Financial Restatements Drop Again in 2009; Will It Last?

The financial-reporting community has good news to celebrate this spring, with restatements falling 27 percent in 2009 to numbers not seen since before passage of the Sarbanes-Oxley Act in 2002.

The question now is whether those numbers are only an inflection point, destined to rise again in coming years as the full force of the financial crisis and recession settles in—or whether all those investments in internal control really have led to lasting improvement in financial reporting.

2009 saw only 674 restatements, down 27 percent from 2008 and down 62 percent from the peak of 1,795 restatements in 2006, according to a new report by Audit Analytics. It was the third consecutive annual decline, and last year’s numbers are even better than the 696 restatements filed in 2002, before massive accounting scandals resulted in SOX and the intense scrutiny of internal controls over financial reporting that came along with it.

The analysis from Audit Analytics suggests that the severity of restatements is diminishing, too: there were fewer problems identified per restatement, and they had less overall impact on net income. Companies are also finding and correcting issues more quickly, the report says.

Whalen

Don Whalen, Audit Analytics’ director of research, admits that the broad improvement on so many fronts caught him by surprise. “The drops the past two years have been so dramatic, I’m beginning to think there has to be some leveling off,” he says.

The decline is not surprising, however, to financial reporting experts in the trenches. “I would have hoped to have seen a decline,” says Carol Stacey, vice president at the SEC Institute and a former deputy chief accountant for the Securities and Exchange Commission. “Sarbanes-Oxley has been around for so long now … I do expect that a more normal range is about where we are now.”

DeLoach

Jim DeLoach, managing director at consulting firm Protiviti, says the internal control reporting and auditing requirements housed in Section 404 of SOX deserve the lion’s share of the credit for improved reporting.

“The objective [of SOX] was to provide a leading indicator to the investment community about exposure of a company to potential financial restatements,” he says. “Here we are some eight years later, and we’re starting to see some interesting data points: reductions in every category that matters … To me, this is a recognition that the system—however you choose to define it, with all of its pieces and parts—is improving. That’s the bottom line.”

Rick Ueltschy, an executive at audit firm Crowe Horwath, says management and audit committees have tightened down on financial reporting processes and conclusions a great deal. “While they were always focused on not doing wrong, today audit committees are focused more on doing precisely what’s right,” he says.

Other Factors

Audit Analytics also theorizes that a less stringent view of materiality at the SEC may also be driving some of the decline. The SEC’s Advisory Committee on Improvements to Financial Reporting had previously concluded that the 2000 spike in restatements was caused partly by restatement of minor errors that never would have led to a restatement before 2002.

Stacey

Stacey, however, bristled at the notion the SEC somehow went soft on materiality as a result. “I would love to see Audit Analytics coordinate the restatement study with a study of [SEC staff] comment letters,” she says.

“Here we are some eight years later and we’re starting to see some interesting data points—reductions in every category that matters. To me, this is a recognition that the system is improving.”

—Jim DeLoach,

Managing Director Protiviti,

Protiviti

Ueltschy says the focus over the past several years on materiality has driven preparers and auditors to work harder at correcting differences before financial statements are issued.

Another factor probably is the arrival of Auditing Standard No. 5, a relaxed version of the original standard regarding how auditors should assess internal control over financial reporting. The Public Company Accounting Oversight Board approved AS5 in 2007. “Auditors aren’t quite as much in the weeds in internal control,” Stacey says. “Maybe they’re not going after the smaller stuff now.”

One vexing trend in statements that persists is the rate at which companies file “stealth restatements”—that is, restatements filed without prior disclosure that the markets should no longer rely on earlier, inaccurate financial statements. The total number of stealth restatements did drop from 435 in 2008 to 310 in 2009, but the ratio of stealth to previously disclosed restatements remains stubbornly high, at 49 percent, compared with only 33 percent in 2005.

Wilczynski

Martin Wilczynski, senior managing director for consulting firm FTI, says stealth restatements are typically rooted in judgments about how material an error might be. “Until the SEC or other regulators take more proactive measures to really push back or challenge the judgments that are made and identified, it will probably continue more or less in the same way,” he says.

Stacey notes that the SEC took heat from the Government Accountability Office in 2006 for having staff guidance that conflicted with SEC rules about restatements. (The rules stipulate that a company must use a Form 8-K within four days of discovering an error to alert markets that a restatement is coming.) Stacey says the SEC has not yet addressed that disconnect, leaving companies some leeway to restate without an 8-K. “It’s still called a stealth restatement, but it may be legitimate if you said you can do it in four business days with a straight face,” she says.

Past Performance, Future Results

While restatements have showed a steady decline over the past three years, that does not necessarily foretell smooth sailing in the coming few years, experts say. Poor economic conditions create a heightened risk for fraud, so there may be errors to report in the coming years related to that, Stacey says.

TOP NINE RESTATEMENT CAUSES

Below are the top causes of financial restatements in 2009 (in order), according to research from Audit Analytics:

Debt, quasi-debt, warrants & equity security issues;

Expense (payroll, SGA, other) recording issues;

Accounts/loans receivable, investments & cash issues;

Deferred, stock-based or other executive compensation issues;

Liabilities, accounts payable, reserves and accrual estimate failures;

Revenue recognition issues;

Acquisitions, mergers, disposals, reorganization accounting issues;

Tax expense, benefit, deferral and other tax reporting issues; and

Cash-flow statement problems.

Source

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align="left">Audit Analytics (February 2010).

Companies have also wrestled with valuations, bad debt, goodwill impairment, and other unpleasant write-downs as a result of stresses in the market, Stacey says. She hopes all of that has been flushed through financial statements at this point, “but that’s just a big old guess,” she says.

Wilczynski also notes that corporate staffing has been cut in many areas, including accounting and internal auditing at many companies, and that could allow mistakes to sneak into the statements. “It wouldn’t be crazy to think in the next few years there could be some complacency,” he says. “Things could turn in the other direction in the controls area due to resource issues.”

Non-accelerated filers are another unknown variable, experts say. They have never had to comply with Section 404(b) of SOX, which requires an external auditor to inspect and attest to the effectiveness of internal controls over financial reporting. They do comply with Section 404(a), requiring management to assess the strength of internal controls, but that does not always mean management’s assessment is correct.

The SEC has delayed Section 404(b) compliance since 2005, and now Congress is considering a permanent exemption. DeLoach wonders whether the external audit requirement, if it eventually goes forward, might lead to more restatements for that population of companies.

“It does add discipline and rigor to the process that simply does not exist in an environment where the external auditor is not involved,” he says. “Would that turn up additional issues that might lead to restatements? We can only guess.”