Understanding the Financial Statements
Material weaknesses in internal control, SEC issues sweeps, and complexity of accounting standards resulted in a record number of restatements in 2005.
Following a year of record-breaking restatements of prior years' financial statements, shareholders will likely have questions about the reasons for past restatements and the likelihood of future restatements. Weaknesses in internal control, complex accounting standards, and "issues sweeps" by the SEC have all been contributing factors.
Restatements and Controls
To put the number of restatements in perspective, statistics compiled by proxy advisor Glass-Lewis indicate that restatements were at an all-time high in 2005, affecting one in every 12 public companies.
One reason for these restatements is an underlying weakness in internal controls. Approximately half the companies filing restatements also reported material weaknesses in internal control. Smaller public companies (non-accelerated filers) have not yet evaluated their internal controls under Section 404. If the correlation between material weaknesses and restatements holds true for these companies, then the trend toward more frequent restatements may continue in 2006.
Another reason why restatements may continue in 2006 is a new accounting standard known as FASB Statement No. 154, Accounting Changes and Error Corrections. Under Statement 154, companies that make changes in their accounting principles must restate their prior year financial statements as if the company had always used the new principle.
As a result of Statement 154, restatements will likely be required more often for new accounting standards. Unless the FASB specifically decides that another transition method is preferable for an individual standard or EITF issue, it will require a restatement.
Companies will need to communicate these kinds of restatements carefully so that shareholders understand that restatements related to changes in accounting principles are unrelated to material weaknesses.
SEC Issues Sweeps
Another significant factor adding to the number of restatements in 2005 was the desire on the part of companies to avoid being caught in an "issues sweep" in which regulators identify an issue with one company, then expand their investigations to other companies likely to be affected by the same issue.
The issues that sparked waves of restatements in 2005 included industry-specific reviews, (e.g., oil and gas issues). But there were also cross-cutting issues, such as accounting for leases. The resulting restatements and adjustments did not follow a change prescribed by an accounting standard-setter or regulator, and they seemed to take many companies and investors by surprise.
If a company is targeted in an SEC issues sweep, management may be required to respond to broad information requests without any indication of wrongdoing. This was one of several areas for improvement cited by the U.S. Chamber of Commerce in its March 2006 "Report on the Current Enforcement Program of the Securities and Exchange Commission." In its report, the Chamber of Commerce recommended that the Commission appoint an Advisory Committee to study its enforcement processes. The report is available at http://www.uschamber.com/publications/reports/0603sec.htm.
Complex Accounting Standards
Another reason for the increased number of restatements is simply misapplication of complex accounting standards. For example, in early 2006, there were a number of restatements for misapplications of the "shortcut" method of accounting for hedges.
Simply put, hedge accounting allows companies to reduce earnings volatility through the use of derivative instruments. But this method requires that companies understand and meet strict criteria to ensure the hedges are effective and any losses are reported on a timely basis.
The FASB has agreed to work with the SEC toward a goal of reducing complexity in accounting standards.
SEC Comment Letters
To help companies understand its concerns about accounting and disclosure issues, the SEC has begun to publish its company-specific comment letters on its Web site.
Some common themes from recent comment letter are as follows:
- " Companies should clearly explain their accounting policies for recording uncertain tax positions.
- " Disclosures regarding pension liabilities should be robust and should include disclosure of the assumed discount rate.
- " Disclosures about non-GAAP measures (figures not defined in generally accepted accounting principles) should clearly explain why the measure is relevant.
- " Considerations involved in determining whether elements of revenue should be presented gross or net should be disclosed to investors.
- " Companies should pay close attention to the impact of redemption features on the classification of a financial instrument as a liability or temporary equity.
- " Disclosures about convertible instruments should indicate whether the conversion feature affects earnings per share.
- " Cash flow statements should provide insightful analysis, including discussion of the reasons for changes in cash flows.
- " Management's discussion and analysis should provide an overview of the company through the eyes of management.
Because these comment letters are now publicly available, shareholders may question related areas of the company's financial statements.
If the company
restated prior years’ financial statements, how was the problem discovered?
Is the company certain that the full extent of the problem has been
identified? What steps have been taken to ensure that this problem does not
Why were there
significant adjustments to the reported earnings of the company during a
particular period or quarter? Are these adjustments indicative of weak
management controls? How is management planning to correct the problems?
Complex accounting standards
does the company have over complex accounting transactions?
Has the company
reevaluated its method for valuing share-based payments? Are effective
systems of internal control in place over accounting for share-based
How will the
adoption of FASB Statement 123(R) affect the company’s earnings?
How will the
company be affected by the FASB’s project on pension and postretirement
Is the company
using the “shortcut” method of accounting for hedges? How sure is management
that the company is meeting all the criteria for the use of this method? How
does the company determine that its hedges are highly effective (from both a
business risk management and a financial accounting perspective)?
and controls does the company have over the use of derivatives and hedging?
Has the audit committee reviewed these procedures and controls in the past
Uncertain tax positions
What is the
company’s accounting policy for uncertain tax positions? How will the FASB’s
proposal affect the financial statements?
Is the IRS or
any other taxing authority currently examining any of the company’s tax
returns? Have any changes been proposed? What is the likely outcome of these
challenges? What is the company doing to minimize income taxes?
does management use to assess the performance of its operating segments? Who
is the chief operating decision maker referred to in the company’s discussion
of its operating segments?
Were there any
changes in senior-level personnel in the company’s accounting function? What
were the reasons for the changes?
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