Restatements by Small Companies Could Revive SOX 404 Debate

A surge in restatements by smaller public companies could reignite the debate over whether they should be subject to an audit of internal controls, per Section 404(b) of the Sarbanes-Oxley Act.

The number of accounting restatements by non-accelerated filers (companies with a market capitalization below $75 million) rose 13.8 percent, from 484 restatements in 2009 to 551 in 2010. The numbers also split sharply between U.S. non-accelerated filers, who had only a 10 percent increase, and foreign non-accelerated filers, whose restatements jumped 29 percent.

That spike among smaller public companies drove an overall 5 percent increase in restatements in 2010, from 699 in 2009 to 735 last year. But restatements among larger public companies actually fell 5.1 percent, from 156 to 148.

Don Whalen, director of research at Audit Analytics, which compiled the data, says pinning an exact reason on the divergence between large and small filers is difficult. But the timing of the increase is curious, occurring just when Congress granted small filers a permanent exemption from Section 404(b) last year. Large filers, in contrast, have had to comply with Section 404(b) for years—and they don't have the same restatement troubles.

“We don't know if but for the auditor's participation this wouldn't have happened,” Whalen says. “It's an amazing coincidence if there isn't some kind of cause.”

Congress granted the permanent exemption to Section 404(b) as part of the Dodd-Frank Act passed last July. Small companies rejoiced; they had fought for the exemption bitterly, and the Securities and Exchange Commission had previously granted one one-year exemption after another. The SEC finally vowed to impose Section 404(b) on small filers as of June 15, 2010, and Congress then overruled the agency with the permanent exemption.

All public companies, small and large alike, must still comply with Section 404(a), which requires management to say whether internal control over financial reporting is (or is not) effective. But small filers are not required to submit that assessment for scrutiny by the external auditor.

The 2010 surge in restatements among smaller public companies isn't likely to escape notice when the U.S. Government Accountability Office conducts a Dodd-Frank-mandated study in 2013, says Jim DeLoach, managing director at consulting firm Protiviti. Among the issues the GAO must address is whether non-accelerated filers issue more restatements than accelerated filers. “If the trend gets worse, 404(b) will be put back on the table,” DeLoach says.

Along related lines, the SEC just published its own study, also mandated by the Dodd-Frank Act, to gauge whether filers with market caps up to $250 million should be exempt from Section 404(b) as well—an idea pushed by numerous Republican lawmakers in Congress. The SEC study came down opposed to it.

Carol Stacey, former chief accountant at the Securities and Exchange Commission, now vice president at the training and education firm SEC Institute, says it's not clear that the Section 404(b) exemption can be linked to the increase in restatements. She points to an equally plausible culprit: a significant increase in the number of restatements tied to problems accounting for debt and debt-like instruments. “It's the top restatement issue, and it just won't go away,” she says.

Since 2005, problems in accounting for debt, quasi-debt, warrants, and equity security issues have been the most commonly cited cause for restatements, according to Audit Analytics. It spiked as the cause for restatements in 2006 (the same year the number of overall restatements peaked), then declined the past three years just as overall restatements have declined.

“I would agree that the non-accelerated filer population going up is not good—not good at all. But I don't think you can point to 404.”

—Carol Stacey,

Vice President,

SEC Institute

Last year restatements based on problems with accounting for debt and debt-like instruments made a comeback, with 34 percent more restatements citing this particular accounting headache as the cause. That makes it hard to overlook as a possible cause, Stacey says. “I would agree that the non-accelerated filer population going up is not good—not good at all,” she says. “But I don't think you can point to Section 404.”

Instead, Stacey points to new accounting rules that took effect in January 2009 as the culprit. They require companies to treat warrants as a liability more often, where before warrants were usually treated as equity. The guidance was contained in EITF 07-5 “Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity's Own Stock,” now found in the Accounting Standards Codification under Topic 815 on derivatives and hedging.

Problems With ‘Down-Round'

Companies that raise capital through certain types of convertible debt instruments, especially those with “down-round” provisions, have had the greatest problem applying the new guidance, says Mark Scoles, a partner with audit firm Grant Thornton. Down-round provisions provide protections for the holders of such instruments in the event a company issues equity shares later at a lower price than the convertible instrument. And smaller companies tend to be the ones that rely on such provisions, he adds.

Under the EITF guidance, companies were required to establish a value for such provisions and put them on the balance sheet. “For the most part, they are liabilities,” Stacey says, getting marked to market every reporting period. She surmises that smaller companies, where accounting staff and auditors may not be up to speed on the latest accounting literature, may have missed the new guidance. SEC staff members have reminded companies at professional conferences to be more careful with the accounting for such instruments.

RESTATEMENTS: TEN-YEAR COMPARISON

The following chart, “Restating Registrant by Accelerated Filer Status” is from Auditor Analytics.

A restatement population breakdown based on size (accelerated filer status) and location (U.S. or foreign) showed that this year's uptick is attributable to non-accelerated filers, both U.S. and foreign.

The restatement filer population can be separated into four categories based on size and location: (1) accelerated foreign

filer, (2) non-accelerated foreign filer, (3) accelerated U.S. filer, and (4) non-accelerated U.S. filer. A review of these

categories showed that the total number of restatements from U.S. and foreign accelerated filers decreased slightly

while the number from both categories of non-accelerated filers increased. As shown on the graph, U.S. accelerated filers

disclosed 142 restatements in 2009 and 136 in 2010. This slight decrease was overtaken by the increase disclosed

by U.S. non-accelerated files: 385 in 2009 and 424 in 2010. A similar breakdown occurred with foreign filers, with

disclosures from accelerated filers decreasing from 14 to 12 and disclosures from non-accelerated filers increasing from

99 to 127. Therefore the uptick in restatements in 2010 is attributable to non-accelerated filers.

Source: Audit Analytics.

Indeed, companies are paying closer attention to the accounting implications associated with convertible instruments, and putting more focus on getting it right the first time, Scoles says. “If it's anything other than plain vanilla, you really need to look at the agreements and the provisions carefully,” he says.

Chris Wright, managing director at Protiviti, says non-accelerated filers rely more on less traditional financing, making them more susceptible to mistakes in accounting for complex debt instruments. He also notes when one company files a restatement related to a particular issue, more usually follow, leading to surges clustered around specific issues. Auditors apply what they learn with one client to other clients, and regulatory inspections that raise concerns on one audit spark reviews of other audits. Restatement bursts have occurred in recent years surrounding leasing, revenue recognition, and stock compensation, Wright says.

Surprise!

Another alarming piece of data in the 2010 restatement report is the number of restatements filed without a Form 8-K filing to forewarn investors, Stacey says. More than half of all 2010 restatements occurred without advance notice that prior financial statements could not be considered reliable. She wonders whether companies are avoiding the non-reliance disclosure where it might be necessary. “I know the [SEC] staff doesn't like that,” she says.

The decline in 8-K filings correlates to some extent with the drop in the severity of restatements, Whalen says. In measuring the effect on earnings, the number of accounting problems identified, and the period of time that mistaken information lingered in financial statements, the overall damage done is no worse in 2010 than in prior years, he says.

Looking forward, Wright expects the next restatement surge may be building around tax issues. He has noticed a number of restatements so far in 2011 focused on problems with income tax accounting. “It's not clear yet what is driving that,” he says, although it may have something to do with losses many companies have posted in the past few years, calling into question the ability to realize tax reserves that were established in brighter times.