Undoing the past: implications of earnings restatements; The number of earnings statement restatements has risen sharply, and a Financial Executives Research Foundation (FERF) study sheds light on some of the consequences to companies and their executives.

Earnings restatements are in the news again, and it's no surprise that restated earnings often result in a serious blow to a company's stock price. On Jan. 4, 2005, Krispy Kreme Doughnuts Inc. said it would restate its financial statements for its 2004 fiscal year ended Feb. 1, 2004. That quickly hit the wires, and its stock price fell $1.83 that day, or about 15 percent. The restatement, the company said, was due to errors in how it accounted for the repurchase of franchises. It explained that such a restatement could reduce its earnings by seven to eight cents a share--more than the company had previously forecast--which could cause it to default on its credit agreement.

[ILLUSTRATION OMITTED]

Earnings restatements can also have dire consequences for the CFO and the outside auditors. On Dec. 15, 2004, Donald T. Nicolaisen, the chief accountant for the U.S. Securities and Exchange Commission (SEC) asked the Federal National Mortgage Association (Fannie Mae) to revise its financial statements to eliminate the use of hedge accounting. On December 21, Fannie Mae's Board of Directors announced the resignation of Vice Chairman and CFO J. Timothy Howard. On Jan. 4, 2005, Fannie Mae announced that its audit committee had approved the engagement of Deloitte & Touche LLP as it independent auditor to perform an audit of 2004 and a re-audit of prior-period financial statements, which will be restated.

These announcements came against a backdrop of increasingly frequent restatements. Huron Consulting Group recently announced that amended SEC filings for financial restatements rose to a record 414 in 2004, up 28 percent from 323 the previous year. The year 2003 had marked the first time that that restatement filings had leveled off, after an upward trend over the past five years, but they jumped up again in 2004. (See chart)

Jeff Szafran, managing director of Huron Consulting, suggests specific reasons for this increase in the number of restatements in 2004. "[It] was the first year of an unprecedented level of regulatory and audit scrutiny, driven primarily by The Sarbanes-Oxley Act of 2002," he says. Also, during 2004, Szafran points to other conditions:

* Public companies spent significant amounts of time and money to comply with the requirements of Sarbanes-Oxley Section 404, and may have found some accounting mistakes in the process.

* The Public Company Accounting Oversight Board (PCAOB) began reviewing the audit practices of the major accounting firms.

* The SEC budget jumped to almost twice what it was during 2001, and it used that budget to hire more professionals to enforce the law.

* The SEC established a new Office of Risk Assessment to look into the practices of certain industries.

* Auditors were doing more work, including testing companies' internal controls.

Szafran provides additional details on the 2004 restatement filings. Of the 414 filings, a record 253 were restated annual reports, which had been audited. The other 161 filings were restatements of quarterly reports, which were not audited. Of some concern to Szafran is that almost 40 percent (101) of the restated annual reports were three-year, multiple-year restatements. "Multiple-period restatements point to flawed accounting policies, practices and errors occurring over a long period of time, as opposed to one-time errors," he notes.

Responding to these numbers, the SEC's Nicolaisen says, "I am always concerned about restatements, but the apparent increase in the number of restatements in 2004 should not be cause for alarm. I suspect that a number of these restatements are due to a heightened focus on internal controls and corporate governance as a result of The Sarbanes-Oxley Act. If that's the case, then the process is working."

[GRAPHIC OMITTED]

Consequences of Restatements

Financial executives have always been particularly sensitive to an earnings restatement, which creates--at best--a perception that someone inadvertently made a mistake or, worse, that someone has committed fraud. They are now particularly sensitive to restatements, because Section 302 of Sarbanes-Oxley requires the CEO and CFO to certify annual and quarterly reports to the SEC.

But there are other consequences to financial restatements, besides the perception of either incompetence or fraud. The Krispy Kreme example cited above shows how the stock price can get hammered. This indicates that investors are revising downward their expectations of future cash flows. They might also be concerned about increased litigation risk or an increased cost of capital.

Additionally, in many cases, a company's credit ratings could be cut following an earnings restatement. In a research project for Financial Executives Research Foundation Inc. (FERF), Steven B. Lilien, professor of accountancy at Baruch College, and a team of researchers from Baruch College and Wake Forest University analyzed over 1,000 financial restatements between 1997 and 2002, then tracked how many of these restatements resulted in credit downgrades.

For their sample of restatements, the researchers used the 845 companies that restated earnings between 1997 and 2002 that were identified by the U.S. General Accounting Office (now known as the United States Government Accountability Office, or GAO) in its report to Congress, Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining Challenges. This was augmented by a search of the Dow Jones newswires for every public announcement of "restatement." In this way, a total of 1,010 restatements were identified.

The researchers then checked how many of the restating companies experienced credit rating changes. Of the total sample of 1,010 cases of restatements, 207 firms had credit rating changes over a two-year period, from one year before the restatement until one year after. Thus, at least 20 percent of the sample companies had at least one rating change.

To be conservative, the researchers decided that if a firm experienced more than one rating change in the same direction within each period (for instance, 6-12 months before a restatement) over this two-year timeframe, it would be counted as just one rating change. Using this method, there were 564 rating changes over the two years for the 207 firms, or an average of 2.7 rating changes per firm.

Of these 564 rating changes, most (413) were down, and most of those (328) followed the restatement. These numbers suggest that, in most cases, the rating agency had not anticipated that the company was having additional problems, and the newly restated data gave them sufficient reason for downgrade. Most rating changes made prior to restatements were also negative, so, in many cases, the rating agency had already identified potential problems and financial risks, which were later validated by the financial restatements made by the companies in question.

[ILLUSTRATION OMITTED]

Restatements: Solution or Problem?

Some believe that an earnings restatement will allow a company to "come clean," and investors will now have correct information with which to make their investing decisions. However, while a restatement may look like a solution to a problem, it may create as many problems as it solves.

Undoing the past is difficult and costly. Obtaining the required information for reconstructing the reported numbers may lead to delays in filing the reported results, as well as increased audit fees. Many of the retroactive adjustments require estimates which should have been based on information available at the time those statements were filed with the SEC. Several years later, that information may not necessarily be available.

Perhaps even more serious, a retroactive adjustment of earlier reported earnings may lead to situations where some revenues, expenses and even net assets will never once pass through a current period earnings statement or the balance sheet. In other cases, revenues and expenses could pass through income or the current balance sheet twice. For instance, the retroactive adjustment of an earlier period's income for a license fee that should have been deferred but was recognized, now ironically results in that same license fee been included in reported earnings a second time.

Even though it is safe to say that current management and its external auditors have determined that there was a violation of generally accepted accounting principles (GAAP) that caused a need for a restatement, the errors themselves are not necessarily straightforward.

The review of restatements suggests that they are not all done in situations where the revenue never existed or the inventory couldn't be counted. For example, there are difficult and complex accounting judgments in issues surrounding bifurcation of revenue.

Another example of difficult and complex accounting judgment occurs for a restatement involving the incorrect reliance on a particular consensus decision by the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB), and the substitution of a new EITF decision as the appropriate authority.

If Sarbanes-Oxley is as effective as planned, there will be increased documentation of internal controls, expanded activities of the internal audit department, greater involvement of the audit committee and greater scrutiny by the external auditor, so that the CEO and CFO can indeed certify the resulting financial statements. If all of this happens as expected, there could be a decrease in earnings restatements both this year and next (2006). If not, we will continue to search for other reasons.

Stephen Bryan ([e-mail]) is Associate Professor of Accountancy at Wake Forest University; Steven B. Lilien ([e-mail]) is Professor of Accountancy at Baruch College; William Ruland ([e-mail]) is Professor of Accountancy at Baruch College; and William M. Sinnett ([e-mail]) is Manager of Research for Financial Executives Research Foundation (FERF).