What Triggers Financial Restatements?

Poor documentation of transactions, the wrong accounting treatment, lack of transparency, weak internal controls, and -- in rare instances -- fraud can wreak havoc on corporate and personal reputations. And the number of restatements keeps breaking records.

The incidence of financial restatements in the United States has soared in the past five years -- a period that includes a slew of major accounting scandals -- and the trend continues as the post-Sarbanes-Oxley era moves forward. But the story runs deeper than the familiar tales of incompetence and fraud. CFOs intent on keeping their names out of negative headlines should understand the causes of this trend as well as the processes that kick into gear after a restatement has been filed with the SEC.

Coming Clean

Since passage of the Sarbanes-Oxley Act, finance functions have encountered significant accounting challenges. Les Stone, a partner in Accenture's finance and performance management global service line in Wellesley, Mass., cites evidence of mounting reporting difficulties: delayed annual filings, which increased dramatically between Q1/2004 and Q1/2005, and the proliferation of voluntary, proactive disclosures of reporting problems by public companies.

In proactive disclosures, companies typically explain what the reporting problem is and describe how they plan to correct it. The 8 percent of SEC registrants who failed their initial Section 404 audits to date have delivered the bulk of recent disclosures. The top three reasons companies give for making a proactive disclosure are failure to close the books on time; difficulties with account reconciliations; and problems in other areas, such as inventory accounting.

But the most telling measure of reporting struggles is the total number of financial restatements filed each year. That figure increased by 77 percent between 2000 and 2004, according to a study by Huron Consulting Group. Although the total leveled off in 2003, when 323 financial restatements were filed compared with 330 the previous year, the decrease was entirely due to a drop-off in restatements of quarterly financial statements (10-Qs). Amended filings of annual audited financial statements (10-Ks) actually increased in each of the past five years (see The Rise of Restatements below).

That trend is significant because 10-Q restatements usually consist of technical accounting errors that have minimal or no effect on revenue and profit. However, accounting errors that cause 10-K restatements typically result in decreased income, which can lower shareholder value; enrage shareholders (and provoke shareholder lawsuits if the restatement is large); create more difficulty in accessing capital; and, in a worst-case scenario, cause an Enron-style collapse. These impacts can spark executive turnover as well. A study by Suraj Srinivasan, an assistant professor of accounting at the University of Chicago Graduate School of Business, finds that the likelihood of independent corporate director turnover increases with the magnitude of income-decreasing 10-K restatements.

Last year, the number of financial restatements surged again to a record 414 filings. According to Huron Consulting Group, the top five areas for reporting problems were revenue recognition; accounting for stock options and other equities; reserves, accruals and contingencies; capitalization and expensing of assets; and inventory valuation.