Study: SOX Helps Cut Restatements

The debate over how to amend Section 404 of Sarbanes-Oxley may be rolling forward this spring unabated, but fresh data about the number and nature of financial restatements in 2006 could be the latest proof that the controversial and costly law actually works.

For the sixth consecutive year, companies set a record for restatements in 2006: 1,876, according to a report from research firm Audit Analytics. That’s a fourfold increase from the 452 restatements in 2001, the last year before Enron’s collapse ushered in the Sarbanes-Oxley Act and changed the corporate-governance universe forever.

But last year’s numbers have one notable difference from prior years’ restatements: For companies already in compliance with Section 404 of Sarbanes-Oxley, which requires audits of a company’s internal control over financial reporting, the number of restatements decreased—but for smaller companies still exempt from 404, restatements continued to soar.

“Restatements among large companies were down and among smaller companies were up,” says Mark Grothe, a research analyst at proxy-advisory firm Glass, Lewis & Co., which issued its own report on restatements. “We attributed that primarily to SOX 404.”

Larger companies that have been through two or three years of 404 testing and auditing “have found all of their control weakness and deficiencies and they’re on the path to fixing their problems,” Grothe says. “The result has been fewer errors in their financial statements.”

Cheffers

Mark Cheffers, CEO at Audit Analytics, agrees. “There was a general belief that the adoption of Section 404 would lead to an increase in restatements, followed by a decline,” he says. “That appears to be the case.”

Correcting errors related to technical accounting issues spurred most of the restatements in 2006, particularly among non-accelerated filers. Improper accounting for convertible securities restatements drove 243 restatements.

Other issues that spurred restatements last year included cash-flow misclassifications, which Cheffers says “have gotten more attention in the wake of Enron,” and stock option accounting issues, which drove more than 100 restatements in 2006. (For more on cash-flow related restatements, see Related Coverage above, right.)

Grothe says it’s somewhat surprising that companies are still struggling with options accounting issues, especially since the Financial Accounting Standards Board provision on expensing options has been in effect for several fiscal quarters. “We would’ve thought the number of option restatements would go down with FAS 123(R) in effect,” he says. “We expected that companies would’ve already looked at their stock option accounting and taken care of any issues.”

Most of the options restatements weren’t related to last year’s backdating scandals. Among 117 companies that had restatements related to stock options in 2006, only 36 had to do with backdating, Grothe says. That means a large number of options restatements is likely again this year as companies with backdating problems restate to correct them.

So-called “stealth” restatements, which refer to those where companies didn’t file amended financial statements and didn’t make the proper Form 8-K filings with the SEC to warn investors that their past reports weren’t reliable, surged for the second year in a row, up to 254 from 163 in 2005.

While it’s too early to tell yet, Cheffers says the SEC’s Staff Accounting Bulletin No. 108, which allows company a simpler way to fix previous financial statement errors without having to issue a restatement, could drive the number of restatements down in 2007. (See box above, right, for SAB 108.)

The Bigger Restatement Picture

The percentage of all U.S. accelerated filers—that is, companies with a market capitalization of $75 million or more—reporting restatements declined from 16.1 percent in 2005 to 13.3 percent in 2006, according to Audit Analytics. For those filers, the absolute number of restatements declined from 620 to 512 in the same period. Among large accelerated filers—companies with market caps of $700 million or higher—restatements fell from 242 in 2005 to 196 in 2006.

“There’s little doubt that a lot more attention is being paid by companies and their auditors to getting the accounting right,” Cheffers says. “There’s been a fairly dramatic improvement in the overall application of GAAP.”

While restatements among larger companies spiked in 2005, Mark Grothe at Glass Lewis & Co. notes that restatements among non-accelerated filers have been “steadily ramping up.” He expects smaller companies to continue to uncover and clean up financial-statement errors until after their second year of Section 404 compliance, when they file their first auditor attestation reports.

Cheffers also notes the number of quarterly versus annual restatements; that, he says, indicates that companies are focusing their efforts on identifying and correcting historical financial statements, indicative of an internal controls deficiency. “Without the increased scrutiny of Sarbanes-Oxley, would we have seen any of it? I suspect not,” he says.

Restatements among non-accelerated filers, however, is a very different story. They continued to increase to record highs last year, soaring from 921 in 2005 to 1,318 in 2006. Both Cheffers and Grothe attribute the spike in restatements by smaller companies to the effects of Section 404.

“Whether non-accelerated filers have to comply with 404 or not, there’s been a fairly significant change in internal controls audit work that’s filtered down to those smaller companies,” Cheffers says. “A lot of the tentacles of 404 are already in place.” He describes it as a “cascade effect,” with personnel at both the non-accelerated filers and the smaller audit firms now focusing more on internal controls.

Grothe agrees that 404 has had “a secondary effect” on some of the restatements at smaller companies.

“There’s a different mentality among companies and auditors, whether they have to comply with 404 yet or not,” he says. “There’s a higher level of importance by companies than in the past on making sure they get their numbers right, even if they have to restate.”

In addition, Cheffers says inspections of auditing firms by the Public Company Accounting Oversight Board and comment letters from the Securities and Exchange Commission to companies on accounting issues have had an impact. “Word gets out among companies about what they focused on,” spurring restatements on certain issues, he says.

As a result of their increased focus on fixing their past errors, Cheffers says non-accelerated filers will be in “better shape” when they face their first 404 audits than their larger counterparts were during their first year.

While restatements among larger companies spiked in 2005 when SOX 404 first took effect, Grothe notes that restatements among non-accelerated filers have been “steadily ramping up.” He expects smaller companies to continue to uncover and clean up financial-statement errors until after their second year of Section 404 compliance, when they file their first auditor attestation reports. “I’d expect smaller company restatement to continue their steady climb through 2009,” he predicts.

Scott Taub, a former chief accountant at the SEC and now a principal at consulting firm Financial Reporting Advisers, describes the restatement numbers as “interesting, but it’s too early to tell what it means.”

Taub

“It hasn’t surprised me to see an increase in restatements in the last few years because companies have been cleaning up things that got out of hand,” he says. “I would expect the number of restatements to start going down. If the number of restatements doesn’t go down, we will have to start asking whether Sarbanes-Oxley is doing its job.”

Both the Audit Analytics and Glass Lewis reports come amid efforts by regulators to revamp the way Section 404 will be implemented for smaller companies, tentatively scheduled to start providing management’s assessment regarding internal control over financial reporting in annual reports for fiscal years ending on or after Dec. 15, 2007. Those filers will comply with the auditor-attestation requirement in annual reports filed for fiscal years ending on or after Dec. 15, 2008.

The SEC and the PCAOB are both reviewing public comments on separate proposals unveiled last December aimed at making compliance with Section 404 less burdensome for smaller issuers. Several business groups and professional associations, however, say the proposed reforms won’t help unless inconsistencies are resolved between the SEC’s proposed principles-based guidance for management and the PCAOB’s more prescriptive proposed new standard for auditors.