Many companies have been turning to
financial restatements to ensure
compliance with today’s complex financial reporting requirements. Restatements can damage public perception of a
company and can be costly in other ways.
“Aside from negative market reaction,
there are direct costs to the company associated with restating a prior period’s financial statements,” says Dan Perushek, an
audit manager with Haskell & White LLP.
“These costs could be substantial and would
include the time incurred by company personnel in restating the financial statements
as well as fees paid to professional service
firms for regulatory compliance or even public relations services related to the financial
restatement. Lastly, restatements may create
legal exposure for companies.”
Smart Business spoke with Perushek
about how financial restatements may affect
your business and how to avoid them.
What do recent trends in restatements show?
The occurrence of financial restatements
has increased significantly in recent years. A
study conducted by the U.S. Department of
Treasury revealed an 18-fold increase in
financial restatements by public companies
from 90 restatements in 1997 to nearly 1,600
restatements in 2006. While a more recent
study on 2007 financial restatements indicated a 17 percent decrease in restatements by
public companies, compared to 2006, current restatement levels are still well above
those of a decade ago.
Studies indicate that the occurrences of
restatements at smaller companies are
increasing at a higher rate than their larger
company counterparts and for different
reasons.
Larger companies restate their financials
to account for revenue recognition and complex accounting issues, such as derivatives,
asset valuations, taxes and foreign subsidiary consolidations. On the other hand,
smaller companies deal with accounting
issues related to ongoing operating expenses, stock-based compensation and debt-related accounting, particularly in growth-oriented organizations likely to rely heavily
on stock-based compensation and convertible debt financing.
What has contributed to these trends?
In 2004, Section 404 of the Sarbanes-Oxley
Act of 2002 required large public companies
to document, test and report on internal controls over financial reporting, and auditors
were required to attest to management’s
internal control over financial reporting
assertions. Efforts to implement this process
increased the frequency and effectiveness of
identifying ongoing financial misstatements
leading to an increase in financial restatements after 2004.
While this process has helped larger public
companies identify financial misstatements
and should help reduce occurrences of
future restatements in larger companies,
smaller companies have not yet been
required to fully implement the process.
Finally, with the issuance of new and complex accounting standards over the past several years, there has been a general increase
in accounting errors related to the application of these standards.
How do restatements affect investors?
Financial restatements typically result in a
negative market reaction, the severity of
which is usually determined by the nature of
the restatement. While restatements related
to fraud, revenue recognition or core operating expenses usually elicit the most severe
reactions, restatements related to nonreoccurring expenses, reclassifications or disclosures generally result in a less severe reaction. These negative market reactions can
result in a loss of stock value for the company shareholders, a decrease in debt rating or
investment grade, compliance issues with
financing agreements, damage to the public’s
perception of the company and, possibly, litigation initiated by financial statement users.
How can financial restatements be avoided?
Avoiding financial restatements begins with
ongoing identification of the areas within a
company’s financial reporting process that
could potentially result in a financial reporting misstatement. Management team members should pay particular attention to financial reporting areas involving complex
accounting issues requiring the application of
complicated accounting standards, financial
reporting areas requiring significant use of
estimates as well as reporting areas affected
by recently issued accounting standards.
Management should also consider their organization’s susceptibility to fraudulent financial reporting and misappropriation of assets.
The implementation of controls effectively
designed to mitigate such risks are essential
to avoiding current financial misstatements
that could potentially result in future restatements. Once implemented, monitoring these
controls periodically for effectiveness is critical to ensure financial reporting is correct.
When addressing financial reporting issues
involving significant estimates or matters of
judgment, it is important for management to
consider qualitative as well as quantitative
factors during decision making processes.
Finally, it is imperative that company management teams maintain a timely awareness
of new accounting standards as they are
released, and assess how any newly issued
guidance affects their company’s financial
reporting. And, it is equally important that
management allocate the proper resources
necessary to ensure the proper application of
new accounting standards.
DAN PERUSHEK is an audit manager with Haskell & White LLP. Reach him at (949) 450-6349 or [email protected].
