Restatements Should Subside As 404, Lease Issues Fade

Public companies set a record in 2005 that they may not want to celebrate. Thanks to Sarbanes-Oxley Section 404 and lease accounting issues, 2005 was a record year for restatements. But experts say the outlook should be better for 2006.

Turner

2005 saw more than 1,200 restatements—about double the number for all of 2004, says Lynn Turner, Glass Lewis & Co. managing director of research and former chief accountant of the Securities and Exchange Commission. In most cases, Section 404 and lease accounting were the culprits. “If it wasn’t for those two factors, we would’ve seen a drop in restatements,” he says.

For companies domiciled in the U.S., the number of restatements jumped from 619 in 2004 to 1,198 in 2005. Restatements by foreign companies jumped from 31 to 72, Turner told Compliance Week. “Far and away, the biggest factor in restatements for 2005 was the number of errors that people found when they did their Section 404 compliance work,” says Turner. Of more than 1,200 restatements in 2005, 620 involved companies where there was also a material weakness, according to Glass Lewis’ research.

“Lease accounting restatements caught the financial reporting world by surprise,” says Jeffrey Szafran, a managing director at Huron Consulting Group. Noting that most companies “believed when they were doing it that they were getting it right,” Szafran says that the lease accounting problems yielded restatements starting in the fourth quarter of 2004 that “rippled through the entire financial reporting world.”

In addition to lease-related restatements, Szafran says that Huron Consulting had identified “the same three accounting issues” that had driven restatements in prior years: revenue recognition; reserves, accruals and contingencies; and equity accounting.

Szafran

In the equity accounting area, Szafran says a combination of both complex accounting rules and increasingly complex accounting instruments are to blame. While the accounting rules for reserves aren’t complex, Szafran says accounting for reserves “requires a great deal of judgment, which makes that area prone to second guessing and applying different judgments to the same set of facts.” According to Szafran, those factors can make equity accounting more susceptible to acts of bad faith. The same is the case with revenue recognition, says Szafran, where complex rules and judgment calls make the area “ripe for unintentional and intentional accounting error.”

For foreign issuers, Turner says tax accounting and incorrectly recording items in the equity section of their balance sheets accounted for many restatements. For example, he says, 10 of the 72 foreign issuer that restated improperly accounted for hedges.

A Decrease In 2006?

Akram

To some, the large number of restatements was not a surprise. “We had expected 2005 to be the year of the restatement, primarily because of Section 404,” notes Raja Akram, senior director of credit policy at Fitch Ratings.

Jeffrey Szafran at Huron Consulting agrees that 2005 was probably an anomaly, calling it “a fairly unique event in the financial reporting world.”

In fact, Szafran echoes the sentiment of several experts, who told Compliance Week they expected the number of restatements to drop in 2006. “Given the unique circumstances surrounding the leasing restatements and the fact that large companies have been under Section 404 for a year, I’m hopeful restatements will decrease in 2006,” he says. “Right now, there’s nothing on the horizon in the financial reporting world that we see causing that kind of impact.”

“I would suspect number of restatements next year will drop significantly because we won’t have the lease accounting issue, we won’t see as many restatements coming from SOX 404, and we still have a year before the small companies will have to [comply with 404],” agrees Turner at Glass Lewis. “I think if small companies have to implement 404, we’ll find a lot of the same problems.”

However, Turner says the expected decline in restatements in those two areas may be partially supplanted by two other potential issues. “There’s a risk that we could find more companies that have done their hedge accounting wrong,” he says (see related article above, right). “And, as the taxing authorities here and overseas start to clamp down, I’d expect to see heightened scrutiny with respect to income tax accounting that could trigger some more restatements.”

RESTATEMENTS, ANYONE?

The excerpt below is from Fitch Ratings' special report, "Accounting and Financial Reporting Risk: 2006 Global Outlook—Serenity Now?" published Jan. 24, 2006.

Financial restatement, whatever its cause, adds

another tier to the analysis that needs to be carried

out. A new FASB standard, SFAS 154, requires

companies to restate prior periods for changes in

accounting principles. Statements for prior years

must be restated as if the company had always used

the new principle. However, an impracticality

exception is provided. Fitch expects that this will

result in an increased number of discretionary

“restatements” driven by changes in accounting

principles in 2006. Additional work will be required

on the part of the investors to differentiate these

“discretionary” restatements from restatements

driven by errors or fraud. Through clear and concise

disclosure preparers can help to explain the reasons

for various restatements—i.e., whether these were mandatory or discretionary. There is still a risk that

genuine errors may be hidden behind voluntary

restatements, and it may well be impossible for

investors to separate the two. In addition, the

impracticality exception may result in false

comparability and distort trend analysis, where users

of the accounts believe that they are comparing

financial information prepared on the same basis,

when in fact companies may have retrospectively

applied a new accounting principle differently from

one year to the next on the basis of their ability to do

so.

Source:

Accounting And Financial Reporting Risk: 2006 Global Outlook—Serenity Now? (Fitch Ratings; Registration Required; Reprinted With Permission)

Akram at Fitch Ratings is expects that restatements will drop from 2005 levels. “We’re hoping for fewer restatements in 2006, since companies have had a chance to get their controls in place,” he says. “We’re hoping for a calmer year,” he adds, “maybe not a calm year, but calmer than 2005.”

Akram agrees with Turner that hedge accounting—specifically, SFAS 133, Accounting for Derivative Instruments and Hedging Activities—could have an impact in 2006. “In late 2005, a lot of financial institutions began restating because of 133 issues,” he says. According to Akram, those restatements were primarily caused by misapplication of a technical requirement of FAS 133 related to a shortcut method that allowed companies to skip testing the effectiveness of certain hedging relationships. “It’s a very narrow exception and many companies were taking the exception broadly,” explains Akram. “It’s hard not to believe that other industries will see the same issues.”

Overseas, Akram expects to see some restatements related to the adoption of International Financial Reporting Standards in 2006. “The adoption of IFRS is likely to result in restatements, since companies will apply different judgments,” he says.

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