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.

Complexity Up, Skills Down?

The reasons companies give for most amended filings will not surprise most CFOs. The problem areas vary by industry; revenue recognition is a major concern in the software industry, for example, but a lesser challenge in financial services and real estate, where reserves, accrual and contingencies represent the top reasons for restatements. But these problem areas have largely held steady across most sectors for the past five years.

A deeper question for senior finance executives is why revenue recognition, inventory valuation and other accounting treatments have become such problems. The answer involves the evolution of financial reporting rules, changes in the corporate finance function and the increased complexity of accounting.

The Sarbanes-Oxley Act and rule changes at the New York Stock Exchange addressed the reporting relationships of the internal audit executive, who now reports to the audit committee but also maintains a dotted-line relationship to the CFO or CEO at most public companies. Other reporting lines are changing to help reduce the likelihood of erroneous judgment calls in accounting gray areas. Stone has observed recently that more manufacturers are establishing a solid-line relationship between the controller and the corporate CFO and a dotted-line relationship with the plant general manager. In the past, companies gave controllers a dotted reporting line to the corporate CFO and had them report directly to the general manager. Business-unit or plant finance executives who report to business-unit executives (presidents and general managers) face more direct pressure to massage the numbers to meet the business unit or plant's performance objectives and financial forecasts. That reporting structure contributed to the rise in restatements but is now changing, according to Stone's field evidence.

Finance has undergone a gradual transformation into a more strategic, efficient and complex function during the past decade. The department's inclusion in corporate strategic planning is evident in each of the past five Business Finance Career and Compensation Surveys, which show that finance executives whose roles favor strategic contributions over transactional activities are more valued and more highly compensated by their companies. In many organizations, the addition of strategy to finance's list of responsibilities has reduced the time spent on traditional accounting areas, leaving the function vulnerable to error.

Cost-cutting has also altered the face of the function. CFOs slashed payrolls and hired or retained less-qualified employees in their quest for leaner departments, but their efforts may have compromised their companies' supplies of technical accounting expertise. Research firms such as The Hackett Group have reported that the highest-performing companies have steadily lowered their corporate finance costs. Today, top finance groups cost their companies a mere 0.7 percent to 0.8 percent of revenue.

Stone agrees with the need to create more efficiently run finance functions, but he and others believe many companies sacrificed too many employee skill sets, including transactional accounting expertise, in their push to attain efficiency benchmarks. "Did we ratchet down finance costs too tightly?" Stone asks. "I think that explains part of the problem."

Companies need to rethink cutting accounting personnel as a means of trimming finance costs and boosting efficiency. The need to retain top talent has not diminished. Why? Because the complexity of accounting has significantly increased. Fifteen years ago, one of the toughest challenges finance and accounting departments faced was determining earnings per share. Today's knotty tax issues, Byzantine financial instruments and fair-value accounting demands can make those old EPS determinations seem quaint.

The Audit Committee Takes Over

In the immediate future, however, accountants must focus on preventing financial reporting errors and on taking action when they do occur. In practice, many different sources can identify accounting irregularities that result in restatements, says Boston-based Jeffrey Szafran, managing director of Huron Consulting Group's disputes and investigations practice. The external auditor most commonly spots the need for a restatement. Often, the problem is uncovered when a new external auditing firm conducts an audit and finds fault with past accounting treatments. The dissolution of Arthur Andersen four years ago and subsequent post-Enron scrutiny by audit committees sparked a flurry of auditing-firm turnover that coincides with the rise of financial restatements.

Whistleblowers, management, the SEC and media investigations also pinpoint problem spots. Not all restatements require an investigation, so once the need for a restatement has been identified (or an allegation made), the audit committee must determine whether an investigation is necessary, says Szafran.

In his study of the impact of restatements on board members, Srinivasan identifies three types of restatements: those that lower reported income, those that increase reported income and those that involve only technical errors. The first type of restatement almost always results in an audit committee investigation; the other types may or may not lead to an inquiry. The audit committee typically hires its own external counsel, which often brings in forensic accountants for assistance.

"The investigation is more focused and dives much deeper into a specific area than an audit ever would," explains Szafran. The forensic accounting team typically includes IT experts, he says, who take forensic images of hard drives. The files, e-mails and deleted data (which still resides on hard drives) are then scoured by the investigators, who use key-word searches and other techniques to ferret out evidence. The investigators also conduct formal interviews of all the finance and accounting and business managers who may have been involved with the error's occurrence.

A regular audit operates under the presumption that management acts with integrity. Since fraud is one cause -- albeit rare -- of accounting problems, restatement investigations usually operate without that presumption. "One of the goals of any investigation is answering the question: Does management have integrity?" notes Szafran. "And that represents a very different starting point than a normal audit."

The audit committee's goals are to find out why the errors occurred and to oversee correction of the financial statements. Setting the scope of the investigation represents a major challenge for the board. "Audit committees invariably want to drive the issue to the ground and answer the questions," says Szafran. "But you also want to avoid doing something that's going to take four years and cost $100 million. There is a balancing act, one that requires judgment and experience involved in setting the appropriate scope of an investigation." Short investigations are measured in weeks, he adds, while a typical investigation lasts several months or years.

Roger Raber, president and CEO of the National Association of Corporate Directors (NACD) in Washington, D.C., notes that most restatements reflect poor documentation of transactions, the wrong choice of accounting treatment, lack of transparency, and/or weak internal controls.

"Good audit committees keep a lookout for all these things," he explains. "And they urge a speedy and accurate restatement when problems surface. That said, for an audit committee to govern, members of the audit committee must be financially competent to understand how the company operates and provide oversight of the company's finance and accounting."

A Time-Consuming Process

The SEC typically conducts its own investigation, which almost always lasts longer than the audit committee's inquiry. Most companies cooperate with the SEC investigation by sharing the results of the audit committee's investigation. Shareholder lawsuits can also crop up.

All of this examination demands large amounts of time and cooperation from senior finance executives, who must also conduct business as usual during the scrutiny. "You can see where the time goes," says Szafran. "You have to explain what happened to several different parties. If a lawsuit is filed, it tends to drag on and can be a huge distraction."

CFOs involved in a restatement should be patient with investigators, active in reaching their own conclusions and extremely communicative. Once the accounting issue has been identified, the corrective action -- the appropriate accounting -- needs to be approved by the forensic accountants advising the audit committee, the CFO and senior management, and the external auditing firm, which provides an opinion.

"Just because there is an investigation, I don't think the CFO sits back and says, 'OK, they're going to take care of it,' " says Szafran. "The CFO and management need to come to their own view as to a) whether the original accounting was wrong and needs to be restated; and b) what the new accounting should be."

Finance executives should also try to step into the shoes of their audit committee members to understand the need for an exhaustive investigation. Srinivasan's study, based on 201 income-decreasing restatements filed between 1997 and 2000, finds that only 6 percent of outside directors were named in shareholder lawsuits during that stretch. However, he also concludes that the "reputational harm" endured by outside directors involved in financial restatements -- the loss of their board positions and of future directorship opportunities -- is much heavier than their legal costs.

That helps to explain why boards are so intent on sniffing out the errors and any signs of wrongdoing during restatement investigations -- and why CFOs should be as cooperative as possible in assisting the investigations. After all, Stone notes, "the last reason any CFO or CEO wants to appear on the front page of The Wall Street Journal for is a financial restatement."