Time for us to consider restatements

ACCOUNTANCY

The number of accounting restatements made by US companies have increased dramatically over the past years. Glass Lewis & Company, a leading research and professional services firm in the USA, reported that the number of restatements by US public companies rose from 116 in 1997 to 1,195 in 2005 and 1,538 in 2006.

In the US, an accounting restatement must be made when the annual or quarterly reports filed with the Securities and Exchange Commission (SEC) are found to be not in accordance with GAAP. Whenever such misstatements are discovered, companies must file amended (restated) financial statements that correct prior results. Since restatements are a public acknowledgement of the violation of the Generally Accepted Accounting Principles (GAAP) or of accounting manipulations, their growing number raises serious concerns about the functioning of the financial reporting system.

Research into this dramatic increase in reinvestments has come up with a number of plausible causes. Some researchers have found evidence that capital market pressures motivate companies to violate accounting standards, eventually leading to accounting restatements. They observed that firms restating earnings have high market expectations for future earnings growth and relatively high levels of outstanding debt. Evidence also suggests that restating firms are more likely to be those which had been attempting to maintain a long-running string of consecutive positive earnings growth and consecutive positive quarterly earnings surprises. Some researchers have also found evidence to suggest that a primary motivation for accounting earnings manipulation is management's desire to attract external financing at low cost. Some believe that the widespread shift towards equity based compensation has played a role in undermining the accuracy of accounting information.

On the other hand there are those who believe that increase in the number of restatements does not signal an increase in accounting manipulations at all. They attribute the growing number of restatements to an overly conservative attitude in the restatement of even those errors that are not material. Similarly, others believe that regulatory reforms like the Sarbanes Oxley Act have forced companies to look harder at financial reporting and correct even those kinds of errors that might have been overlooked in earlier years ""voluntary restatements being more welcome than forced restatements. It is also argued that the rise in restatements can be traced to the increased complexity of accounting standards and reporting rules.

SEC staff reviewed some of the restatements disclosed in filings from 2003 to 2005 to get an insight into the causes of errors and restatements. The findings suggest that approximately one-third of the errors related to situations in which there were one or more contributing factors from outside the company. In around 15 per cent of the restatements, the use of judgement in applying accounting standards was cited as a contributing factor to the error. Another 15 per cent of the time, one or more attributes of the accounting literature seem to have been an underlying factor that contribute to the error. For example, lack of clarity in accounting standards, difficulty in identifying all of the relevant accounting literature and the complexity of the accounting literature contributed to the error.

One paradox regarding restatements is the observation that capital markets do not react significantly to restatements. This lack of market reaction signals has been used by some in the US to argue that restatements are not important and should be discontinued. However, the argument is not tenable. It is inappropriate to allow managers to publish erroneous statements and then to leave them that way. It is unwise to assume that market know errors before they are disclosed.

Markets do not overreact to restatements because restatements do not provide surprises and shocks. Earlier, restatements used to be viewed as confessions of misdeed. But now, the markets do not see it that way. Restatements provide an opportunity to clear the uncertainty about the correctness of financial statements. Restatements not only provide new information, they provide reassurance to the market that once an error has been detected, it will not recur in the future.

Many argue that restatements reflect a failure on the part of 'reputational intermediaries', including auditors, on whom investors rely for verification and certification. Many believe that restatements also signal the failure of the internal auditor and the audit committee. However, in most investigations auditors were not found guilty of negligence. Interestingly, in the pre-Sarbanes Oxley Act regime, disclaimers by audit committees were not uncommon. In May 2005, in a story relating to restatements by American International Group Inc. (IAG), the insurance giant, Washington Post reported that in 2001 and 2002 the five-member audit committee reported in an annual corporate filing that the committee oversight did "not provide an independent basis to determine that management has maintained appropriate accounting and financial reporting principles." Further, the committee said, it could not assure that audit had been carried out according to normal standards or even that PwC was in fact 'independent'. Some experts felt that this should have been seen as a red flag. Perhaps, the audit committee wanted to distance itself from undisclosed or undiscovered accounting problems. In fact, a good corporate governance system does not ensure that accounting errors would not occur.

In India we do not yet have the practice of 'restatements'. Perhaps it was not required earlier because business models were not complex and accounting was simple. But, situations have changed, and changing rapidly. Indian companies are using complex business models and using innovative financial instrument to manage financial risks. India will adopt IFRS effective from 2011. Therefore, it is the time to consider whether we should also adopt the US practice of restatements of financial statements.