VideoWhen Mark Blinn became Flowserve Corp.'s finance chief in November 2004 — 10 months after the company uncovered accounting errors and announced that it would restate past results — his first job was to help staffers shake off the negativity. "I didn't want them to feel tainted," he says, "or that we all of a sudden wore a scarlet A."
The lesson in positive thinking, not to mention many other restatement-related exercises, lasted another 15 months. Initially attributed to "isolated computer-system implementation difficulties," the problems ultimately extended to numerous material weaknesses in internal controls. By early 2006, when Flowserve, a Dallas-based maker of industrial pumps, seals, and valves, finally filed restated reports going back to 2000, Blinn himself had a new outlook. "Restatements aren't something to fear," he says. "They're a fact of life."
Certainly not a very pleasant one. "It's almost like a death in the family," says Trent Gazzaway, national managing partner of corporate governance for audit firm Grant Thornton LLP. In cases where fraud or some premeditated accounting abuse is at the root of the errors, fear of litigation or prosecution adds to worries about how to correct the numbers and reestablish internal controls. "But the same feelings — just not of the same magnitude — occur when there's simply a flat-out miss," Gazzaway adds. "It can permeate the whole organization."
Recently, the magnitude of those "flat-out misses" has been staggering. U.S. public companies made a record 1,420 restatements overall last year, according to investor research firm Glass, Lewis & Co., and a sharply rising trend in small companies finding errors suggests that the overall tally may be at least as high this year. The 2006 total — more than 12 times higher than in 1997 — now represents 1 of every 10 public companies. Since Congress passed the Sarbanes-Oxley Act of 2002, a year in which there were 330 such filings, nearly a quarter of U.S. public corporations have had to admit that previously reported financials were unreliable and needed to be fixed. The three top categories of errors, according to Glass Lewis: equity, expense recognition, and misclassification (see "(Re)Stating the Case" at the end of this article).
While accounting scandals and issues like stock-option backdating may dominate the front pages, studies of corporate restatements "suggest that well over half of the errorsÂ…were caused by ordinary books and records deficiencies or by simple misapplications of the accounting standards," according to a November presentation by Scott A. Taub, then the Securities and Exchange Commission's acting chief accountant. Carol Stacey, currently chief accountant of the SEC's division of corporation finance, notes further that errors "often stem from the complexity of the company transactions themselves, and not necessarily from the accounting." For example, in cases such as convertible debt, where the primary intention is to raise capital, "a lot of times it's apparent that no one has read the transaction documents closely enough," says Stacey.
The epidemic of restatements reflects many factors other than increasingly complex regulations and sophisticated financing techniques, such as hedging through derivatives. The examination of internal controls, mandated by Sarbanes-Oxley Section 404, is routinely turning up legacy errors that once may have gone undiscovered, while other mistakes are dredged up during new enterprise-resource-planning software implementations. Some critics fault the amounts spent by companies on accounting and auditing in past years, while dumb mistakes and inept interpretations of even simple standards also appear rife.
And yet, the very ubiquity of restatements, including those announced recently by corporate leaders like General Electric and General Motors, is making the process easier for companies to stomach, and provides some valuable reassurance to investors who were once shocked by such things.
Is Reporting Secondary?
"It's certainly true that not all accounting mistakes imply ill intentions," says Chris Paisley, a former 3Com finance chief who now teaches accounting at Santa Clara (California) University. While he was the audit-committee chairman of Brocade Communications Systems, Paisley was involved in the 2005 audit that resulted in one of the earliest cases of a multiyear restatement to reflect stock-option backdating. But he notes that while at 3Com in the late 1990s, he presided over a restatement that was more typical — reflecting fairly technical SEC questions about 3Com's accounting method for blending the fiscal-year results of a company 3Com had acquired.
Like other CFOs who have helped lead companies through restatements, Paisley blames the increasing complexity of the regulations themselves, starting well before Sarbox. "The rules governing revenue recognition have gotten increasingly complicated, as have the rules covering tax accounting, to name a few," he says. Finance chiefs also cite merger accounting, leasing, warranties, and stock options as being potential minefields. And, of course, the recent spate of stock-option backdating revelations has led to a rush of restatements.
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