Do restatements mean Sarbanes-Oxley is working?

Restatements Should Be Eyed Suspiciously," read the headline of an item by Bruce Meyerson, national business writer for The Associated Press, earlier this year. Noting the oft-cited Glass, Lewis & Co. restatements study, "Getting it Wrong the First Time" Meyerson warned it is "best to view restatements with the suspicious eye of an exterminator: where there's one, there may be more."

The Glass, Lewis study was also cited in Glenn Cheney's article, "Making Sense of Revenue Recognition," on page 32 in this issue. Cheney writes that shareholders "can't help but wonder whether the restatement is a case of accounting confusion or shenanigans." Meyerson took a darker view, grouping restatements into three categories: "honest error," "aggressive corporate mentality" or "intentional deception."

The data raise a number of questions. For instance, how many of the 1,295 restatements indicate fraud or intentional deception, vs. "honest errors" resulting from the "complicated ... unclear mishmash" of accounting standards?

To what extent is Sarbanes-Oxley Section 404 driving restatements--or, on the flip side--to what extent are restatements driving reported "material weaknesses in internal control?" Is the reporting of such material weaknesses serving the intent of Section 404 in rooting out fraud and building investor confidence? Can investors readily discern restatements resulting from changes in reasonable, good-faith judgments under generally accepted accounting principles (GAAP)--previously signed off by company management, auditors and legal counsel, but subsequently reinterpreted due to an error or fraud?

The questions above can be summarized as: do restatements mean Sarbanes-Oxley is working? Or that Sarbanes-Oxley needs more work? A number of developments in Washington may hold keys to a possible answer.

Recent Developments

First, an "all-out war on complexity" has been called for by SEC Chairman Christopher Cox. At a March 29 Congressional hearing, FEI President and CEO Colleen Cunningham, leaders of other business and professional associations and representatives of the SEC, PCAOB and FASB concurred that it is time for all interested parties to come together in this "war on complexity."

Second, on May 17, the SEC and PCAOB announced "next steps" for Sarbanes-Oxley compliance, including an SEC concept release aimed at easing compliance and potential amendments to PCAOB Auditing Standard No. 2 (AS2). AS2 was cited by some participants at the SEC's and PCAOB's May 10 roundtable on internal control as driving an inordinately high level of restatements, with questionable benefit to investors. Cunningham participated in the Roundtable, citing FEI's recent Section 404 survey, and recommendations of FEI's Committee on Corporate Reporting (CCR).

"Restatements are a problem," PwC CEO Samuel DiPiazza told the May 10 roundtable. He explained there are "very serious issues" about when a restatement--defined in AS2 as, at a minimum, a significant deficiency and a strong indicator of a material weakness--leads to a material weakness and an adverse opinion on internal control. DiPiazza called on the regulators for help on what has been interpreted as a "default" provision of AS2, and asked for further guidance on materiality as soon as possible.

The SEC previously indicated it plans to release guidance on materiality, which is expected to set forth the staff views on use of the "iron curtain" vs. "rollover" method for assessing materiality. The SEC may also consider the need for guidance on interim (quarterly) vs. annual materiality, and how that factors into restatements.

The impact of restatements on investor confidence cannot be ignored. Gleason, Jenkins and Johnson found in its 2004 study, Financial Statement Credibility--The Contagion Effects of Accounting Restatements, that "accounting restatements induce an economically meaningful share price decline among non-restatement firms in the same industry."

Should restatements be eyed suspiciously? My answer is "yes." Do restatements mean Sarbanes-Oxley is working? The 2002 Act may be working in overdrive. The combination of restatements, with fear of the current litigation environment and the complexity of financial reporting requirements, is causing the unintended consequence of classifying nonfraudulent matters as "material weaknesses" in internal control.

FEI Senior Vice President Grace Hinchman noted in Congressional testimony earlier this year that FEI was one of the first organizations to support the Sarbanes-Oxley Act, and continues to believe in its goals. The regulators have the opportunity--and the responsibility--to streamline financial and internal control reporting to better meet the intent of the Act. The "next steps" announced by the SEC and PCAOB on May 17 can go a long way toward achieving this.

Edith Orenstein ([e-mail]) is Director, Technical Policy Analysis for FEI.