March 17, 2008
Two Items on Financial Restatements
The SEC's Advisory Committee on Improvements to Financial Reporting met last week in San Francisco, and discussed a February report from the Committee finding that companies are restating financials "for trivial reasons that have no bearing on their true financial situation," as BNA sums up the report. Ultimately, the Committee report proposed that:
· Prior period financial statements should only be restated for errors that are material to those prior periods.
· The determination of how to correct a material error should be based on the needs of current investors. For example, a material error that has no relevance to a current investor’s assessment of the annual financial statements would not require restatement of the annual financial statements in which the error occurred, but would need to be disclosed in an appropriate document, and, to the extent that the error remains uncorrected in the current period, corrected in the current period.
Although this seems to me to be a sensible position, a number of concerns were raised by consumer and investor advocates and some institutional investors. Most notably, a representative from the Capital Group, a very large fund manager, argued that a company should restate previously reported amounts for individual income and expense items on the income statement even though the previously reported net income number would not change as a result, stating that "[w]e are very interested in the corrected individual components of the income statement and use the changes in specific income and expense items over time as part of our trend analyses."
The Capital Group’s position aside, I suppose that the real value in restatements for investor rights advocates is that a restatement is sometimes a prelude to a securities litigation claim—decreasing the number of restatements will probably decrease the number of securities fraud suits, which investor advocates promote as an important check on management.
In related news, Plumlee (Utah) and Yohn (Indiana) recently posted on SSRN a study entitled An Analysis of the Underlying Causes of Restatements :
The dramatic increase in the volume of restatements over the past years has been attributed to causes such as the complexity of the accounting standards, internal control reviews, changes in materiality thresholds, the overly conservative nature of auditors, earnings management, increased transaction complexity, and the second guessing of management judgments. While there are many explanations for the increased number of restatements, empirical evidence on the underlying causes of restatements has been lacking. This study provides such evidence by directly addressing the questions of what causes restatements, what characteristics of the accounting standards cause restatements, and whether the materiality threshold for restatements has fallen over the years. We analyze the disclosures related to each restatement filed during 2003 through 2006 and identify and categorize the underlying cause of each. Using these data, we analyze the relationship between the causes and various firm characteristics, including size and auditor type. We also consider the impact of contributing factors (including the clarity of standards and the use of judgment) on restatements caused by characteristics of the standards.
We find that, inconsistent with the notion that increased complexity has caused the rapid increase in the number of restatements, restatements are most often caused by basic internal company errors unrelated to the accounting standards themselves. We also find that for those restatements caused by some characteristic of the accounting standards, the primary contributing factor was the lack of clarity in applying the standards and/or the proliferation of the literature due to the lack of clarity in the original standard. Judgment and the use of bright lines are much less frequently cited as the contributing factors, and the proportion of restatements that they are related to has decreased across our sample period. Finally, we find some evidence that the materiality threshold applied in the decision to restate appears to have decreased over our four year sample period.
Posted by: Paul Rose