Ever since the days of Enron, financial restatements have been considered big news. Not all accounting mistakes are created equal, of course: thousands are discovered every year, but most are not material enough even to warrant a disclosure. A few, though, are severe enough to cause a restatement. The consequences could be grim: as serious as Enron’s bankruptcy, or as mild as a CFO losing their job.
In our 2012 restatements report, Audit Analytics disclosed that the number of financial restatements, after a period of turbulence, had finally stabilized. Average number of days restated is an indicator that measures the number of days that the restatement extends back. According to the same report, this indicator remained steady for three years dating back from the report.
On the other hand, an absolute value of the indicator averaged at 534 days. This means that companies had to correct an average of a year and a half of financial data. This raises a major question: why now? If the errors went undetected for so long, how were they finally discovered?
Audit Analytics identifies three categories of financial restatements.
- Financial fraud refers to restatements that were caused by intentional manipulation of financial data or by misappropriation of assets. This category is potentially the most harmful, since it raises questions about the integrity of the management, and about the overall health of the corporate environment. As harmful as they are, though, fraud-related restatements are relatively rare. In 2012, only 11 restatements were related to intentional misrepresentation of data.
- Clerical errors refers to restatements that were caused by simple clerical and bookkeeping errors, such as mathematical mistakes.
- GAAP/Foreign Accounting Principle failure or misapplication refers to errors that were caused by unintentional mistakes in the application of GAAP, IFRS, or foreign accounting principles. Most financial restatements fall into this category.
Most unintentional errors are discovered during annual audits. Companies whose financial year coincides with the calendar year typically review and prepare their annual reports between February and April of the subsequent year. Out of the 768 restatements covered in the 2012 Audit Analytics restatement report, 295 restatements, or 38%, were disclosed during this period.
In some cases, new SEC guidance may also cause a company to review its accounting policies. In February 2005, the SEC issued a clarification on lease accounting. The end result was more than 285 lease-related financial restatements in 2005 alone.
Sometimes a restatement by a large player may cause a snowball effect: a number of the company’s industry peers will likely find similar issues in their own reporting, and may also issue a restatement. During the end of 2005 and beginning of 2006, a number of analytical reports suggested an unusual correlation between the stock prices of various companies, and the number of options granted to their key employees. These revelations, while targeted at a few specific companies, caused an industry-wide avalanche of restatements related to deferred compensation practices. Since top executives were involved, investors perceived these restatements as very serious. In some cases, the SEC and the DOJ opened formal investigations.
Least-discussed among restatement triggers are routine examinations by the SEC. Comment letters do not guarantee a restatement. In some cases, errors are not material, while in others, the SEC will raise questions about errors that have already been disclosed. Still, in 2012 alone, 74 companies explicitly stated in their comment letters that they would restate financial statements as a result of discussions with the SEC. Interestingly, only 49 companies indicated in their restatements disclosure that the SEC was in any way involved in the restatement process.