Maintain control Featured

8:00pm EDT March 26, 2009

Many companies have been turning to financial restatements to ensure compliance with today’s complex financial reporting requirements. Restatements can damage public perception of a company and can be costly in other ways.

“Aside from negative market reaction, there are direct costs to the company associated with restating a prior period’s financial statements,” says Dan Perushek, an audit manager with Haskell & White LLP. “These costs could be substantial and would include the time incurred by company personnel in restating the financial statements as well as fees paid to professional service firms for regulatory compliance or even public relations services related to the financial restatement. Lastly, restatements may create legal exposure for companies.”

Smart Business spoke with Perushek about how financial restatements may affect your business and how to avoid them.

What do recent trends in restatements show?

The occurrence of financial restatements has increased significantly in recent years. A study conducted by the U.S. Department of Treasury revealed an 18-fold increase in financial restatements by public companies from 90 restatements in 1997 to nearly 1,600 restatements in 2006. While a more recent study on 2007 financial restatements indicated a 17 percent decrease in restatements by public companies, compared to 2006, current restatement levels are still well above those of a decade ago.

Studies indicate that the occurrences of restatements at smaller companies are increasing at a higher rate than their larger company counterparts and for different reasons.

Larger companies restate their financials to account for revenue recognition and complex accounting issues, such as derivatives, asset valuations, taxes and foreign subsidiary consolidations. On the other hand, smaller companies deal with accounting issues related to ongoing operating expenses, stock-based compensation and debt-related accounting, particularly in growth-oriented organizations likely to rely heavily on stock-based compensation and convertible debt financing.

What has contributed to these trends?

In 2004, Section 404 of the Sarbanes-Oxley Act of 2002 required large public companies to document, test and report on internal controls over financial reporting, and auditors were required to attest to management’s internal control over financial reporting assertions. Efforts to implement this process increased the frequency and effectiveness of identifying ongoing financial misstatements leading to an increase in financial restatements after 2004.

While this process has helped larger public companies identify financial misstatements and should help reduce occurrences of future restatements in larger companies, smaller companies have not yet been required to fully implement the process.

Finally, with the issuance of new and complex accounting standards over the past several years, there has been a general increase in accounting errors related to the application of these standards.

How do restatements affect investors?

Financial restatements typically result in a negative market reaction, the severity of which is usually determined by the nature of the restatement. While restatements related to fraud, revenue recognition or core operating expenses usually elicit the most severe reactions, restatements related to nonreoccurring expenses, reclassifications or disclosures generally result in a less severe reaction. These negative market reactions can result in a loss of stock value for the company shareholders, a decrease in debt rating or investment grade, compliance issues with financing agreements, damage to the public’s perception of the company and, possibly, litigation initiated by financial statement users.

How can financial restatements be avoided?

Avoiding financial restatements begins with ongoing identification of the areas within a company’s financial reporting process that could potentially result in a financial reporting misstatement. Management team members should pay particular attention to financial reporting areas involving complex accounting issues requiring the application of complicated accounting standards, financial reporting areas requiring significant use of estimates as well as reporting areas affected by recently issued accounting standards. Management should also consider their organization’s susceptibility to fraudulent financial reporting and misappropriation of assets.

The implementation of controls effectively designed to mitigate such risks are essential to avoiding current financial misstatements that could potentially result in future restatements. Once implemented, monitoring these controls periodically for effectiveness is critical to ensure financial reporting is correct.

When addressing financial reporting issues involving significant estimates or matters of judgment, it is important for management to consider qualitative as well as quantitative factors during decision making processes.

Finally, it is imperative that company management teams maintain a timely awareness of new accounting standards as they are released, and assess how any newly issued guidance affects their company’s financial reporting. And, it is equally important that management allocate the proper resources necessary to ensure the proper application of new accounting standards.

DAN PERUSHEK is an audit manager with Haskell & White LLP. Reach him at (949) 450-6349 or dperushek@hwcpa.com.