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An explosion in accounting errors — in part reflecting the difficulties of today's complex rules — has forced nearly a quarter of U.S. companies to learn the art of the restatement.
Roy Harris, CFO Magazine
April 1, 2007
When 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.
"These days you have to be a tremendous student of the accounting rules to understand the subtleties," says Bob Blakely, who as CFO of Fannie Mae completed a monumental December restatement that focused largely on the mortgage-lending giant's flawed derivatives accounting. For a time, the federal government contemplated fraud charges against Fannie Mae, which overreported earnings by $6.3 billion. Blakely's posting to Fannie Mae came a year and a half after he completed a no less challenging restatement as the CFO brought in to clean up WorldCom, which committed the biggest accounting fraud in history (see "Extreme Makeover," CFO, July 2004).
Fortunately, for his work at the mortgage lender Blakely has "a whole staff that does nothing but work on accounting policies." At the peak of that restatement effort, Fannie Mae was spending $50 million a month on outside services, and had 2,000 contractors working on restatement-related matters with 400 people from its controllers organization.
Of course, that's a unique situation. Generally, companies have tried to keep auditing fees at a minimum. Glass Lewis managing director Jonathan Weil, the editor of the San Francisco–based firm's financial research, suggests that restatements often stem from companies having spent at "ridiculously low levels" for their pre-Sarbanes-Oxley auditing.
Perhaps not surprisingly, Grant Thornton's Gazzaway agrees. "Companies are in business to produce their product and sell it at a profit, and the reporting of the processes around that is a secondary goal," he says. "In some cases, it's become too secondary."
Too Little Harmony
As challenging as modern corporate accounting can be, the complexities only increase during the process of restatement. The Public Company Accounting Oversight Board (PCAOB), in revising its controversial Auditing Standard No. 2, recognizes the need for a clearer guide for audit firms dealing with client-company restatements, for example. PCAOB deputy chief auditor Laura Phillips has been working on new language designed to clarify, among other things, that restatements don't always mean that there is a "material weakness" in internal controls. "Outraged, indignant companies sometimes say, 'I grudgingly accept that I need to restate my financials, but what really bothers me is having to tell the world that I have a material weakness,'" according to Phillips. "It can add insult to injury." (Actually, Glass Lewis research shows only about half of restating companies also disclosed material weaknesses in the past two years.)
Further, the SEC is dealing with confusion on how these very restatements should be reported. The Government Accountability Office, which issued the first of several reports on the restatement trend in 2002, told the commission this past July that it should "harmonize" guidelines for filing so-called nonreliance disclosures. The Form 8-K "current report" devotes Item 4.02 to notifying investors of "nonreliance on previously issued financial statements." Yet the GAO notes that "about 21 percent of the companies GAO identified as restating did not appear to file the proper disclosure when they announced their intention to restate."
The SEC's Stacey says that the commission believes 8-Ks, filed within four business days of finding a problem, "to be the best alert to the market that investors can no longer rely on previously reported financial statements." And it has sent out letters to companies that have not filed 8-Ks when they announce plans for a restatement, asking them to explain why. She notes that elsewhere in the 8-K instructions the SEC does allow nonreliance disclosures to be made through a regular quarterly or annual 10-Q and 10-K reports. "We told the GAO that we would take under advisement the harmonizing of the instructions," says Stacey.
For its part, Glass Lewis bluntly labels the reporting of errors without the filing of an 8-K as "stealth restatements." A report last year by research analyst Mark Grothe and research editor Weil accused those companies of keeping errors "under the radar, by making it difficult for shareholders to find out about them." In its latest research, Glass Lewis determined that companies with under $75 million in market capitalization were the worst offenders, with 52 percent of their restatements unaccompanied by 8-Ks.
Numb to the Numbers?
In Glass Lewis's campaign to increase awareness of the restatement phenomenon and its causes, it argues against the common corporate line: that restraints imposed by recent reforms are too expensive and should be reduced. Rather, it says, the prevalence of simple accounting errors — along with fraud, stock-options backdating, and other abuses — confirms that companies still need pressure if they are to clean up their financial act.
"There's this never-ending push by the CEO lobby, which doesn't like Sarbanes-Oxley precisely because it holds them more accountable than they would have to be without it," says Weil. "And a lot of the Sarbox bashers have been pointing to the increase in costs associated with the controls, like it's some runaway train." But for the most part, once a company restates because of problems it has detected, accounting errors are less likely to recur. "This is a one-time ramp-up," he says of the sharp rise in investment in internal controls, and the number of restatements should fall in future years.
In pointing to the recent decline in restatements by large companies — reflecting their earlier implementation of Section 404 — Weil notes that smaller companies that have been exempt so far from 404 guidelines have surged ahead in restating prior financials. Glass Lewis says in its latest report that "now's a bad time to lighten the requirements for managements' internal-control evaluations," and adds that of the companies disclosing material weaknesses just after 404 took effect, nearly all had told investors in the previous quarter that their controls were effective. "That tells us that management either lied or just wasn't aware of the weaknesses."
Reports showing the prevalence of errors due to equity accounting, followed by expense recognition, general "misclassification," acquisitions and investments, revenue recognition, and tax accounting, confirm for Weil that companies weren't spending enough on internal and external auditing pre-Sarbanes-Oxley. That, as much as harsh rule-making, was at the root of many restatements. "Find me one major institutional investor who has ever complained about auditor fees," he says. "Glass Lewis doesn't like excessive costly duplicative regulation either. But the stronger regulation you have of internal controls, the lower the cost of capital should be for companies."
His company also has addressed the issue of whether a company's market value suffers from a restatement. Generally, it finds that in this day of routine restatements, Wall Street often is numb to restated numbers. Most investors perceive the changes in reported financials — except in the case of fraud or other abuse — "to be mere technicalities, with little impact on companies' fundamentals," according to the report by Grothe and Weil. They add: "Such restatements aren't likely to lead to investor lawsuits when there are no corresponding drops in stock prices."
A Project Approach
Behind the scenes, though, may be some hard work by CFOs in managing the restatement process and keeping investors informed.
At Flowserve, the process that Mark Blinn took over as CFO in 2004 was his first experience with a restatement. He asked the finance team "to adopt a project approach," much like what his prior employer, the Kinko's Office and Print Services unit of FedEx Corp., had used in fighting rival office superstores and challenging the rise of home printing. "In a project, there is a beginning, a middle, and an end," Blinn says. "By treating the restatement effort like a project, it didn't seem like an endless effort. Otherwise, people can despair."
The audit committee and outside auditor PricewaterhouseCoopers were the CFO's almost constant companions. The finance staff conducted a comprehensive review and began designing new processes to repair the control problems. New problems were found, and delays resulted. In February 2005, the company announced more areas of material weakness and said it was working with the Internal Revenue Service on a pending audit. Analysts were wary, but the stock price stayed at around $26 a share, $6 higher than when it had first announced the problem in January 2004. "Flowserve's update revealed that its internal issues appear to be further reaching than first thought," wrote Robert W. Baird & Co. analyst Michael A. Schneider.
Flowserve kept talking to analysts, filing 8-Ks, and issuing press releases with each major problem discovered. Adding to the early material weaknesses — relating to intercompany accounts, deferred taxes, and currency translation — were new ones, including accounting for derivatives, accounts receivable, and mergers. An early-2004 estimate of $11 million in pretax charges for correcting inventory balances caused by errors eventually culminated in a net-income reduction of $35.9 million.
In December 2005, Flowserve called the filing of the 2004 10-K and restatements "near completion" and announced a resolution to the IRS tax audit with little cash impact. It also projected strong bookings and cash flow. Analyst Schneider seemed convinced. "While the perpetual financial statement filings are disappointing," he wrote, "the latest delay appears to be merely mechanical as tax provisions are finalized." But it was only after the company did file the 2004 10-K and restatements, in February 2006, that Schneider could write of being "newly impressed by the order rates and profitability due in 2006." As they had done after every previous financial report, CFO Blinn and his CEO, Lewis Kling, held a post-news-release conference call with analysts. During the month, the stock climbed to 52-week highs in the mid-40s.
"I'm the one who had to stand up to the public markets and take my lumps," says Blinn. "People get frustrated because they want to see the numbers, but you've got to make sure they're accurate. They may or may not remember if you delay a couple of times, but they'll surely remember if you have to go back and do it again."
Blakely agrees that good communication is essential. In addition to regular contact with regulators, securities analysts, and investors, CFOs also find themselves routinely facing the company's stock exchange, credit-rating services, creditors, customers, and employees. "Communicating with all these constituencies is a prodigious task, and critically important," says Blakely. "People tend to assume the worst unless you're in front of them all the time" (see "Lessons from Fannie" at the end of this article).
Of the stock-price reaction, Blinn says: "Investors are sophisticated. They've seen now that a restatement doesn't necessarily equate to fraud, or that a company is on its last leg or not generating cash flow." He notes that the company was being refinanced during the restatement process, and "people could say, 'The banks know what's going on; maybe it's not that bad.'"
Internally, Flowserve's finance department lightened up as the hardest work ended and the actual restatement approached. A 2005 year-end party for finance staffers was followed by a postfiling bash at the Gaylord Texan Resort. Employees were encouraged to schedule vacations that many had put off. "The parties," says Blinn, "were not so much a celebration as giving some people time with their families." Individual efforts were recognized, and T-shirts were distributed bearing the words: "Looking to the Future." For a team just coming off a restatement, it was an inside joke. "One of the biggest challenges of a restatement is that you're always looking backwards, not forwards," says Blinn. "We were ready for a change."
Roy Harris is a senior editor at CFO.
Lessons from Fannie
Bob Blakely's Tips on Restatements
"A restatement is not a happy thing to have happen on your watch," says Fannie Mae CFO Bob Blakely, who was hired to help the company correct what turned out to be $6.3 billion of overreported earnings. He suggests overcoming the stigma quickly, which may hinge on creating positive energy among finance-team members. "Assure them, 'You don't go to the penalty box because you find something wrong.'" Below are some additional thoughts from Blakely about handling restatements: