual report, disclosed in a Form
12b-25 “NT” filing. The authors use the term
“obscure” if a company filed either an amended
report or an 8-K, but not both; also for a company that
disclosed a restatement in an NT filing but filed neither
an 8-K nor an amended report.
Trick
1: Restate, but don’t amend. When a
company files a restatement, it typically does so by filing
an amended report for the period affected (for example,
a Form 10-K/A for a year period, a Form 10-Q/A for a quarter).
The “A” alerts investors that something has
changed. Upon reading the filing, an investor usually will
find an explanatory note describing the reason for the amended
filing; in this case, a restatement of previously issued
results. While the majority of 2005’s restatements
used amended reports, 45% of restatements did not. In 2004,
9% of restatements were filed without amended reports; in
2003, just 5% were.
Many
companies avoid using amended filings by restating previous
periods in their next regularly scheduled quarterly or annual
filings. For example, many companies restated amounts for
their 2003 fiscal years in their fiscal 2004 annual reports,
filed on Form 10-K. Had these companies instead filed separate,
amended annual reports for fiscal 2003, using Form 10-K/A,
their restatements would have been far more transparent
to investors.
Companies
that file restatements without amending their prior filings
often leave investors unaware that prior periods have been
restated. The authors suspect this is by design. Investors
reading a company’s current financial reports simply
may not notice the small print. They may dismiss a restatement
as relatively minor, because the company was able to tuck
it away quietly in the current period’s results.
Trick
2: Restate, but don’t announce. Another
way for companies to avoid drawing attention to restatements
is fairly obvious: They don’t file press releases
announcing them. In 2004, the SEC created a section in the
Form 8-K Current Report (commonly used to file press releases)
to be used by companies to warn investors that they shouldn’t
rely on previously issued financial statement (SEC Release
No. 33-8400, Additional Form 8-K Disclosure Requirements
and Acceleration of Filing Date, effective August 23,
2004). Since August 23, 2004, companies have been “required”
to file Form 8-K, Item 4.02, to announce restatements and
alert investors not to rely on the previously issued financial
statements affected by the restatement. (See Form 8-K, Current
Report General Instructions, Item 4.02.) An Item 4.02 must
be filed if: a) “the registrant’s board of directors,
a committee of the board of directors or the officers …
concludes that any previously issued financial statements,
covering one or more years or interim periods for which
the registrant is required to provide financial statements
… should no longer be relied upon because of an error
in such financial statements as addressed in [APB Opinion
20],” or b) “the registrant is advised by, or
receives notice from, its independent accountant that disclosure
should be made or action should be taken to prevent future
reliance on a previously issued audit report or completed
interim review related to previously issued financial statements.”
The authors put “required” in quotes because
there are some big loopholes.
Shortly
after the new reporting requirements were issued, the AICPA’s
SEC Regulations Committee explicitly asked the SEC if all
restatements needed to be reported on Form 8-K pursuant
to Item 4.02. The SEC staff said they would support the
view of the profession and not require all restatements
to be announced in a Form 8-K, Item 4.02. The decision has
led to significantly less transparency surrounding the reporting
of restatements.
In
this case, the rules themselves may be to blame. Where a
company’s board, officers, or outside auditor concludes
that any previously issued financial statements should not
be relied upon, the company has four days to file a report
disclosing that such an event has occurred. However, if
the company includes that same information in a quarterly
or annual report before the four-day period ends, the information
need not be repeated in an 8-K.
When
that four-day period begins, however, is in the eye of the
restater. For example, a company’s auditor and board
members may haggle for months about whether a restatement
is necessary—before they finally “conclude”
that it is. In that case, the conclusion date may fall conveniently
within four days of when the company was scheduled to file
its next quarterly or annual report. Outsiders can do little
to challenge the company’s judgment. And so the restatement
announcement gets buried.
Prior
to the effective date of Item 4.02, some companies did announce
restatements in Form 8-K filings. In 2005, 66% of companies
that restated announced their restatements using Form 8-K,
Item 4.02. The authors believe this number probably would
have been closer to 100% had the SEC not given companies
such broad discretion in filing Item 4.02 disclosures.
That
said, the revised 8-K reporting requirements have improved
transparency for investors. In 2003, just one-third of restatements
were announced using 8-K filings; in 2005, two-thirds were.
Still, there were 406 restatements in 2005 where, in the
authors’ view, the companies did not properly alert
investors.
Trick
3: File late, keep quiet, then restate. The
majority of companies that restate postpone at least one
annual or quarterly report before they complete their restatements.
For 64% of 2005’s restatements, the company also was
late in filing either a quarterly report or an annual report
during the year. This was up from about 54% in both 2003
and 2004.
Assuming
they become aware of a company’s intention to restate,
investors may interpret a late filing as an indication of
the restatement’s severity. It also may signal the
depth of the control weaknesses that precipitated the restatement.
Companies typically wait to file restatements until they
determine the correct amounts and believe they have fixed
the problem that caused the restatement in the first place.
If a company is in the process of restating—and unable
to file financials on time—one would expect it to
explain just that in the late-filing notices. This isn’t
always the case, however: Many companies fail to provide
adequate explanations in their NT filings.
In
the authors’ study, of the 191 companies restating
in 2005 that didn’t use 8-K forms or amended financial
reports to disclose their restatements, 107 filed NT notices
before they restated. Of those 107, 76 did not explain in
their NT notices that their filings were late because they
were busy restating their previous periods.
Stealth
restatements—the trifecta. To recap,
535 of 2005’s restatements did not use amended returns.
There were 406 restatements that weren’t announced
in 8-Ks. As for the 760 restatements that came less than
a year after NT notices, the vast majority of those NT notices
didn’t cite the companies’ forthcoming restatements
as the reason the companies’ filings were late.
About
14% of 2005’s restatements were “stealth”
restatements that completed the trifecta. That is, they
were: 1) not filed via an amended filing, 2) not announced
in an 8-K, and 3) not mentioned in any late-filing notices.
The first time that readers of the companies’ filings
had the opportunity to learn of these restatements was when
the companies filed their regularly scheduled annual or
quarterly reports, in which they tucked the restated periods
behind their latest periods’ numbers. There were 160
stealth restatements in 2005, up from 13 in 2004 and just
two in 2003.
Last
year, 21 stealth restatements were due to lease accounting
issues. Companies with market capitalizations of less than
$75 million accounted for 102 of last year’s 160 stealth
restatements. For companies filing restatements, the authors
believe the best practice is to file an 8-K, Item 4.02,
as soon as they know they will restate, warning investors
that they no longer should rely on previously issued financial
statements. Companies should also file their restatements
using amended filings that explain exactly what was corrected.
And if the restatements delay their filings, they should
explain so in their late-filing notices.
Restatements
and Securities Litigation
Contrary
to what one might expect—a corresponding rise in the
number of investor lawsuits seeking to recoup losses through
class actions—the number of securities class actions
has gone down, mainly due to a decline in investor losses
tied to such suits. While restatements by U.S. public companies
in 2005 set an all-time record of 1,195, securities class
actions fell 17% to 176, according to a Cornerstone Research
study that also found that 89% of these lawsuits in 2005
alleged misrepresentations in financial documents, compared
with 78% a year earlier.
Because
not all restatements trigger substantial market-capitalization
losses, restatements don’t necessarily lead to securities
class actions. Investors are more likely to suffer large
losses—and in turn file lawsuits—if a company
discloses revenue overstatements, as opposed to, say, a
balance-sheet misclassification.
Consider
last year’s 249 lease restatements. A few of these
restatements may have increased expenses materially. Still,
investors perceived most—but not all of them—to
be mere technicalities, with little impact on companies’
fundamentals. Such restatements aren’t likely to lead
to investor lawsuits when there are no corresponding drops
in stock prices.
In
its review of 2005 lawsuits, Cornerstone found the three
most frequently mentioned accounting allegations were revenue
overstatements (40 cases), overstatements of accounts receivable
(17 cases), and understatements of liabilities (14 cases).
Because these accounting issues are the ones most likely
to result in a drop in share price, they are more likely
to lead to litigation.
Surprisingly,
only five of the 176 shareholder suits filed in 2005 named
companies’ outside auditors as defendants, down from
eight in 2004, according to Cornerstone. That’s less
than one case for each of the six largest accounting firms—Deloitte
& Touche, Pricewaterhouse-
Coopers, KPMG, Ernst & Young, Grant Thornton, and BDO
Seidman. By comparison, companies audited by these firms
filed 782 restatements in 2005.
Auditor
Analysis
The
first responsibility of auditors is to protect the investing
public. Their job is to ensure that companies’ financial
statements are presented fairly and comply in all material
respects with GAAP. Unfortunately for investors, too often
auditors fall short of their objectives.
Exhibit
8 shows that Grant Thornton had the highest restatement
rate (number of restatements divided by total number of
public companies audited) during 2005, followed by BDO Seidman.
Of all the companies audited by Grant Thornton, 12% restated
during 2005, compared with 3.8% in 2004. Among the Big Four,
KPMG’s 2005 restatement rate was highest: 7.1%; Deloitte
& Touche’s 5.6% rate was the lowest.
Assessing
what it means for an auditor to have a high or low restatement
rate is difficult for outsiders. An accounting firm with
a low restatement rate may be providing high-quality audits;
or a low rate may signal that the auditor seldom forces
companies to correct mistakes. Although a high restatement
rate could indicate poor audit quality, it may also indicate
that a firm is more willing than others to require corrections.
PricewaterhouseCoopers
and Deloitte had the largest volume of restatements in both
2005 and 2004. Both had 200 or more restatements last year.
While Deloitte had the lowest restatement rate among the
Big Four, its volume of restatements increased by 130% in
2005, the largest increase of the Big Four.
Companies
audited by the six largest accounting firms, including Grant
Thornton and BDO Seidman, accounted for about two-thirds
of 2005’s restatements. The number of restatements
at companies audited by other firms more than doubled: 413
in 2005, compared with 189 in 2004.
Audit
firms with less than $100 million in annual revenue had
the highest restatement rate by far. In 2005, 37.2% of the
companies audited by smaller firms restated. The authors
view this rate as intolerable. By comparison, the Big Four’s
combined rate was 6.1%; the second-tier firms’ combined
rate was 8.4%.
Under
SOX, annual PCAOB inspections are required only for firms
that audit more than 100 companies with U.S.-listed securities.
Smaller auditors must be inspected once every three years.
The authors’ study, which found the restatement rate
for smaller firms extraordinarily high, demonstrates that
triennial inspections may not be frequent enough for some
firms.
While
companies audited by smaller firms restate more frequently,
companies audited by the Big Four still account for the
largest volume of restatements. In 2005, 706 restatements
were at companies audited by the Big Four, compared with
389 at companies audited by small firms. The number of Big
Four restatements increased 81% during 2005, while the number
of restatements at small firms jumped 114%.
The
auditor-turnover rate for companies with restatements was
twice as high as the overall auditor-turnover rate. From
2003 to 2005, the average turnover rate for all companies
was about 12%. The average auditor-turnover rate for companies
with restatements during the same three-year period was
about 24%.
Smaller
Companies Restate More Often
More
than 11% of U.S. public companies with market capitalization
of less than $250 million restated during 2005, compared
with about 6% of companies with market capitalizations of
$2.5 billion or more. Restatement rates increased across
all size categories in 2005; the rates doubled among companies
with market capitalizations of more than $250 million. About
one of every 19 companies in the largest category ($7.5
billion or more) restated financials in 2005, compared with
just one of every 46 in 2004.
Even
with the high growth in restatements by larger companies,
what stands out is that one of every eight small companies
(market capitalization under $75 million) restated in 2005.
More than half of last year’s restatements were filed
by the smallest companies, which registered 604 restatements.
The number of restatements declines from there as market
capitalization rises.
The
trend in 2004 was clear: The smaller the market capitalization
or annual revenue, the more likely a company was to restate.
However, the trend in 2005 was more mixed. Higher annual
revenues in 2005 didn’t necessarily translate into
lower restatement rates, although higher market capitalizations
did.
Sarbanes-Oxley
Was Not an Overreaction
Financial
statement restatements continue to rise. But according to
a relative handful of senior executives and policy makers,
the big problem isn’t that investors got bad information
the first time; rather, they contend that Congress overreacted
when it passed SOX and that, for the good of global capitalism,
Congress should now relax the scrutiny it imposed on corporate
boards and executives after the collapses of Enron and WorldCom.
After
surveying the accounting mishaps and do-overs that were
reported in 2005 and first nine months of 2006, the authors
couldn’t disagree more. It’s precisely because
of the heightened auditing standards mandated by Sarbanes-Oxley
that investors are finally getting a true sense of how much
work remains to be done before they can feel confident about
the accuracy of the financial statements prepared by corporate
managers.
Lynn
E. Turner, CPA, is managing director of research
at Glass Lewis & Co., LLC, and senior advisor to Kroll,
Inc.
Thomas R. Weirich, PhD, CPA, is a professor of accounting
at Central Michigan University, Mt. Pleasant, Mich.
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