Financial Reporting Restatements What Are the Causes and Warning Signs

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Jul/Aug 2002

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The headlines today are dominated by stories of accounting improprieties, questionable
auditor relationships and management teams that suffer from a lack of integrity.
Nomenclature and phrases such as SPE, earnings management, swaps, channel stuffing and
self-dealing are being tossed around from Capitol Hill to Wall Street and from
corporate board rooms to office coffee rooms. While these same headlines continue to
serve us a daily dose of billion-dollar scandals with names such as Enron,
WorldCom, Adelphia and Xerox, the fact is that the majority of financial reporting
restatements issued are dominated by public companies with revenues of less than $500
million.

A recent study<a href="#3" name="3a">3</a> entitled "A Study of Restatement Matters, for the Five Years
Ended Dec. 31, 2001," looked at a total of approximately 980 restatements
over this five-year period (Figure 1). This study has revealed that
77 percent of all public-company restatements during the past five years have been
by companies with annual revenues of less than $500 million (Figure 2). Further, 51 percent of all restatements during the past five years have
been by companies with revenues of less than $100 million.<a href="#4" name="4a">4</a> Interestingly, this
is the market segment where most private companies reside. Although not subject to
public company pressures and reporting, private companies face similar market and business
conditions, yet we have no access to whether financial reporting problems exist.

Data collected in the study also suggests that many companies filing restatements
due to accounting misstatements seek bankruptcy court protection within a year. The
companies that file for bankruptcy do so within an average of 344 days from the
filing of the restatement. This one-year early warning period may afford banks and
other investor groups the ability to minimize their losses, investigate and possibly
seek recourse against inappropriate company management behavior. In order to understand
what steps may be taken to monitor companies more closely and identify potential
improprieties that might lead to a restatement, one must first understand the common
factors that ripen the environment for misstatements.

<h3>The Root Causes of Misstatements</h3>

The root causes of financial reporting misstatements generally start with market and
company-specific factors. Market-specific factors such as economic recession, market
transformation and competitor innovation are factors that cannot be controlled by the
company and must be adapted to. In a weakening economy, companies find it more
difficult to meet their original profit targets. Well-managed companies will be proactive
in managing down the expectations of analysts and shareholders, even at the expense
of a lower stock price in the short-term. Other companies may adopt more aggressive
accounting practices to meet earnings expectations (and may even resist appropriate public
disclosures). Company-specific factors such as undesirable product mix, poor risk
management, excessive cost base, design failures and general inefficiencies in the
business are directly attributable to company management decisions. These factors help
to create an environment in which the business underperforms and helps to set the
stage for another root cause—excessive pressure on management.

History shows that when put under severe pressure, even good people may do bad
things, like "cook the books" to meet expectations. The Treadway Commission found that
fraudulent financial reporting frequently came about as "the culmination of a series of
acts designed to respond to operational difficulties." What tended to happen, the
commission concluded, was that initially, "the activities may not be fraudulent, but
in time they become increasingly questionable until finally, someone steps over the
line."<a href="#5" name="5a">5</a> The demands placed on management by shareholders, analysts, board members and
lenders are no different in any well or poorly performing public company. According
to CFO Magazine (September 1999), 60 percent of CFOs have felt pressure to
manage earnings. This pressure is often most strongly felt by those in middle
management, including controllers and divisional personnel.<a href="#6" name="6a">6</a> The pressure intensifies as
lofty financial goals are put in place and management incentives and compensation are
directly linked to those goals. Often, management appear in denial as weeks and months
pass with management unable to change course and right the ship by admitting flaws in
the strategy or operation.

Many times the cause centers on opportunity. Financial reporting misstatements could
not occur without the opportunity that is fostered by an environment where poor internal
controls exist. This may start with an ineffective or non-existent internal audit
department. Additionally, unintegrated information systems relied on for financial
reporting purposes can invite the problems associated with human error in reconciliation
of transactions. Finally, the opportunity for misstatements is often found in
organizations characterized by dominant managers and disempowered employees. Dominant
managers often control the ultimate financial reporting function as well as the auditor
relationships. Stereotypically, they tend to make all vital decisions regarding accounting
positions and 10-K language discussing operating results; as well as the footnotes
to the financial statements. The disempowered employee, while doing most of the
legwork, is shielded from any significant decision-making and input regarding the final
product. While the dominant manager creates an environment where authority is neither
challenged nor questioned, the disempowered employee is content to stay the course for
fear of being chastised and possibly losing his or her job.

Another cause of misstatement reflects organizations with a flawed character or
attitude. The "tone at the top" set by management permeates the entire organization
and creates a culture with the potential for unethical behavior. These organizations
lack any form of ethics leadership by senior management. Anti-fraud, ethics or
compliance programs are generally not present or strictly enforced, and there exists a
lack of pressure placed on the organization to improve ethics.

Financial reporting misstatements could not occur without the opportunity that is fostered by an environment where poor internal controls exist.
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<h3>Types of Misstatements</h3>

Of all restatements published from 1997 through 2001, revenue recognition
issues dominate with slightly more than 20 percent of the total (Table 1). In
2000, many observers believe there was a sharp increase in restatements as the
technology bubble burst and the SEC made revenue recognition a hot-button enforcement
issue in 1999. Companies began to pay closer attention to methods of revenue
recognition that came to light with the publication of the SEC's Staff Accounting
Bulletin 101. Many high-tech software companies fell victim to questionable
accounting that was addressed by the American Institute of Certified Public
Accountant's (AICPA) release of SOP 97-2 and the subsequent correct application
of software revenue recognition. Revenue recognition misstatements include sham sales,
recognizing revenue before all the terms of the sale are complete, improper sales
cutoffs, improper use of the percentage of completion method, unauthorized shipments and
improper recording of consignment sales.

Additional areas where misstatements were most commonly found include improper
acquisition accounting (primarily through inappropriate utilization of merger-related
reserves), improper capitalization of assets, inappropriate inventory and
accounts-receivable valuation, vendor rebates and marketing support, manipulation of
contracts and related party transactions.

<h3>Potential Warning Signs</h3>

When looking for signs of potential misstatements, it is useful to first focus on
the relationship between the company's income statement and balance sheet. This is best
performed by comparing cash from operating activities to net income. In addition, how
does cash from operations compare to sales, accounts receivable and inventory? A
thorough ratio analysis performed every reporting period is a practice that may be
helpful in the early identification of potentially improper accounting methods. The
existence of irrational ratios or trends over consecutive reporting periods will likely
raise red flags and questions to be directed toward management concerning the business.

Operating efficiency measures such as changes to gross profit margin and discretionary
expenses as a percentage of sales are good measures of a company's performance.
Periodic drops in gross margin are a sign that a company's performance is suffering
and there is greater potential for earnings manipulation. Ratios focusing on the
relationships between accounts receivable and sales will help to raise questions to
determine whether sales are real. Examples of questions that may arise include: Is
accounts receivable turnover decreasing? Are "days sales outstanding" increasing over
time? Do the accounts receivable show any signs of deterioration?

Analysis of the relationships between inventory and cost of sales is also helpful
in flagging potentially misstated asset valuations and inflated profits of an
organization. When analyzing the financial statements over time, look for unusual trends
in the following areas: Is inventory increasing faster than sales? Is inventory
turnover decreasing? Are shipping costs decreasing as a percentage of inventory? Is
inventory rising faster than total assets? Are payables increasing in tandem with
inventory? Finally, is cost of sales falling as a percentage of sales?<a href="#7" name="7a">7</a>

Comparing the company's performance to that of the industry is another valuable
analytical tool. Look at the company's performance over time and compare its sales and
profitability trend to that of the industry. How is the subject performing relative
to the industry in down as well as up markets? Does the company's performance look
believable? Our experience is often that if the company's financial performance looks
too good to be true, it probably is not true.

Other warning signs to consider include complex transactions with no apparent economic
benefit from the structure, excessive related-party transactions, confusing notes to the
financial statements, aggressive accounting positions and high employee turnover in key
finance areas.

<h3>Conclusion</h3>

It is evident that while all companies are vulnerable to financial misstatements,
the data indicates that small companies are more susceptible than large. Although
the root causes are similar for all companies, performing in-depth diligence and
analysis may raise potential warning signs of a financial reporting problem.
Evaluation of the company's performance in comparison to the industry may identify
areas requiring further clarification. Additionally, performing a thorough evaluation
of the style of a company's management will assist in understanding the "tone at
the top." Finally, when performing analytics, always look critically at key
relationships between the financial statement accounts and categories. Knowing the
warning signs to look for in an organization may help uncover problems before the
result becomes inevitable.

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<h3>Footnotes</h3>

<a name="1">1</a> Michael C. Sullivan is a director in Huron Consulting Group's Corporate Advisory Services practice. He has a wide variety
of experience in the reorganization of companies and in performing forensic accounting studies and fraud examinations, and has been appointed as
examiner in a number of matters. <a href="#1a">Return to article</a>

<a name="2">2</a> Darrin K. Wald is a manager in Huron Consulting Group's Corporate Advisory Services practice. He has a wide variety of
experience in the reorganization of companies and in performing accounting due diligence for financial as well as strategic buyers. <a href="#2a">Return to article</a>

<a name="3">3</a> Prepared by Huron Consulting Group LLC. <a href="#3a">Return to article</a>

<a name="4">4</a> The study includes all public companies filing 10-K/As and 10-Q/As from 1997 through 2001, including the Enron Corp.
restatement, which was disclosed in an 8-K filing. The study defines restatement as any restatement of financial statements that was the result
of an error, as defined by Accounting Principles Board Opinion No. 20. It excludes restatements due to changes in accounting principles
and non-financial related restatements. For a copy of the study, please contact the authors at <a href="mailto:msullivan@huronconsultinggroup.com">msullivan@huronconsultinggro…; or <a href="mailto:dwald@huronconsultinggroup.com">dwald@huronconsultinggroup.com</…;. <a href="#4a">Return to article</a>

<a name="5">5</a> Young, Michael R., Accounting Irregularities and Financial Fraud, A Corporate Governance Guide, Harcourt Professional
Publishing, 2000. <a href="#5a">Return to article</a>

<a name="6">6</a> Duncan, James R., "Twenty Pressures to Manage Earnings," The CPA Journal, July 2001. <a href="#6a">Return to article</a>

<a name="7">7</a> Wells, Joseph T., "Ghost Goods: How to Spot Phantom Inventory," Journal of Accountancy, June 2001. <a href="#7a">Return to article</a>

Journal Authors

Darrin Wald

Michael C. Sullivan

Journal Date

Monday, July 1, 2002 - 12:00

Bankruptcy Rule

2002