Financial restatements: the changing rules of the game

Catalyst (Dublin, Ohio), March-April, 2007 by Laura Hay, Gary Sandefur

The "Numbers Game" was declared by Securities and Exchange Commission (SEC) Chair Arthur Levitt in 1998, challenging that the quality of financial reporting had been eroded by accounting practices seeking to manage earnings.

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More than eight years later, companies are issuing restated financial statements at a significantly increasing rate. Glass Lewis & Company reports that the number of restatements by U.S. public companies increased from 116 in 1997 to 1,195 in 2005. In a period of increasing regulation, internal and external scrutiny and heightened complexity in the rules are contributors to this trend.

With this historic increase, various groups such as the U.S. Government Accountability Office (GAO) and various consulting groups have studied the reasons for the surge in restatements. What do the trends in restatements tell us about changing practices and rules? What has been the impact on public confidence in financial reporting? And what are the implications for companies of all sizes as we look forward?

The trends

The number of public companies restating financial statements grew from 3.7 percent in 2002 to 6.8 percent in 2005, according to a 2006 GAO study. In order of frequency, reasons for restatements included:

1. Cost or expense recognition -- 35.2%

This included companies understating or overstating costs or expenses, or improperly classifying expenses. The category also included an increase in lease accounting restatements made in 2005.

2. Revenue recognition -- 20.1%

Companies in this category were recognizing revenue sooner or later than would have been permitted under Generally Accepted Accounting Principles (GAAP). While still second in frequency, this category realized a significant drop in restatements from a previous GAO study conducted in 2002.

3. Securities related -- 14.1%

Restatement reasons in this category included accounting for derivatives, warrants, stock options and other convertible securities.

4. Restructuring, assets and inventory -- 11.8%

This category included asset impairment, accounting for investments, inventory valuation and intangibles.

5. Reclassification -- 6.8%

Companies in this category improperly classified financial statement items, including current and long-term assets and liabilities, and cash flow statement classification.

Other causes for financial restatements included:

* Accounting for loans

* Doubtful accounts and other accounting estimates

* Fraud or accounting errors

* Mergers and acquisitions

* Related party transactions

* In-process research and development.

The increase in cost or expense recognition adjustments was confirmed in a study by Glass Lewis & Company. Extending their research into the third quarter of 2006, Glass Lewis & Company found that restatements were occurring twice as often at companies with market capitalizations of less than $75 million, as compared to the same period in 2005. In contrast to larger public companies, smaller company restatements were more likely to be caused by misapplication of basic accounting rules, material internal control weaknesses or a lack of qualified accounting personnel.

The Glass Lewis researchers speculated that many of these organizations had experienced growth at rates faster than their internal control systems could handle. Another cause for the increased restatements in smaller companies may be that larger entities had already completed initial certification of internal controls over financial reporting, and smaller entities were beginning to identify errors while preparing for deferred Sarbanes-Oxley Act (SOX) compliance requirements.

Causes for the trend

In November 2006 remarks to the Financial Executives International Scott A. Taub, acting chief accountant of the SEC observed, "Some suggest that the large number of restatements shows that an overly conservative attitude pervades, resulting in restatements for errors that simply are not material. Others believe that the large number of restatements show that the reforms of recent years are working, causing companies to look harder at financial reporting and correct errors that arose in earlier years. Others argue that the rise in restatements can be traced to the increased complexity of accounting standards and reporting rules."

Taub's remarks echo the leading theories on the rise in financial restatement.

* Management Scrutiny -- The GAO 2006 study found that internal parties prompted most restatements. Certainly, the certification of internal controls required by SOX has resulted in a greater focus by management on the quality of financial reporting. With increased accountability, in some cases, the restatements may be perceived as a "clean-up" exercise. But has the pendulum swung too far, shifting perceptions of materiality? In either of these two cases, these trends should result in a reduction in restatements in the short-term.

* External Scrutiny -- One can't dispute that the CPA profession is more highly regulated than it has ever been with respect to the audit function. Public Company Accounting Oversight Board (PCAOB) inspections of registered CPA firms and increasing SEC enforcement activities and resources have increased the accountability of external auditors. Increased scrutiny of particular types of transactions is also a factor in the increase in restatements, such as an emphasis on stock option backdating practices and executive compensation.