Annual Financial Restatements Continuing to Generate Significant Attention

Annual Financial Restatements Continuing to Generate Significant Attention
Sarbanes-Oxley and Increased Regulatory Scrutiny Considered Major Factors

By Craig Casey and Debbie A. Cutler

Nearly four months after Huron Consulting Group released its “2004 Annual Review of Financial Reporting Matters,” financial restatements continue to make headlines. The report, which analyzed the leading causes and trends in financial restatements for 2004, reported a record increase in the number of restatements filed last year—rising to a record 414, up from 323 in 2003. The dramatic 28 percent increase took many in the industry by surprise after restatements had leveled off in 2003.

According to the report, several trends and events led to the increased number of restatements. First and foremost, the Sarbanes-Oxley Corporate Governance Act, which requires publicly held companies to annually certify the soundness of the company’s internal financial-reporting controls, has had a significant impact in this regard. Many companies implemented the certification procedure for the first time last November, and it is no doubt linked to many of the reported restatements.

Other contributing factors included the expanded purview of the Securities and Exchange Commission, compliance reviews from the newly formed Public Company Accounting Oversight Board, and more-assertive auditors who are less likely to ignore indications of financial wrongdoing in the wake of the corporate scandals of recent years.

Not surprisingly, all of these changes have put publicly held companies under unprecedented scrutiny to thoroughly document, test and take responsibility for the effectiveness of their company’s financial reporting safeguards and systems.

Similar to previous years, the Huron report found five categories of accounting issues that accounted for nearly 60 percent of the problems reported in the 2004 financial restatements. The underlying causes for these restatements included misapplication of accounting rules, human error and ethical lapses. The three leading reasons for restatements were accounting for: revenue recognition; equity accounting; and reserves, accruals and contingencies.

The Huron study also found that a significant percentage of companies restating results last year had experienced previous financial trouble. Fifteen percent of the restatements reported in 2004 had been filed by “repeat filers,” or registrants, that had reported erroneous financial information on more than one occasion since 1997. Although this trend does not bode well for these particular companies, it does indicate that fewer companies are contributing to the problem than the number of filings would suggest.

In addition, the report found that in 2004, the number of filings involving restated annual audited financial statements rose to a record high of 253, representing 61 percent of the total restatements filed during the year. This compares to 64 percent in 2003, 56 percent in 2002, 52 percent in 2001 and 42 percent in 2000.

Huron’s report also identified a rising trend in the number of periods contained in each restatement. For the fifth consecutive year, the number of filers reporting errors in at least three of the prior annual periods rose; in 2004, to nearly 40 percent. According to Huron, this trend is most likely an indication of ongoing problems with a company’s accounting policies, practices and errors, rather than an example of a one-time error.

Effective Aug. 23, 2004, new Form 8-K regulations went into effect relating to “Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review” (restatements). Prior to this regulation an 8-K filing was not required for restated financial statements. The new Item 4.02 states that disclosure is required within four business days of (i) when a company’s board of directors or officer of the company concludes that any of the company’s previously issued financial statements should no longer be relied on, or (ii) when a company receives notice from its auditors that a company should make disclosure or take action to prevent further reliance. A separate 8-K must be filed even if a triggering event occurs within four business days before a registrant’s filing of a periodic report.

In terms of what lies ahead, financial restatements are likely to continue making news for the foreseeable future. Companies appear to be more conservative and are electing to restate voluntarily rather than be questioned by regulators. In a Feb. 7, 2005, letter from SEC Chief Accountant Donald T. Nicolaisen to the chairman of the Center for Public Company Audit Firms, Nicolaisen issued the SEC staff’s views on certain lease accounting matters. He noted there have been a number of recent restatements attributed to lease accounting. Most in the industry agree that the number of restatements reported over the next few years will remain higher than average as companies continue to clean up their books and the new accounting controls and standards become institutionalized across the industry.

Craig Casey is a managing director at Huron Consulting Group’s Disputes and Investigations Practice, and Debbie A. Cutler is a partner at Kramer Love & Cutler LLP in Manhattan and a member of the New York State Society of CPAs.