Earnings Restatements

1
Earnings Restatements

• Incidence
• Firm characteristics
• Stock market effects
• Causes
• Quantifying errors and materiality

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Restatements in 2006
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Growth in Restatements
Glass Lewis (2007)
4
Percentage of Companies Restating
5
Restatements and Company Size
Glass Lewis (2007)
6
Restatements and Auditor Type
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The Incidence of Restatements

• A significant portion (10) of publicly traded
  companies restated financials in 2006.
• The number of restatements has increased by over
  150 from 2003 to 2006.
• A disproportionate number of restatements come
  from companies with low market capitalization.
• A disproportionate number of restatements come
  from small auditors.

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Types of Restatements
9
Market Reaction to Restatements
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Effect of Restatements

• Restatements cost investors 10 of their stock
  value from the day before to the day after a
  restatement.
• The stock market starts to exhibit a decline 6 to
  8 months prior to the restatement (-16).

11
Factors that Affect Market Reaction

• Revenue recognition restatements generate more
  negative reaction to restatements
• Reaction related to impact on net income
• More negative reaction if restatement initiated
  by an outsider

12
Effect of Restatements on Markets Reliance on
Subsequent Financials

• Market response to earnings released after a
  restatement is lower than the response to
  earnings prior to a restatement.

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Firm Characteristics
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Characteristics of Firms that Restate

• Raise more funds through stock and debt
• Have lower free cash flows
• Have higher leverage
• Have more quarters with earnings per share growth
• Have more quarters with small positive forecast
  errors
• Have higher P/B ratio
• Have higher working capital growth
• Have higher long-term net operating asset growth
• ?Higher growth!!!!!!

15
Causes of Restatements

• Are restatements caused by earnings management,
  by bad internal controls, by accounting
  complexity, or by some other factor?
• The SEC performed a study on the underlying
  causes of restatements
• Books and records deficiencies
• Simple misapplications of GAAP
• Misapplications of GAAP with contributing factors
• Intentional misstatement

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Causes of Restatements

• The SEC found that
• Over half of the restatements are caused by books
  and records deficiencies or simple
  misapplications of GAAP, suggesting that
  accounting complexity is not the driver of
  restatements.
• One-third of the restatements had contributing
  factors.
• The factors most often contributing to the
  restatement are the use of judgment (15) and
  lack of clarity in the standard or proliferation
  of the accounting literature (15).

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Determining When an Error Exists

• Proposed FSP 154-a
• FAS 154 provides guidance on reporting the
  correction of an error that is material
• FAS 154 does not specify the appropriate method
  for quantifying whether a misstatement is
  material
• SEC issued SAB 108 to clarify but it only applies
  to SEC registrants

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Proposed FSP 154-a

• FSP 154 does not identify when a misstatement is
  material that is up to professional judgment.
• FASB Concept Statement 2 defines material as the
  magnitude of an omission or misstatement of
  accounting information, in the light of
  surrounding circumstances, makes in probable that
  judgment of a reasonable person relying on the
  information would have been changed or influenced
  by the omission or misstatement.

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Proposed FSP 154-a

• FSP 154 states that for purposes of evaluating
  the materiality of a misstatement, an entity
  shall quantify the effect of the misstatement in
  its current-year balance sheet and income
  statement using both the rollover approach and
  the iron curtain approach.

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Quantifying Misstatements

• Rollover Approach
• Quantifies a misstatement based on the amount of
  the error originating in the current year income
  statement
• Iron Curtain Approach
• Quantifies a misstatement based on the effects of
  correcting the misstatement existing in the
  balance sheet at the end of the current year,
  irrespective of the misstatements year of origin

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Proposed FSP 154-a

• If a misstatement is material to the current year
  financial statements using either the rollover
  approach or the iron curtain approach, then it
  must be corrected in the current year financial
  statements.
• The correction is required even if the prior year
  misstatements were and continue to be immaterial
  to the previously issued financial statements.

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Example

• Smudges, Inc. improperly accrues warranty expense
  of 20 each year for five years, such that the
  warranty liability is overstated by 100.
• Smudges previously concluded that the
  misstatement was immaterial to each of the
  previous four years.

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Smudges, Inc.

• Rollover approach
• 20 overstatement of expenses in current year
  income statement
• Iron curtain approach
• 100 overstatement of liabilities in current year
  balance sheet
• If either approach suggests that the misstatement
  is material then the current and previous
  financials must be restated.

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Proposed FSP 154-a

• If a company used either the rollover approach or
  the iron curtain approach and concluded that the
  misstatement was not material, then the effect of
  misstatements that must now be restated can be
  reported as a cumulative effect adjustment to the
  opening balance of retained earnings when this
  FSP is adopted.

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Restatements and Errors

• The incidence is rising quickly!
• The market reaction is pronounced.
• The SEC and FASB are trying to understand why
  there has been such an increase in restatements.
• The SEC and FASB are trying to put some
  systematic analysis into the materiality decision.