It’s 5 pm, 49 hours before your company’s third quarter earnings go out over the wire. You’re in the office putting the final flourishes to the press release and conference call script, when in bursts Teddy, the CFO’s factotum, waving a piece of paper. ‘Stop the presses!’ he yells. ‘We have to restate last quarter’s numbers.’
Before you reach for that bottle of tranquilizers, you should realize you’re not alone. In 2004 some 414 restatements were issued by public companies, according to Chicago-based financial and operational consultancy Huron Consulting Group, which has collected data on restatements since 1997. Huron’s report characterizes the increase in filings this year as ‘dramatic,’ up 28 percent on 2003, when it appeared the numbers were leveling off.
Huron cites several reasons for the upswing including the Public Company Accounting Oversight Board (PCAOB) – which is putting pressure on outside auditors to be absolutely sure a firm’s books are in order – Section 404 compliance and additional staff at the SEC.
‘Clearly there’s a wide range of reasons for restatements, from the benign to the very severe,’ says Jeffrey Szafran, managing director and co-author of the Huron report. Szafran attributes the majority of restatements to the misapplication of rules, human error and ethics.
Revenue recognition is consistently the prime reason. This is due to the intense attention revenue receives from analysts and investors as it requires judgment calls, and the rules on revenue recognition are lengthy, complex and open to interpretation, explains Szafran. The second most prevalent reason for a restatement is equity, which is not particularly fraught with fraud but is prone to misapplication of rules. Reserves, accruals and contingencies are also sensitive areas that require judgment and are thus more likely to cause restatements.
Size does matter
While most restatements come out of the manufacturing industry, Szafran notes this sector is also largest in terms of the percentage of public companies reporting, so it’s not an indication of institutional incompetence. Size, however, does seem to increase a company’s potential for restating the financials: nearly 75 percent of all financial restatements over the past five years were reported by companies with annual revenues under $500 mn.
But it’s the marquee names that stand out. A roundup of companies restating their financials published at the end of February by Dow Jones lists 27 firms, including Benihana, Countrywide Financial, Fisher Scientific, Lowe’s, Nextel Communications (a serial restater), Sears Roebuck, Siebel Systems (another recidivist) and Starbucks. Interestingly, of the 26 companies (Motorola was listed incorrectly), eight revised earnings upwards.
Also notable is the recidivism rate: a full 15 percent in 2004, according to the Huron study. ‘Given the painful experience a restatement causes, you’d think companies wouldn’t want to go through it all again,’ Szafran comments.
Huron Consulting is not the only one picking up on the restatement trend, either. Accounting guru Jack Ciesielski, founder and editor of the Analyst’s Accounting Observer, devotes an entire section of his web log (and a good dose of his dry wit) to restatement punditry.
An April 8, 2005 a posting on Ciesielski’s Restatement Zoo reads: ‘If all you care about is the number, here it is: 238 companies have restated, made catch-up adjustments or are in the process of reviewing their accounting… This is an overwhelmingly retailer-driven phenomenon, and there are plenty of them with January year-ends. Of the 238 instances found so far, 132 of them are retailers, 55 are in the hospitality industry, 13 in the wireless tower business, seven in real estate investment trusts (Reits) or other real estate enterprises, and the remaining 31 are not in any one industry in particular.’
Sooner is better
The mechanics of issuing a public release about a restatement follows no particular rule or convention. Some companies issue a release stating that a restatement is forthcoming. Others skip right to the restatement release and still others include the information in their regular earnings release, where it may be an up-front item or buried in the back.
A simple single line may suffice, or, in more complex situations – such as that recently experienced by King Pharmaceuticals, which had to restate two and a half years of financials – a 16-page release might be necessary. ‘You’re always better off disclosing in stages, rather than saving the bomb for the end,’ advises Don Allen, principal of the Allen Group in Orange County, California. ‘It’s only going to haunt you later if you postpone the haircut your stockholders may give you.’ Allen, who took a sabbatical from consulting to work in technology, experienced up close and personal the revenue recognition sleight-of-hand that was common practice in the software business a decade ago.
Hugh Burns, a managing director at Citigate Sard Verbinnen, recommends moving with all deliberate speed in issuing a restatement release. ‘You have to be sure not to get ahead of the information too quickly,’ he says. ‘You want to make your explanation of what’s happened clear so the market doesn’t have a knee-jerk reaction. The worst case scenario is when word leaks out, forcing you to go public before you’re ready.’
If the restatement is the result, for example, of an innocent clerical error, it’s obviously quite a different matter from having a rogue executive. In the latter case ‘it’s important to give the public a sense of how high up the chain it goes,’ says Burns, an attorney by training. He feels the post-Enron, Sarbanes-Oxley culture is making it ‘harder and harder to deliver on a deadline, due to the increased layers instituted.’
Word on the Street
From the analysts’ point of view, restatements can range from the heart-stopping to the ho-hum, and it’s important from the get-go to figure out exactly which category a restatement falls into. KeyBanc Capital Markets’ managing director Chuck Cerankosky, whose beat is food marketing, reveals his train of thought when a company he covers issues a restatement: ‘Rule one for me: is it fraud or not? Rule two: is it cash or non-cash? And rule three: how big is the number? If we’re talking about moving pennies around from one quarter to the next then I start to feel sorry for the trees that were cut down.’
Cerankosky says the recent slew of restatements that has inundated his sector has had little effect. He can’t even recall a single question about the restatements on a conference call, and they haven’t hurt any of the stocks he covers. ‘The companies are restating and the market is yawning,’ Cerankosky observes. But if he saw a restatement that suggested sloppy bookkeeping, or indicated that a company was deliberately inflating income or the error had gone on for a long period of time, he would definitely sit up and take notice.
While the Huron report consolidates data and does not out firms that issued the largest restatements in any given year, some remain classic cautionary tales, lingering in the working memory of IROs. In mid-January, for example, McKesson Corp announced it had agreed to pay $960 mn (and take a $1.2 bn pre-tax charge) to settle a class action lawsuit sparked by its 1999 restatement. This is the third-largest settlement of a class action securities case and shows the sort of one-two punch a restatement can cause.
In January 1999 McKesson acquired HBOC for $12 bn in stock. Then, in April, the firm announced that HBOC had improperly recognized revenues, and McKesson’s stock dropped $9 bn in market cap; senior management was fired and 91 class action suits ensued.
While these events were excruciatingly painful for the company and its shareholders, McKesson is generally acknowledged to have done the right thing in the wake of the restatement: it removed offending executives immediately, initiated an independent board audit and honestly owned up to what it had done. But there’s no question that investors – not to mention the SEC and the US attorney general – prick up their ears when a restatement is issued.
Veteran consultant Robert Ferris, executive managing director of RFBinder Partners, believes savvy IROs should go the distance when dealing with restatements. He advises three actions. First, it’s vital to acknowledge how the error was uncovered. ‘If you discovered it yourselves, it speaks well to your financial integrity and you should emphasize this fact,’ he says. Second, indicate what corrective actions are being taken. Third, include a quotation in the press release from the chairman of the audit committee of the board. ‘This demonstrates that he or she is satisfied appropriate steps have been taken, the audit committee is working in sync with management and the board is fully informed and approves of the action taken,’ explains Ferris.
Ferris also believes there will be a significant increase in restatements in 2005 – a prediction Ciesielski clearly shares. He puts the onus squarely on Section 404, which he sees as instituting closer financial control programs, which in turn are uncovering material weaknesses. For IR professionals, it’s important to liaise closely with the corporate secretary and the internal audit committee to ensure the communications strategy for any potential restatement is well underway. Because, while it’s sometimes impossible to avoid a restatement, the best way to recover from one is to get out in front of the investment community and reassure it the situation is being rectified quickly and thoroughly.
Major accounting issues
Revenue recognition:
2004 16.4%
Total five-year average 19.0%
Reserves, accruals and contingencies:
Total five-year average 14.7%
Capitalization/expense of assets:
2004 7.7%
Total five-year average 8.7%
2004 3.5%
Total five-year average 4.8%
