1.2.1 rePorts by regulatory bodies
Restatements had a significant effect on trust in corporations, their executives and in their gatekeepers. They also led to some well publicized significant bankruptcies. In some cases, employees lost big portions of their pension savings and the corporate reputation of ‘US Inc’ was at stake. Hence, interest by US regulators and law makers was extensive. When we started our studies in 2002-03, these regulators were the first to provide overviews of the effects of restatements on stock markets. In addition, they provided the first authoritative lists of companies which had encountered restatements and gave some more details on restatement specifics. Regulators and law makers in the US reacted vigorously to the restatement problem (and its causes) which led to the enactment of the Sarbanes-Oxley Act. This was followed by numerous improvements of corporate governance regulations in the world. The reports also describe the role of executives in restatements and illustrate that a significant number of CEOs and CFOs were prosecuted because of suspected intent to defraud. One of the reports also considers, in some more detail, the role analysts played in the accounting irregularities. Management intent and the role of analysts, and also the corporate governance measures (and their effect on analysts’perceptions) will be considered in more detail in studies 1 and 2, hence, this overview.
During the ten-year period (1997 to 2006), in which the occurrence of restatements proliferated, a number of reports/studies by regulatory bodies have been issued, shedding light on the relevance of restatements to capital markets and the significance of market reactions to restatements (both in the near term as well as further out in the future). These reports were initiated by either the US Senate or other regulatory bodies (e.g. the US Treasury, the SEC, the Department of Justice), and addressed the possible causes and consequences of questionable accounting practices. Those practices included causes, such as pressures on corporate executives to meet quarterly earnings projections, executive compensation practices, complexities of rule-based accounting standards, complex corporate financing arrangements, the usage of special purpose vehicles, and stock market reactions. Outlined consequences included implications for the accounting and auditing professions, the effect on analysts’ governance and independence, and corporate governance recommendations.
Next to these reports, which were issued largely out of governmental attempts to engage in the policing of public responsibility, detailed analysis of causes and consequences of restatements can also be found in reports by the Huron Consulting
Group (HCG), such as the ‘2004 Annual Review of Financial Reporting Matters’.4
From 2005 onwards, Glass, Lewis & Co. has issued a number of its own detailed annual reports, including ‘Restatements – Traversing Shaky Ground’ (covering the restatement phenomenon as it built steam in 2004); and following up with ‘Getting it Wrong the First Time’ (2005), and ‘The Errors of Their Ways’ (2007). Audit Analytics, a commercial database, also keeps track of restatements, and has been used as a data source for the US Treasury studies referenced above. An earlier report on fraud, issued in March 1999, was commissioned by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), an organization sponsored and funded by five main professional accounting associations and institutes, with the mission to improve the quality of financial reporting through internal controls, governance, and ethics. In its report, ‘Fraudulent Financial Reporting: 1987-1997: An Analysis of US Public Companies’, COSO (1999) concluded that smaller companies were more prone to committing reporting fraud and CEO involvement appeared to be a general shared trait – in 72 per cent of the cases studied, the CEO appeared to be associate, while the CFO was involved in 43 per cent of the cases. The study was based on data kept by the SEC on alleged fraudulent financial reporting, so-called Accounting and Auditing Enforcement Releases (AAERs). COSO concluded that one of the major limitations of prior academic research regarding fraud risk factors was the lack of a robust conceptual model describing the link between fraud risk factors and the likelihood of financial statement fraud. In that conclusion, the committee refers to one of the first conceptual models that was proposed by Loebbecke and Willingham (1988), and which described the probability of material misstatement due to fraud as a function of three factors:
1. The degree to which conditions are such that a material management fraud could be committed,
2. the degree to which the person or persons of authority and responsibility in the entity have a reason or motivation to commit management fraud, and
3. the degree to which persons in positions of authority and responsibility
4 Huron was formed in 2002 by previous Arthur Andersen employees and reported a yearly restatement overview starting with a review of 2001 restatements; the group issued restatement reports until 2004.
in the entity have an attitude or set of ethical values such that they would allow themselves to commit management fraud.
In the section on Methods, for Study 2, we shall use current insights into drivers of fraud as the basis for developing our model of CEO perceived behaviour. All the reports cited by name in this section have been considered in this study.
One of the first reports on restatements was a report to Paul Sarbanes, the US Senate chairman of the Committee on Banking, Housing, and Urban Affairs, issued by the GAO in October 2002. The report, entitled ‘Financial Statement Restatements, Trends, Market Impacts, Regulatory Responses, and Remaining Challenges (GAO-03- 138)’, addressed the following aspects of restatements:
• The number of, and reasons for, other trends in financial restatements since 1997;
• The impact on the restating companies’ stock market capitalization; • The research and data available to determine the effect of restatements on
investors’ confidence in the existing US system of financial reporting; • SEC enforcement actions involving accounting and auditing irregularities;
and,
• The major limitations of governance and oversight structures.
This first regulator-involved major report on restatements found that the type of companies involved in restatements had moved significantly into the domain of larger listed companies, not into the realm of small companies and companies operating in the technology industry who had previously been responsible for the bulk of issued restatements. Based on total assets, the proportion of large companies (assets in excess of US $1 billion), increased from 25 per cent in 1997, to more than 30 per cent in 2001. The report also found that revenue recognition accounts for some 40 per cent of the accounting misstatements identified in the 1997-2002 period. (Later in this research, we will focus more on earnings management, which often leads to revenue misstatements as one of the primary causes of managements’ involvement and intent in causing restatements.) The report also confirmed findings from academic researchers that restatements involving revenue recognition resulted in relatively greater losses in market capitalization.
the new millennium, considered pursuit of accounting fraud and/or irregularities as one of its top enforcement priorities. The GAO report addressed enforcement actions taken by the SEC on the basis of possible violations of securities laws by companies and executives, enforcement actions involving accounting firms and the charges against these firms on the basis of audit failures, failure to comply with Generally Accepted Auditing Standards (non-GAAS), failure to take appropriate action when fraud is discovered by the auditors (Section 10A); and auditor failure to act independently as a result of conflict of interests, often caused by consulting (or other significant) fee- paid assignments.
The GAO report did not stop there; it criticized the role of both security analysts and credit rating agencies, making reference to the possible conflicts of interest between analysts and their firms’ investment-banking and underwriting services. Already, mention has been made of the New York State Attorney General investigation and subsequent prosecution of a number of larger investment banking firms, actions that ultimately resulted in the so-called ‘Global Settlement’ of a US $1.1-billion payout by 10 firms. The enforcement actions brought by the SEC alleged that, from approximately mid-1999 through mid-2001 or later, all of the 10 firms engaged in practices that created or maintained inappropriate influence by investment banking over research analysts, imposing conflicts of interest on the analysts that the firms failed to manage in an adequate manner. In addition, the regulators found supervisory deficiencies at every firm. The 10 firms who were part of the settlement were Bear, Stearns & Co. Inc., Credit Suisse First Boston LLC, Goldman, Sachs & Co., Lehman Brothers Inc., J.P. Morgan Securities Inc., Merrill Lynch, Pierce, Fenner & Smith, Inc., Morgan Stanley & Co. Inc., Citigroup Global Markets Inc., Salomon Smith Barney Inc., UBS Warburg LLC and US Bancorp Piper Jaffray Inc. The agreement included measures meant to avoid future effects of conflicts of interest between investment banking and analyst departments.
The GAO report concluded with a detailed case study of 20 major US companies, providing a business overview, and exploring restatement data, accounting/auditing firms, stock price movements, security and credit rating agencies’ recommendations and actions, and legal and regulatory actions. The report also included the first ‘paper’ database of 919 restatements from 1997 to 2002. In January 2003, the GAO updated its previously issued report, and, to accommodate researchers, published
stock ticker symbols, exchange market names, dates of the announcement, entities that prompted the restatement, and the reason for the restatement. The GAO also made this database electronically available. One obstacle for impact within either the capital or financial markets and/or in the academic arena was that the GAO failed to include stock price movements around the dates of the restatement announcements, as the agency obtained such data from proprietary resources.
In July 2006, the GAO again updated its 2002 report alongside its second restatement
report to the US Senate5. A major finding in the new report, covering the period from
2002-05, was that stock price movement in the days surrounding a restatement announcement were much lower than found in the original 2002 report (-9.5 per cent for the period from 1997 to mid-2002, and -2 per cent for the mid-2002 to 2005 period). The report also compares the restatement database developed by GAO to
databases developed by both Huron Consulting and Glass, Lewis & Co.6
Following the implementation of the Sarbanes-Oxley Act in July 2002, the July 2006 report signaled that the strong increase in restatements in the initial 2002-05 period may indeed have been caused by:
• Company executives focusing on financial reporting accuracy that resulted from the certification of financial reports by management as required by Section 302 of the Sarbanes-Oxley Act.
• Company self-assessment of the quality of internal controls on financial reporting as required by Section 404 of the Sarbanes-Oxley Act, and the opinion thereon issued by the independent auditors.
• Issuance of new auditing standards also covering standards on fraud identification by the newly founded PCAOB (responsible since 2003 for the supervision of the accounting profession).
• Increased staffing and review by SEC and other regulatory/judicial bodies. The report found that in the period 2002-05, large companies (those with assets greater than US $1 billion), continued to account for an increasing share of companies engaging in restatement, growing from some 30 per cent in 2002, to more than 37 per
5 ‘Financial Restatements: Update of Public Company Trends, Market Impacts, and Regulatory Enforcement Activities (GAO-06-678)’ – it also includes an electronic (updated) version of the restatement database (GAO-06-1079SP).
6 These reports/databases are important as they will be used for determining the sample of restatement companies we have used in the quantitative analysis sub-study on analysts perceptions (see Study 2).
cent in 2005. Also in the same period, market capitalization of a restating company increased from US $3 billion (in the latter half of 2002), to over US $10 billion in 2005. The updated report identifies that cost- or expense-related issues surpassed revenue recognition issues as the predominant cause of restatements.
The 2006 report also mentioned some ambivalence on the part of investors and analysts when it came to interpreting the severity of restatements (GAO, 2006: 34). Restatements since the enactment of the Sarbanes-Oxley Act and the creation of the PCAOB could have resulted from any number of factors, such as (a) reaction to aggressive or abusive accounting practices; (b) greater complexity and stricter application of accounting standards; and, (c) improved internal controls on financial reporting and/or past accounting (recording) deficiencies. The report noted that some analysts consider the increased number of restatements to have been no more than a by-product of increased efforts by company executives and their auditors to achieve higher-quality financial reporting (restatements as part of a ‘cleansing process’), with the added inducement to comply, arriving in the form of heightened judicial actions and more severe penalties that accompanied enactment of the Sarbanes-Oxley Act. A progress report on financial reporting issued by the SEC in February 2008 provides the following explanation for the steep increase in the number of restatements in 2006 (SEC, 2008: 60):
The increase in restatements has been attributed to various causes. These include more rigorous interpretations of accounting and reporting standards by preparers, outside auditors, the SEC, and the PCAOB; the considerable amount of work done by companies to prepare for and improve internal controls in applying the provisions of section 404 of the Sarbanes-Oxley Act; and the existence of control weaknesses that companies failed to identify or remediate. Some have also asserted that the increase in restatements is the result of an overly broad application of the concept of materiality and discussions regarding materiality in SAB 99, Materiality (as codified in SAB Topic 1M) – that is, resulting in errors being deemed to be material when an
investor may not consider them to be important.7
7 Studies considered by the SEC in drafting their Progress Report include the GAO study, ‘Financial Restatements: Update of Public Company Trends, Market Impacts, and Regulatory Enforcement Updates’ (March 2007); Glass, Lewis & Co. study, ‘The Errors of Their Ways’ (February 2007); and two Audit Analytics studies, ‘2006 Financial Restatements: A Six Year Comparison’ (February 2007) and ‘Financial Restatements and Market Reactions’ (October 2007). The SEC also considered findings from the PCAOB’s Office of Research and Analysis’s (ORA) working paper: ‘Changes in Market Responses to Financial Statement Restatement Announcements in the Sarbanes-Oxley Era’ (October 18, 2007).
A third report was issued pursuant to Section 704 of the Sarbanes-Oxley Act of 2002, which directs the SEC to study enforcement actions over the five years preceding the act’s creation, in order to identify areas of issuer financial reporting most susceptible to fraud, inappropriate manipulation, or inappropriate earnings management. In addition, Section 704 directs the commission to report its findings to Congress, along with a discussion of recommended regulation or legislation. This study involved the review of all of the commission’s enforcement actions filed from July 1997 to July 2002, and which were based on improper issuer financial reporting, fraud, audit failure, or auditor independence violations. Next to categorizing of restatements, the study revealed the following, with respect to the parties held responsible:
The majority of the persons held responsible for the accounting violations were members of issuer senior management. The study found that 157 of the 227 enforcement matters involved charges against at least one senior manager. In these enforcement matters, charges were brought against 75 Chairmen of the Board, 111 Chief Executive Officers, 111 Presidents, 105 Chief Financial Officers, 21 Chief Operating Officers, 16 Chief Accounting Officers and 27 Vice Presidents of Finance. In addition, the study determined that the commission brought charges against 18 auditing firms and 89 individual auditors.
A fourth report was issued in February 2008 by a committee the SEC commissioned in July 2007 and tasked with examining the US financial reporting system and making recommendations intended to increase the usefulness of financial information to investors, and reduce the complexity of the financial reporting system to investors, companies, and auditors. The report from the Advisory Committee on Improvements to Financial Reporting contained a number of proposals focused on how to eliminate unnecessary restatements. The majority of suggestions centered on restatements of the most recent years at the time (2006-07), when there were significant numbers of restatements (mainly related to lease classification and option accounting), for which there was lack of a statistically-significant market reaction. The reasoning behind the proposal was that in the absence of a significant reaction, the restatement contains no information of value, and thus the restatement is without meaning.
A fifth report was issued to the US Department of the Treasury in April 2008, ‘The Changing Nature and Consequences of Public Company Financial Restatements,
1997-2006’ (Scholz, 2008); commissioned to Suzan Scholz, an associate professor of accounting at the University of Kansas. Scholz’s study analysed 6,633 restatements announced during the 1997-2006 period, addressing and expanding on a number of issues identified in earlier GAO reports. The report also analyses restatement trends and characteristics, including restatement severity, accounting issues (typology) and the number of periods/years affected (these characteristics are also covered in academic studies on restatements which we will cover shortly). Next, the study analyses the characteristics of restating companies, their industries, exchange listings, size and profitability. Finally, it provides an analysis of market reactions to restatements, both nearby (+2 days) and further out (up to +250 days).
Major findings of the study include that:
• The strong increase in the number of restatements (1,577 in 2006), comes mainly from companies not being listed on the major US stock exchanges (NYSE, AMEX and NASDAQ).
• Over the years, the market reaction to restatements has declined; however, restatements caused by fraud and those resulting from revenue recognition issues tend to have more negative market reactions. Fraud was attributed to 29 per cent of all restatements in 1997, while only 2 per cent of restatements
in 2006 were linked to fraud.8
• Restating companies are typically loss-making; in the year prior to announcing a restatement, more than half of the companies reported a net loss.
The report contains a number of illustrative graphics, a number of which have been attached to this research as appendices.
While Section 704 of the Sarbanes-Oxley Act directed the SEC to study enforcement actions over the period between the 1998-2002 fiscal years, it should be noted that misreporting is not a phenomenon exclusively occurring in US markets. In many other countries, misreporting and subsequent adjustments to financial statements have occurred. The misreporting phenomenon seems to exist in different periods
for different countries. In the early 1990s, questionable accounting practices led to corporate collapses in the United Kingdom. These scandals led to the introduction of
more stringent accounting guidelines.9 However, no extensive reports and/or studies
are available that document these events systematically. This is also due to different treatment for the correction of accounting errors under various GAAP frameworks.
1.2.2 rePorts on sPeciFic corPorate scandals and/or Financial rePorting Fraud
Some of the more significant corporate scandals have been the subject of in-depth studies. The pervasive economic effects and implications of these frauds on governance systems, the role of gatekeepers, management decision making, whistleblowers and corporate ethics can be seen as explanation for heightened attention. For example, the Powers Report on the Enron accounting scandal – formally titled, ‘The Report of the Investigation by the Special Investigative Committee of the Board of Directors