Corporate Governance

Restatements, Restatements, Restatements: The Treasury Weighs In

By J. Robert Brown

We have followed on this Blog the shift in the number of restatements that have occurred since the adoption of SOX. The restatements are most likely the product of improved internal controls and the resulting discovery that prior financial statements are materially inaccurate. Evidence of this includes the fact that larger public companies, those subject to Section 404 for a number of years, are showing a decline in the number of restatements. In contrast, the companies not subject to Section 404 are an increasingly significant percentage of those companies restating their earnings.

The Secretary of the Treasury has already indicated that he is concerned about the number of restatements.  As he has previously noted: 

• Restatements "have the potential to confuse investors and erode public confidence in financial reporting.  Some of these restatements might not be material to investors, and others may simply reflect new accounting interpretations." 

Well the data is in.  A Treasury (aka the Paulson Department) commissioned study has produced data on restatements.  The data largely confirms what has already been written.  Moreover, it provides little real support for Paulson's view that investors may be confused or public confidence may have eroded.  What does the data show?  The study examined restatements from 1997 to 2006. According to the summary of the study:

• While the number of restatements increased from 90 in 1997 to 1577 in 2006, the bulk of the restatements were from non-exchange traded companies (increasing from 23% in 1997 to 62% in 2006).

The executive summary also pointed out that the growth in restatements preceded the adoption of SOX, with the growth beginning in 2001, "well in advance of the passage of the Sarbanes-Oxley Act."  The paper attributes the increase to the economic downturn.  Perhaps.  But 2001 was also the year of the collapse of Enron and probably the beginning of the period when relations between accounting firms and companies were becoming more arms length.  It has always been the case that the role of SOX in encouraging accounting firms to take a more neutral approach to audits of public companies had been overstated, ignoring the market forces (and concern over liability) that were pushing them in the same direction. 

In any event, once SOX was put in place, large companies found themselves needing to restate their financial statements.  "Section 404 appears to be associated with an increase in restatements beginning in 2003, particularly among large companies. The size of restating companies appears to diminish in 2006, after larger companies implemented SOX." 

As the number of restatements has increased, the number associated with fraud have remained steady and, as a result, declined as a percentage of restatements.  In addition, the market reaction to restatements has likewise declined.  The data is consistent with the market not reacting negatively to restatements that both result in improved financial reporting, something that will ensure greater accuracy for subsequent financial statements, and from restatements that do not reflect a fundamental problem with the company's business. 

Full post as published by The Race to the Bottom on April 24, 2008 (boomark / email).