F
S R
inancial
Recent years have seen a
significant increase in the number
of financial statement restatements.
According to the Government
Accountability Office (GAO), the
number of financial statement restatements
identified each year rose from 92 in 1997
to 225 in 2001, with some 10 percent of
all publicly traded companies releasing
at least one restatement from January
1997 through June 2002.1 Despite the
passage of the Sarbanes-Oxley Act in
2002, the number of restatements for
U.S. companies continued to rise in
subsequent years to encompass 513
restatements in 2003 and 627 in 2004,
while the number of restatements soared
to 1,255 and 1,420 restatements in 2005
and 2006, respectively.2 To put this data in
perspective, it is important to understand
the leading causes of misstatements in
the financial statements and the effects
of restatements. This article explores the
issue of restatements for publicly traded
companies since the ability to gather such
information for non-public companies is
difficult, especially when trying to confirm
the accuracy of the information.
Types of Misstatements
Little consensus exists regarding
the single leading cause of financial
statement restatements because the
leading cause changes from year to year.
In separate studies revenue recognition
was found to be the leading cause for
restatements.3 However, in 2006, expense
recognition was the most common type
of error4 while another study concluded
that equity errors were the leading
cause of misstatements.5 Even
though causes of financial statements
misstatements change from year to year,
the main accounting issues causing
misstatements have remained
fairly stable. A description
of the prevailing types of
misstatements follows.
Revenue Recognition
Staff Accounting Bulletin 101
(SAB 101) outlines the four criteria for
recognizing revenue: (1) evidence
of an arrangement such as a signed
arrangement or an established
tatement
Causes and Effects
By Jennifer Bischoff, Jane Finley and Daniel LeBlanc
historical business practice; (2) delivery has
occurred or services have been rendered,
which should be evident with title transfer
or documentation of services provided; (3)
the price is fixed and determinable with
payment obligation evident, including
concessions, discounts or contingencies
and any unfilled commitments by the
seller; and (4) collectibility is reasonably
assured and any unpaid amount can be
reasonably estimated or the client has the
financial resources to pay the remaining
amount. In general, if a potential revenue
item does not meet these four criteria,
revenue should not be recognized.6
Common revenue misstatements involve
percentage-of-completion accounting,
transactions with consignees, transactions
with repurchase obligations and bill and
hold transactions.7
Expense Recognition
Improper expense recognition
includes a variety of accounting practices
designed to achieve an overstatement
of net income either by intentionally
understating expenses or improperly
deferring them to future periods.8 A
common technique used to manipulate
expenses is the setting up of “cookie
jar” reserves. The intended result is to
manage earnings by creating an initial
overstatement of expenses in earlier
periods, then netting the excess reserves
against expenses in future periods to
create a smooth upward trend in net
income. Other methods utilized to
understate expenses include: (1) failure
to record expenses or losses via improper
capitalization/deferral or through lack of
accrual; (2) overstating ending inventory
values to reduce cost of goods sold; (3)
understating bad debts or loan losses; and
(4) failure to record asset impairments.
Equity Errors
Restatements driven by
misstatements in equity accounts primarily
arise from improper accounting for
earnings per share (EPS), stock-based
compensation, stock options, warrants
and convertible securities.9 Equity-driven
restatements rose by 77 percent in 2005.10
The stock option backdating scandals that
plagued companies in 2004 caused the
estatements:
Financial Accounting Standards
Board (FASB) to respond with
a revision to FAS 123 that requires
“a public entity to measure the cost
of employee services received in
exchange for an award of equity
instruments based on the grant-date
fair value of the award”.11 For example,
companies must show the fair value,
determine by an option-pricing model, of
any stock option awards on their income
statements. Often companies showed the
Black-Scholes value of their stock options
in the income statement footnotes, not as a
line item on the statement.
Misclassification
Misclassification refers to improperly
classifying items in the balance sheet,
income statement or statement of cash
flows. Cash flow related misclassifications
appear to be the most prevalent. Allocating
cash flows among operating, investment
and financing activities does not change
total net cash flow, but does affect the
balance among the three categories. The
statement of cash flows is used as an
additional gauge to assess the quality of
a company’s earnings – more specifically,
how much cash a company is generating
to support its operating activities. If a
company’s cash flow from operating
activities is significantly lower than its
earnings, investors should beware.12
Disclosure of Restatements
Public companies are required to
disclose restatements by filing amended
SEC (Security and Exchange Commission)
annual and quarterly filings on Form
10-K/A or 10-Q/A which contain
the corrected (restated) financial
statements.13 Additionally, in 2004
the SEC began requiring that public
companies also announce restatements
using Form 8-K, item 4.02.14
However, because of the SEC’s
flexibility in filing Item 4.02
disclosures, many companies
have been engaged in a practice
known as “stealth restatements,”15
in which companies employ
trickery to avoid publicly announcing
restatements.
continued on page 6
APRIL APRIL | Tennessee
2008 2008 | Tennessee
CPA Journal 5
CPA Journal 5
 Financial Statement Restatements: Causes and Effects
continued from page 5
Public companies generally use
three tricks to keep restatements out of
the spotlight.16 The first trick involves
restating without filing the necessary
amended 10-K or 10-Q reports. Instead,
companies merely restate previous periods’
financial reports by tucking them in the
next regularly scheduled quarterly or
annual filings, causing investors to take
little notice. The second trick is for
companies to restate the financial
statements, but not issue a press
release alerting investors to the
change. This strategy may seem
fairly obvious, but does indicate
intent to downplay restatements by
minimizing communication to investors.
The third trick is called “file late, keep
quiet, then restate.”17 In 2005 nearly two-
thirds of restating companies were late
in filing a quarterly report or an annual
report during the year. A key assumption in
employing this trick is that the investors are
unaware of a company’s intention to restate.
Many companies then fail to adequately
explain the reasons behind the postponement
of annual or quarterly reports in their NT
filings. Overall, some 40 percent of restating
companies failed to take all the steps
necessary to disclose the restatements in the
proper way.
Implications of Restatements
Effects on Stock Price and Market Cap alters the precision of investors’ information
Restating financial statements can
cause a wide variety of market responses,
but overall the market tends to react
negatively to such news. On the positive
side, restatements often specify which item
was improperly reported in the original
statement. This information allows investors
and other users of the financial statements to
study the marginal importance of these items
on the company’s operations and market
cap.18 For instance, the GAO’s report found
that revenue restatements had the largest
negative effect on market capitalization
loss during the period studied, accounting
for over half of the market cap lost, but
only 39 percent of the total restatements.
Restatements related to mergers and
acquisitions accounted for only six percent
of the restatements, but caused 20 percent of
the market cap losses. In contrast, improper
or questionable accounting for expenses
comprised 14 percent of restatements in the
period studied, but accounted for only 4.8
percent of the negative market cap impact.19
In general, restatements reflect
poorly on management and give investors
the impression that management is
incompetent or intentionally attempting to
defraud investors. Previous studies have
6 Tennessee CPA Journal | APRIL 2008
shown that restatements are related to a
decline in firm value,20 a decrease in future
earnings prospects and an increase in the
cost of capital.21 The most immediate and
pronounced market reaction to financial
restatements is a significant drop in the
offending company’s stock price and market
capitalization. According to the GAO, the
stock price of restating companies dropped
by an average of 10 percent during the three
trading days surrounding the restatement.
The stock prices remained depressed for
long periods following the restatement,
although the GAO report concedes that other
factors may have contributed to these price
depressions.22
Conversely, the GAO found that
restatements related to restructuring,
asset impairment and inventory issues
actually contributed to an increase in
market capitalization of some $2.9 billion
during the period studied.23 Salavei and
Moore also found evidence to support this
phenomenon, noting that a restatement can
lead to less uncertainty regarding the future
of a company, which results in positive
market reaction. They further maintain
that estimates such as “bad debt reserves,
restructuring charges, pension plan rates of
return, long-term restructuring plans and
securities-related entries … are inherently
imprecise”24 and that such increased
certainty regarding estimates positively
set.
Implications for Investor Confidence
Evidence also suggests that
restatements negatively affect investor
confidence. Investor confidence is by nature
difficult to quantify because investors use
several types of information in making
investment decisions. However, one key
indicator shows the impact of restatements
on investor confidence.
The UBS Index of Investor Optimism25
shows that investor optimism plunged
in the wake of the Enron and WorldCom
accounting scandals. In a press release dated
May 28, 2002, the Index registered at 90.26
In that poll, investors were asked about
conditions that could be
detrimental to the U.S.
investment climate. Eighty-four percent of
the investors polled stated that the issue
of questionable accounting practices was
negatively affecting the markets. In addition,
nearly three-quarters of the investors
stated that such accounting concerns were
widespread in the business environment.
Regulatory Environment
In the late 1990s, the SEC recognized
the need for closer scrutiny and enforcement
of securities laws relating to accounting
violations.27 The first step directed SEC staff
to create accounting guidance regarding
proper revenue recognition. The direct result
of this consideration was the release of Staff
Accounting Bulletin 101. At the time of SAB
101’s release, revenue recognition practices
accounted for nearly half of the SEC’s
accounting-related enforcement cases.28 The
second step mandated SEC staff reviews of
public companies that announce practices
such as major write-offs or the restructuring
of liability reserves that appeared to be
attempts at earnings management. The
SEC began investigations in 1999 which
resulted in 30 enforcement actions against
68 companies and individuals for fraud and
misconduct. The most obvious implication of
restatements is the passage of the Sarbanes-
Oxley Act in 2002.
Conclusion
Financial statement restatements,
which have increased rapidly over the
last few years, have had far-reaching
implications. The causes may vary by year,
but tend to remain in four narrow areas:
revenue recognition, expense recognition,
equity errors and misclassifications. The
impact of restatements has caused significant
reaction from the stock market, individual
investors and regulatory authorities. The loss
of investor confidence led Congress to pass
Sarbanes-Oxley as a necessary response to
regaining public confidence in the financial
reporting of public companies. Many see
the Act as a way to ensure
more
accurate financial reporting, while others
do not believe the benefits justify the cost
of complying with the law. In addition,
venture capitalists are concerned that the
high legal and auditing fees associated
with Sarbanes-Oxley are driving
companies to take initial public offerings
overseas29 which would involve reporting
within International Accounting Standards.
Restatements, the causes and effects, is
an area that is likely to continue an active
debate between both the profession and
the investment community. n
Endnotes:
1. Government Accountability Office. Financial
Restatements: Trends, Market Impacts,
Regulatory Responses, and Remaining
Challenges.
2. Grothe, Mark. The Errors of Their Ways. Glass,
Lewis & Co., LLC. 27 February 2007. www.pbs.
org/nbr/pdf/GlassLewis-Errors.pdf.
3. Government Accountability Office. Cross,
Meredith B., Erika L. Robinson, Knute J. Salhus,
Jennifer A. Zepralka. “Restatements of Financial
Statements: Selected Legal and Accounting
Issues.” The Securities Reporter, The Newsletter
of the Committees on the Federal Regulation of
Securities, Volume 9, Issue 1, Spring 2004.
4. Turner, Lynn E. and Thomas R. Weirich. “A Closer
Look at Financial Statement Restatements.”
5. Grothe.
6. Staff Accounting Bulletin No. 101, Release No.
SAB 101, 64 Fed. Reg. 68,936 (Dec. 9, 1999).
7. Floyd, Joseph J. An Analysis of Restatement
Matters: Rules, Errors, Ethics for the Five
Years Ended December 31, 2002. May 2003,
p. 11. www.huronconsultinggroup.
com/uploadedFiles/Huron_
RestatementStudy2002.pdf.
8. Securities and Exchange Commission (SEC).
Report Pursuant to Section 704 of the Sarbanes-
Oxley Act of 2002. 24 June 2007 www.sec.gov/
news/studies/sox704report.pdf.
9. Grothe.
10. Turner and Weirich.
11. Financial Accounting Standards Board.
Statement of Financial Accounting Standards No.
123. Revised 2004. Accessed on 24 June 2007 at
www.fasb.org/pdf/fas123r.pdf.
12. Grothe.
13. Grothe.
14. Securities and Exchange Commission (SEC).
17 CFR Parts 228, 229, et al. Federal Register
Part VI: Additional Form 8-K Disclosure
Requirements and Acceleration of Filing Date;
Final Rule.
15. Turner and Weirich.
16. Turner and Weirich.
17. Turner and Weirich.
18. Salavei, Katsiaryna, and Norman Moore. Signals
Sent by Financial Statement Restatements. Draft,
Revised May 12, 2005, pp. 2-3.
19. Government Accountability Office.
20. Anderson, Kirsten L. and Yohn, Teri Lombardi,
“The Effect of 10K Restatements on Firm Value,
Information Asymmetries, and Investors’ Reliance
on Earnings” (September 2002), p. 19.
21. Hribar, P., and N. T. Jenkins, 2004. “The Effect of
Accounting Restatements on Earnings Revisions
and the Estimated Cost of Capital”, Review of
Accounting Studies 9 (2004), pp. 337-356.
22. Government Accountability Office.
23. Government Accountability Office.
24. Salavei and Moore
25. The UBS Index of Investor Optimism is a
monthly survey that measures the attitudes of
private investors. In the survey, investors are
defined as households with at least $10,000
of investable assets in the United States. The
overall Index is calculated on the basis of seven
questions, which cover the personal financial
dimension and the macroeconomic dimension of
investments. The Index
level reflects the balance of optimistic and
pessimistic responses. The Index’s baseline
point of comparison is 124, established
with the inaugural measurement in 1996.
For more information, see www.ubs.com/
investoroptimism.
26. UBS Index of Investor Optimism, published
28 May 2002. Accessed 29 June 2007 at www.
ubsinvestmentbank.com.au/1/e/media_
overview/media_americas/search1/
search10?newsId=58949.
27. Government Accountability Office.
28. Government Accountability Office.
29. Levy, Ari and Jesse Westbrook.
“Sarbanes-Oxley Foes Find Hope.”
Bloomberg News, 13 November
2006. Accessed 29 June 2007 at
www.iht.com/articles/2006/11/12/
bloomberg/bxoverhaul.php.
Other Resources:
General Accountability Office Report to the
Chairman, Senate Committee on Banking,
Housing & Urban Affairs, GAO-03-138
(October 2002), available at www.gao.gov.
Palmrose, Z., V. J. Richardson, and S. Scholz,
2004. “Determinants of Market Reactions
to Restatement Announcements.” Journal of
Accounting Economics 37, pp. 59-89.
The CPA Journal December 2006. Vol. 76, Iss. 12:
p. 12.
About the Authors:
Jennifer Bischoff is an accountant with the
Vanderbilt Athletic Department. She can be reached
at jennifer.m.bischoff@vanderbilt.edu.
Jane Finley is a professor of accounting at
Belmont University. She works for Deloitte and
Touche. She can be reached at finleyj@mail.belmont.
edu.
Daniel LeBlanc is an accountant for KPMG.
He can be reached at dleblanc@kpmg.com.
APRIL 2008 | Tennessee CPA Journal 7