A new academic study challenges the widespread notion that complicated accounting rules are mostly responsible for the surge in restatements in recent years.
Rather, the study blames human error or, more precisely, errors made by accountants.
“Restatements are most often caused by basic internal company errors unrelated to the accounting standards themselves,” the study flatly says.
And where restatements were caused by some convoluted accounting rule, the primary cause usually was lack of clarity in how a particular rule should be applied or a mis-reading of guidance intended to illuminate how the standard should be used.
“The use of judgment is the second-leading contributing factor for the restatements caused by a characteristic of the standards,” the study says. “Detailed rules contribute to a very small fraction of the restatements.”
Such findings are especially relevant as U.S. regulators contemplate scrapping U.S. Generally Accepted Accounting Principles in favor of International Financial Reporting Standards—a system that relies much more on judgment and “principles-based accounting” than GAAP does. Should the United States adopt IFRS, the study contends, even more restatements are possible.
Plumlee
The authors of the research were accounting professors Marlene Plumlee of the University of Utah and Teri Lombardi Yohn of Indiana University. They examined restatements from 2003 to 2006. According to proxy research firm Glass, Lewis & Co., restatements surged in that period from 475 to 1,538.
The financial reporting community has suggested a wide range of possible causes for that surge: complex accounting standards, complex business transactions, problematic reviews of internal controls, changes in materiality thresholds, overly conservative auditors, earnings management, and more. Plumlee and Yohn, however, have few kind words for those theories. “While there are many explanations for the increased number of restatements, empirical evidence on the underlying causes of restatements has been lacking,” they write.
They claim that 57 percent of restatements from 2003 to 2006 were caused by basic internal company errors. They note that this conclusion is consistent with similar research done by Scott Taub, former acting chief accountant at the Securities and Exchange Commission, who in November 2006 stated that “well over half of the errors that resulted in restatements were caused by ordinary books and records deficiencies or by simple misapplications of the accounting standards.” (Taub is now a columnist for Compliance Week, and is no relation to the author of this article.)
WHY RESTATE?
Below is an excerpt from the study, “An Analysis of the Causes of Restatements.”
Accounting restatements have been filed at record levels in the past few years. Glass Lewis (2007) documents that 1,538 restatements were filed in 2006, over three times the 475
restatements filed in 2003.
We find that the majority of restatements (57 percent) filed from 2003 to 2006 were caused by basic internal company errors, inconsistent with the conventional wisdom that the complexity of the accounting standards drives most of the restatements.
The second most common cause of restatements filed during the four-year period was some characteristic of the accounting standards (37 percent). We find that restatements related to acquisition/investments, other comprehensive income (OCI), equity, revenue, and capital assets are significantly more likely to be caused by some characteristic of the accounting standards than restatements related to other issues.
Of the restatements caused by a characteristic of the accounting standards, 58 percent of them include the lack of clarity in the standard and/or the proliferation of the literature due to the lack of clarity in the original standard as a contributing factor. Thirty-seven percent of these restatements include the use of judgment in applying the standard as a contributing factor.
ARGUMENTS FOR RESTATEMENTS:
Some argue that restatements are due to accounting complexity
(Ciesielski and Weirich, 2006).
Others argue that restatements are driven by reinterpretations of judgments that could not have been foreseen by company executives (Pozen, 2007).
Some argue that restatements are due to company management’s inability to sift through the thousands of pages of accounting standards to find the paragraphs that apply to the transaction of interest (e.g., Dzinkowski, 2007).
Others argue that the implementation of Sarbanes Oxley 404 internal control reviews has uncovered past errors and that the increase in restatements in recent years is due to Sarbanes-Oxley simply working as it should.
Others argue that the increase in restatements is due to transaction complexity—that
businesses and transactions have become too complex for the accounting (Dzinkowski, 2007).
Source
The Underlying Causes of Restatements (March 2008).
The second most common cause of restatements filed during the four-year period was some characteristic of the accounting standards—such as a requirement to make a judgment, which later turns out to be wrong. Thirty-seven percent of restatements could be traced back to some characteristic of the account standard. For example, restatements related to acquisitions, other comprehensive income, equity, or capital assets appear significantly more likely to be caused by “characteristic problems” rather than other issues.
Of those restatements that do seem connected to characteristics of accounting standards, 58 percent of the group was due to a lack of clarity in the standard or the proliferation of guidance because of that lack of clarity. And 37 percent of the group had problems due to use of judgment in the standard.
Yohn and Plumlee also found that restatements related to misclassifications, expense recognition, other comprehensive income, and equity are significantly more likely to include the lack of clarity in the standard as a cause, while restatements related to revenue recognition, inventory, tax, capital assets, and reserves or allowances are more often due to the use of judgment in applying the standard.
Yohn
“A lot of people blame complexity for the majority of restatements,” Yohn says. “We were surprised that it was not the complexity that drives restatements.”
The study also found that, in general, the reporting of control weaknesses has increased significantly over the period. That is not terribly surprising, since the arrival of Sarbanes-Oxley has forced many companies to pay much closer attention to internal controls, uncovering numerous problems.
Meanwhile, Plumlee and Yohn warn that if auditors and regulators don’t respect judgments made by management, then more restatements will result. “These findings are especially important to keep in mind as the [United States] moves toward convergence with International Financial Reporting Standards,” they write in their study. “More restatements might result as the [United States] moves toward IFRS and the need for judgment increases.”
Exactly how much judgment U.S. investors, auditors, and regulators really would tolerate in a principles-based world is the subject of much speculation. Yohn and Plumtree say that question is well founded. “Both Marlene and I have raised some concern that if there is a move to principles-based standards, they must be very clear,” Yohn stresses.
Turner
Lynn Turner, another former SEC chief accountant and the former managing director at Glass Lewis, says Yohn and Plumtree’s findings are in step with what he and his team saw when they analyzed the restatement data.
“Unfortunately, for too long, companies have not made the necessary investments in internal controls, systems, and competent people, and it is coming back to bite them on the back side,” he says. “At the same time, the Financial Accounting Standards Board needs to do a better job of writing their standards, so that those who have to implement them, such as controllers, can understand them and implement them in the way intended.”
No comments yet