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Clear Thoughts
Restating financials in 2004
Originally Published Friday, January 21, 2005
| After new litigation, the number of restatements have increased. What effect does this have on the information world and how Clear selects stocks? |
Clear Asset Management's investment philosophy and process relies on accurate data. The data is supplied by the over 10,000 public companies and certified by their accounting firms. In the wake of Enron, Worldcom and too many others and the fall of Arthur Anderson, the world has changed. The government has helped by passing important legislation.
The number of restatements by publicly held companies surged to a high in 2004, according to results of a study of regulatory filings by the Huron Consulting Group.
The firm found that 253 companies restated their annual audited financial reports last year, a 23 percent increase from 206 in 2003. Another 161 companies restated quarterly financial statements, versus 117 in 2003. Although this is a significant year-over-year increase, less than 3% of public companies restated results.
The study also found that the number of companies restating results from more than one year increased. About 40 percent - 101 - of the companies restating annual results were revising financial reports for three years.
A large number of companies are "repeat offenders" of having to restate results. More than 60 companies that filed restatements last year reported errors in filings in previous years, too.
There are various possible explanations for the overall increase in restatements.
Some of the surge was a result of companies' efforts to comply with Section 404 of the Sarbanes-Oxley Act, the corporate governance legislation passed in the wake of corporate fraud in 2002. That provision requires that companies have their outside auditors review their internal controls which are the processes companies use to record financial transactions and report their results. Nearly a third of the restatements involved improper reporting of revenue or faulty accounting for stock options or other equity instruments, according to Huron.
Some of the restatements may simply reflect that auditors are more conservative and more inclined to instruct a client to restate earnings after finding an error that several years ago might have been ignored. The criminal prosecution of Enron's auditor Arthur Andersen put accounting firms on notice that times have changed.
Not all restatements are evidence of fraud. Much of this is Corporate America cleaning up its act. Many investors assume that a restatement inevitably leads to litigation, which is not accurate. Restatements can happen for entirely non-fraudulent reasons, and restatements do not always lead to significant stock price declines.
In general, a restatement to ensure more accurate data is available to investors is beneficial to the market. Whether the motivation for companies to do this is to avoid sanction or to increase transparency is, ultimately, irrelevant. The important point is that this legislation and enforcement has improved quality in the universe of information, and that is inherently good.
We are ever diligent watching every company in our portfolios and watch lists real-time every day. We exclude or sell companies when their data is deemed inaccurate as our investment policy states.
We look forward to a decline in restatements this year as firms and their auditors more fully understand that investors and their watchdogs demand fair reporting and clarity.
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