Finally, a downturn the corporate world can be happy about.
Financial restatements dropped dramatically in 2007, reversing nearly a decade of ever-higher numbers that reached a record in 2006. What’s more, restatements fell both for companies that do need to comply with Section 404 of Sarbanes-Oxley and those that do not—another telling sign that Corporate America’s financial reporting is finally getting better.
According to data from Audit Analytics, 1,109 companies filed 1,237 restatements last year. That’s a drop of 30 percent and 31 percent, respectively, from 2006 restatements.
“Every way you slice it, the number, severity, and effect of financial restatements declined in 2007,” says Mark Cheffers, chief executive of Audit Analytics.
Restatements had been marching steadily upward since 2001, and that trend had been the chief reason for numerous regulatory reform efforts now underway. The Securities and Exchange Commission has an advisory committee crafting recommendations aimed at reducing the number of what it says are unnecessary restatements; the Treasury Department is working on its own study due later this year on the cause of restatements.
But according to Cheffers and other financial reporting experts, the latest data on restatements is further evidence that the quality of financial reporting overall has improved since SOX arrived in 2002.
“This trend appears to indicate that publicly traded companies are adapting to the more rigorous conventions … adopted in response to the Sarbanes-Oxley Act of 2002 and other rules adopted to improve the accuracy and reliability of corporate financial disclosures since the collapse of Enron and WorldCom,” the Audit Analytics report states.
Among those who agree is former SEC Chief Accountant Lynn Turner. “Several studies have clearly shown that restatements are coming down in the past couple of years, as companies have implemented better controls and started to get their accounting correct on the first, rather than second try,” he says.
In addition to focusing attention on a company’s internal controls, SOX has also forced executives to certify the accuracy of financial statements or face severe penalties for erroneous or fraudulent numbers. That harsh dictum has focused top executives’ minds on getting things right the first time.
“Holding senior executives heavily accountable creates a different culture,” says David Rubenstein, a partner at accounting firm Weiser. “The tone at the top is changing.”
Fewer, Smaller, and Simpler
Not only is Corporate America seeing fewer restatements, but the restatements are also smaller in size and scope. The average restatement in 2005 nicked a company’s net income by $21.33 million; by 2006, the average fell to $17.8 million. Last year, the average restatement only hurt net income by $3.64 million. The largest restatement for 2007—a $341 million adjustment by General Electric—would not even crack the top five restatements in the previous two years.
The total yearly number of restatements this decade.
Audit Analytics (2007).
“The sense we’ve gotten out in field is that the lessons of the early 2000s and the pains of implementing Sarbanes-Oxley have worked their way through the system,” says Jeffrey Szafran, a managing director at Huron Consulting Group. “The types of restatements that are really problematic, like revenue recognition restatements, have begun to drop off.”
Other evidence that restatements are becoming less of an ordeal:
2007 restatements cited an average of only 1.87 accounting issues, compared to 1.97 in 2006 and a record high of 2.41 in 2005.
The average 2007 restatement didn’t need to look as far back into the past. At its peak in 2005, the average restatement period was 746 days. That dropped to 710 days in 2006, and only 643 days in 2007.
37 percent of last year’s restatements had no effect on net income for companies trading on one of the three major U.S. exchanges, compared with roughly 30 percent in 2006 and 24 percent in 2005.
Despite the good news, non-accelerated filers—which have not yet had to comply with Section 404 of SOX—clearly lag behind their larger counterparts in improving financial reporting. The absolute number of restatements among non-accelerated filers fell from 1,048 in 2006 to only 746 last year, but the portion of restatements attributed to small filers has risen from 58 percent in 2005 to 68 percent in 2006 to 72 percent in 2007.
RESTATEMENT BY STATUS
Restatements by filer status.
Audit Analytics (2007).
“I think that shows that once firms made the investment in SOX 404 systems, there was a payoff in terms of better controls leading to fewer restatements,” says Jack Ciesielski, publisher of the Analyst’s Accounting Observer blog. “That’s an investment yet to be made by non-accelerated filers and a payoff yet to be realized.”
Szafran also says it makes sense that non-accelerated filers will account for a larger portion of overall restatements. “From an internal controls standpoint, the smaller the company, the less robust the control environment is going to be,” he says. Moreover, he notes, even relatively small errors are more likely to be material to a small company. “Large companies can absorb a lot of human error before they have to restate. For a smaller company, a fairly small error could be material,” he says.
The Cause Remains the Same
The most common causes for restatements in 2007 were debt, quasi-debt, warrants, and equity security issues; expense-recording issues; revenue-recognition issues; deferred, stock-based, or executive compensation issues; liabilities, payables, reserves, and accrual estimate failures and acquisitions, mergers, disposals, and reorganization accounting issues. All of those were the top reasons for restatements in 2006 as well.
Cash-flow statement classification errors, which ranked seventh among restatement causes last year, have also become more common this decade. In 2001, only 0.49 percent of the restatements filed restated cash flow. That number has crept up each year to reach 11.35 percent in 2007.
Observers note that cash-flow statement classification has been a focus of regulators in recent years. Some of the restatements in that area may have been driven by past SEC staff remarks on the topic, Ciesielski says.
A breakdown of the accounting issues leading to restatements in recent years.
Debt, quasi-debt, warrants & equity
Expense (payroll, SGA, other) recording issues
Revenue recognition issues
Deferred, stock-based, and/or executive comp issues
Liabilities, payables, reserves, and accrual estimate failures
Acquisitions, mergers, disposals, re-org accounting issues
Cash-flow statement (SFAS 95) classification errors
Audit Analytics (2007).
Cheffers calls the restatement report good news, but does cite two caveats: The effects of Financial Interpretation No. 48 and of SEC Staff Accounting Bulletin 108 shouldn’t be overlooked. FIN 48 requires companies to disclose how certain they are (or are not) about their tax positions, and SAB 108 requires companies to clean up old errors that have accumulated on the balance sheet.
“Apples to apples, 2007 was a great year for financial reporting,” Cheffers says. But, he adds, preliminary data show that last year at least 1,500 public companies made FIN 48 adjustments and at least 300 had SAB 108 adjustments.
Those are “effectively back-door restatements” that allow companies to make adjustments to beginning retained earnings without going through a whole restatement, Cheffers says. While both are “one-time, one-year deals,” he contends that some of those adjustments might have otherwise resulted in restatements.
Going forward, Cheffers predicts fewer restatement disclosures, “but not necessarily fewer errors.” He expects restatements to decline further, in part because more companies “will take advantage of the SEC’s recent updates to … materiality thresholds to not disclose a restatement at all.”
Observers also note that unexpected “surprises” could cause restatements to spike again.
“A few years ago, lease accounting and stock options backdating issues caught everyone by surprise, and when they hit, they hit quickly and steamrolled hundreds of registrants,” Szafran says. “We’ve been watching and wondering, ‘Is there a next one?’“
There may well be, according to Thomas Weirich, an accounting professor at Central Michigan University. He says a move by the United States toward International Financial Reporting Standards (something that won’t happen for several years at least) could result in an uptick in restatements.
Under IFRS, which is a principles-based system, “more judgment will come into play,” Weirich says. “Auditors may try to second-guess judgments and the application of IFRS,” leading to a rise in restatements.