When National City, a full-service bank, needed to restate its earnings for 2002, the IR team kicked into gear well before anyone outside the executive suite knew what was pending.
According to Reuters, National City restated its 2001 and 2002 net income results after discussion with the SEC on the application of certain technical provisions of the Statement of Financial Accounting Standards number 133, Accounting for Derivative Instruments and Hedging Activities. The IR department found out exactly how much money was involved in the restating and what impact it would have on shareholders. Then it figured out a way to explain to shareholders the devilishly complex accounting used to quantify the company’s derivatives and hedging activities.
Thomas Richlovsky, National City’s senior VP and treasurer, who also handles investor relations, recognizes that restatement is an emotional issue. ‘Our concern was that the uninformed reaction to it would be very negative, when the substance, if you spent the time to understand it, wasn’t anything to be concerned about,’ he says.
In fact, when the news was released at the same time as the regular earnings announcement, the reaction was muted. ‘Substantively, nothing happened,’ Richlovsky says with audible pleasure. ‘It was a non-event.’ And as anyone who has been through a restating announcement will tell you, that ‘non-event’ equates to a standing ovation for the IR department.
Sox curbs enthusiasm
Restatements of annual earnings hit a record high last year, with 213 audited annual restatements filed with the SEC. That’s a 13 percent increase over the previous year, which experts say is attributable – in part – to new accounting and accountability standards enforced by Sarbanes-Oxley.
But although Sarbanes-Oxley has created a surge in restatements, observers say the new laws will most likely mean fewer restatements in the future. Sarbanes-Oxley and Regulation FD have leveled the playing field among portfolio managers, analysts and retail investors – who used to get company news almost secondhand.
In a frantic effort not to miss estimates, some companies used to get creative with expenses, earnings and other line items. That could encourage fraud, with company executives cooking the books to better the estimate and create a short-term surge in the stock price, then exercise their options for personal gain and sort it all out later.
‘There will be less pressure in the future to hit the mark,’ says Rebecca Todd McEnally, vice president for advocacy at the Association for Investment Management and Research (AIMR). ‘Sox has shifted the emphasis to the longer term, which is better for the companies.’
Of course, none of this means much to IROs – until it’s their company contemplating a restatement. Those who have been through it say that IROs have to be involved in the strategizing from the get-go. Unless the CFO is also working closely with the IR team, this could be problematic.
The fact that a company is in talks with the SEC, for example, over what is commonly described as a ‘difference in interpretation’ of an accounting standard, does not warrant a public announcement. And if the adjustment to prior quarters amounts to only a few pennies per share, is that cause for alarm? At what point does accounting for lost inventory need to be accounted for with special web site links and custom-written Q&As?
It’s all in the details
If that decision is up to you, experts agree you should err on the side of caution. It may mean more work, but it could also be the difference between a ‘non-event’ and the conference call that never ends, or the share price that slides.
‘I believe this is an instance where you should bore people with all the material you’re putting out,’ says one IRO, who is happy to pass along the tip, but doesn’t want it connected to her company. ‘It’s not like you want to bury the news, but you want to account for every penny, every principle, deflect every possible question. Ideally, reporters and other people should get overwhelmed with your thoroughness and walk away, figuring you have nothing to hide.’
Most IROs who discussed restatements agree with that tactic to some degree. As with all bad news, the more prepared you are, the better it will go for your company. Richlovsky, for example, says investors’ concerns were so important to company management that National City actually rushed a resolution with the SEC just so it could announce the restatement at the same time it released quarterly earnings.
The company was able to treat its restatement as just another piece of corporate news: referred to in press releases, amplified on the web site, explained in detail in a reconciliation of the books, and mentioned at the morning-after conference call with investors.
Not the MSN way
However, when the company is Microsoft and the restatement causes earnings to plummet by 27 percent over two years, the news is going to spread faster than an e-mail virus disguised as a Paris Hilton video.
Although Microsoft’s accounting change on stock options was widely hailed by corporate governance experts, the company itself is surprisingly skittish when asked about it – further proof of just how touchy the subject of restating expenses actually is. Calls to the Seattle-based company were routed to an outside PR company, which refused to do anything more than e-mail chunks of the company’s restatement package in response to questions.
‘We are unable to write up an anecdotal case study on the company’s decision to restate its earnings based on the change in equity compensation,’ e-mailed an account executive in response to IR magazine’s request for an interview with someone on Microsoft’s IR team.
And taking the stance of some shareholders that a restatement has only negative connotations, an account executive added by phone: ‘This is not the classic case, which would imply an error had been made.’
Reasons for restating
There are lots of reasons for restating earnings. Some of them are as innocuous as a change in the fiscal year, or an alteration in accounting rules. Companies routinely restate earnings after a major event, such as an acquisition or when a division is spun off. Sometimes the culprit is revenue recognition, where a transaction takes longer to complete than anticipated and revenue arrives over a prolonged period instead of neatly in a single quarter.
Other restatements involve an SEC ‘suggestion’ of alternative accounting methods. Frequently there is no admission of wrongdoing; more likely the SEC found the finance folks pushing the Gaap envelope.
These are examples of ‘positive’ restatements, suggest observers, because they allow analysts to continue comparing apples with apples over several years’ balance sheets. But then there is the red flag of restating, redefined by companies like WorldCom, which in June 2002 announced that earnings for the previous year had been misstated by close to $4 bn. That news led to a 96 percent drop in the stock’s value, the resignation and prosecution of top executives, and a loss of confidence in public companies that continues to this day.
Perhaps the most significant recent restating was last summer when software giant Microsoft announced it was retroactively cutting earnings for fiscal 2002-03, to account for its decision to start expensing the fair-market value of stock options, including those already awarded. The announcement sent shockwaves through executive compensation committees and the technology industry, and was generally lauded by corporate governance experts.
Whatever the reason for it, a restatement is a tricky event to stage-manage, mainly because when shareholders hear a company is changing its previously announced earnings, many of them instantly believe fraud or theft has occurred.
‘There are a thousand things that can go through investors’ minds when they hear a company is restating its earnings,’ sighs Greg Knapp, vice president of finance at Missouri-based Empire District Electric. In January the company restated its 2002 earnings to reflect a change in pension benefit costs that amounted to 6 cents per share over the year.
According to recent analysis from the Huron Consulting Group, the single largest reason for restating was improper accounting for reserves. Joseph Floyd, author of the Huron report, says this section of a company’s accounts usually comes under the closest scrutiny by regulators, who are alert to sometimes flawed earnings estimates, as well as misuse of facts and outright fraud. Errors related to accounts receivable and inventory reserves are also significant factors for restating previous earnings, with revenue recognition issues figuring prominently in the explanations.
Huron notes that the overall growth rate in the number of companies restating earnings is slowing down, which could be taken to mean that the shake-out over Sarbanes-Oxley is leveling off. Observers say corporate officials are restating earnings to comply with Sarbanes-Oxley while there is still a de-facto grace period. There is also increased pressure during a market correction, where there isn’t as much money to gloss over mistakes.
‘The bubble was bigger and longer this time, so it generated more [restatements] than it usually would,’ explains Chuck Hill, director of research for Thompson First Call. ‘There is nothing unusual about having a rise in the early stage of a recovery. The shenanigans that have been going on – well, none of it is surprising.’ And he agrees with Floyd that the flood of restatements will lessen – at least until next time.
