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Home > Accountancy Best Practice > What Are the Leading Causes of Financial Restatements?

Accountancy Best Practice

What Are the Leading Causes of Financial Restatements?

by Todd DeZoort

Executive Summary

  • Financial restatements are serious corporate reporting failures that have the potential to undermine stakeholder confidence and decisions.

  • The quality of corporate governance, risk management, and compliance systems is critical in controlling financial restatement risk within organizations.

  • The number of financial restatements increased consistently after the Sarbanes–Oxley Act until 2007, when the number and magnitude of restatements started to decrease.

  • The research literature in accounting and finance provides useful evidence about the leading causes of financial restatements, including accounting complexity, transaction complexity, human error, and fraud.

  • The effects of restatements are widespread and contingent on the cause of the restatement. Possible restatement effects include negative market reactions, reduced credit access, and turnover within management and the board of directors.

Introduction

Both the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) in the United States highlight the importance of “reliability” as a primary qualitative characteristic necessary to make accounting information useful to users making economic judgments and decisions. Reliability in this context refers to a quality of financial reporting that makes it a verifiable, faithful representation of transactions and events that have occurred within an organization.1

Financial restatements represent reporting failures where companies admit that previous financial representations are not reliable. Such reporting failures have various potential causes and effects that can undermine company health and raise questions about the expertise and integrity of individuals that affect reporting, operations, and compliance. In the post-Sarbanes–Oxley era, financial report users (for example, investors, creditors, analysts) have seen an explosion in the number of restatements, giving rise to questions about why so many companies find it difficult to produce accurate information.

Understanding Financial Restatement Trends

Companies face daunting challenges when compiling financial reports that users rely on when making economic decisions. For example, managers preparing financial reports work in highly competitive business environments where they face: complex business transactions; the need to comply with complex accounting rules, regulations, and laws; pressure to control reporting and compliance costs; and powerful incentives to report results in the best possible light. Given the diversity and magnitude of these challenges, huge emphasis has been placed on the importance of quality governance, risk assessment, and compliance (GRC) systems to help companies achieve their objectives and ensure accountability among key players in the financial reporting process.

Financial restatements must be made when financial GRC systems fail and companies file annual or quarterly reports that are not in conformity with generally accepted accounting principles (GAAP). Companies filing misstated financial statements must restate and correct previous reported results. For example, US public companies that file inaccurate reports are required to provide a formal restatement announcement in 8-K filings with the Securities and Exchange Commission (SEC).2 Further, the SEC highlights that “the restatement process, which may take longer than 12 months, imposes significant costs on investors as well as preparers. During that process, companies often go into a ‘dark period’ and issue very little financial information to the public.”3 Some companies attempt to avoid alarming users by providing “stealth restatements” that are disclosed in quarterly or annual reports without formally filing an 8-K.

Although restatement numbers in the United States increased prior to 2000, the passage of the Sarbanes–Oxley Act of 2002 (SOX) prompted a dramatic increase in the number of financial statements filed each year. The Act (for example, Section 404 on internal controls) created significant focus on the quality of financial governance by management, audit committees, internal auditors, and external auditors.

Interestingly, Figure 1 indicates that the number of financial restatements in the United States dropped in 2007 for the first time since the passage of the SOX, although over 1,200 restatements were still filed. The recent decrease in number of restatements has been accompanied by recent decreases in the average number of issues per restatement and the average income effect. For example, Table 1 reveals that the average income decrease per restatement in 2005 was over $21.3 million; in 2006 the average income decrease was $17.8 million. In 2007, the average income decrease dropped to only $3.6 million.

Table 1. Restatement characteristics. (Source: Audit Analytics, 2008)

Average income effect

Average number of issues

Average restatement period

2005

–$21.33 million

2.41

746 days

2006

–$17.81 million

1.97

710 days

2007

–$3.64 million

1.87

643 days

These trends raise questions about whether financial reporting is actually improving or whether regulators are simply becoming more lenient in their approach.

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Further reading

Articles:

  • Archambeault, D. S., F. T. DeZoort, and D. R. Hermanson. “Audit committee incentive compensation and accounting.” Contemporary Accounting Research 25:4 (2008): 965–992.
  • Graham, J. R., S. Li, and J. Qiu. “Corporate misreporting and bank loan contracting.” Journal of Financial Economics 89:1 (2008): 44–61.
  • Srinivasan, S. “Consequences of financial reporting failure for outside directors: Evidence from accounting restatements and audit committee members.” Journal of Accounting Research 43:2 (2005): 291–334.

Reports:

  • Audit Analytics. “Financial restatements: A seven year comparison.” February 2008. For purchase online at: www.auditanalytics.com
  • Audit Analytics. “Financial restatements and market reactions.” March 2008. For purchase online at: www.auditanalytics.com
  • Glass, Lewis & Co. “Restatements: out of sight, out of mind.” May 30, 2008. Available from Glass, Lewis & Co. by subscription from: www.glasslewis.com
  • Government Accountability Office. “Financial restatements: Update of public company trends, market impacts, and regulatory enforcement activities.” Washington, DC: US Government Accountability Office, 2007. Online at: www.gao.gov/new.items/d06678.pdf
  • Plumlee, M., and T. L. Yohn. “An analysis of the underlying causes of restatements.” Working paper, 2008. Online by search at: www.ssrn.com
  • Scholz, S. “The changing nature and consequences of public company financial restatements 1997–2006. Department of the Treasury, 2008. Online at: www.imanet.org/pdf/USTR.PDF
  • Securities and Exchange Commission. “Final report of the Advisery Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission.” Washington, DC: SEC, 2008.

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