Corporate reporting quality has been at the forefront of the profession since the major corporate accounting scandals such as Enron and WorldCom at the beginning of the century. Within the last 15 years, the corporate reporting environment has been reshaped by revised corporate reporting standards. This article analyzes various characteristics of financial statement restatements and frauds discovered from 2000 to 2014 to shed some light on how financial restatements and frauds have been affected by shifts in the regulatory and economic environment.
Financial restatements are initiated by public companies, independent auditors, or the SEC. Generally, independent auditors discover misstatements in financial statements during audit and inform managers and audit committees of such findings. Auditors, managers, and the audit committees then evaluate the nature and materiality of misstatements and make decisions prior to issuing the financial statements. Managers may waive correcting misstatements that are deemed to be immaterial.
The SEC’s Final Rule: Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, effective August 23, 2004, requires that Form 8-K, Item 4.02 be filed by a reporting company to announce restatements if the company or its auditor concludes that “any previously issued financial statements … should no longer be relied upon because of an error in such financial statements.” Such an announcement should be made within four days after the company or its auditor concludes that any previously issued financial statements should not be relied upon. If the same information is to be disclosed in scheduled quarterly or annual reports issued before the end of the four-day window, however, the reporting company need not announce the restatements. In practice, there is an increasing trend of filing restatements without first announcing them because the determination of the day previously issued financial statements should no longer be relied upon is subject to the discretion of the companies and their auditors (Marsha B. Keune and Karla M. Johnstone, “Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees,” Accounting Review, September 2012, http://bit.ly/2jYUVpS).
In recent years, many companies have not announced restatements in Form 8-K and have avoided amending previously issued financial statements for the periods affected.
Following restatement announcements, companies typically file restatements by amending their previously issued financial statements for the periods affected (known as “Big R” restatements). In the meantime, the audit opinion is also revised to reflect the restatements. In recent years, however, many companies have not announced restatements in Form 8-K and have avoided amending previously issued financial statements for the periods affected. Companies have instead revised the affected numbers for the previous periods and showed them in subsequent quarterly or annual reports (known as “little r” restatements) (Christine E. L. Tan and Susan M. Young, “An Analysis of ‘Littler’ Restatements” Accounting Horizons, September 2017, http://bit.ly/2jZ37pX).
The Role of the SEC
The SEC reviews public companies for violations of securities laws and requires compliance with financial reporting standards. These reviews usually ensue following firms’ press releases, media reports, anonymous tips, or amended filings of firms’ periodic reports. The SEC initiates informal comment letters requesting clarifications after reviewing disclosures and transactions already reported in firms’ periodic reports, and may subsequently issue a formal comment letter if a public company’s response to an informal comment letter is deemed insufficient.
Moreover, the SEC may initiate a formal investigation into a potential restatement or fraud case; such a decision depends upon factors such as availability of resources, potential discoveries of mis-statements, company-specific characteristics, and the potential relevance of the investigation on emerging accounting and financial reporting matters in the capital markets. This discretion to prosecute companies and their executives limits regulatory enforcement. Recent developments suggest a trend towards prosecuting executives responsible for wrongdoing beyond reaching settlements with their companies (Matt Apuzzo and Ben Protess, “Justice Department Sets Sights on Wall Street Executives,” New York Times, Sept. 9, 2015, http://nyti.ms/2jZDkmn).
To facilitate public companies’ compliance with the Sarbanes-Oxley Act of 2002 (SOX) section 404, the SEC released an interpretive guidance for public companies, and the Public Company Accounting Oversight Board (PCAOB) approved Auditing Standard (AS) 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements, in 2004. In an effort to reduce SOX compliance costs, the PCAOB in 2007 superseded AS 2 with AS 5, An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements, to provide public accounting firms with guidelines for auditing accelerated filers’ ICFR under SOX section 404(b). The 2008 global financial crisis and subsequent recession precipitated the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). Section 989G of Dodd-Frank in particular exempts permanently non-accelerated filers (public companies with a total market value of common equity less than $75 million) from compliance with SOX section 404(b).
The authors set out to analyze how financial reporting quality (i.e., the deterrence and detection of restatements or frauds) has been affected by trends in restatement and fraud from 2000 to 2014. This analysis period includes the passage of SOX, which was enacted to restore public confidence in the U.S. capital markets following major accounting scandals in the early 2000s. In particular, SOX section 404, effective in 2004, mandates management and an external auditor to assess the effectiveness of a public company’s internal control over financial reporting (ICFR), contributing to higher compliance costs.
This survey used the Audit Analytics database (AA; http://www.auditanalytics.com), which scans corporate filings and press releases to identify restatements and frauds. AA defines corporate financial restatements as “errors due to unintentional misapplication of U.S. GAAP” and corporate financial frauds as “intentional manipulation of financial data or misappropriation of assets.” The authors follow AA’s taxonomy of accounting issues to identify the major categories associated with restatements and frauds.
These statistics appear to support the view that the passage of SOX and the implementation of SOX section 404 led to increased restatements.
Frequency of Financial Statement Restatements versus Frauds
Exhibit 1 presents the yearly distribution of corporate financial restatements and frauds in the United States discovered during the analysis period. The number of discovered financial restatements begins in 2000 at 4% of total public reporting companies, peaks in 2006 at 17% of total reporting companies, then decreases to approximately 8% of total reporting companies per year after 2007. These statistics appear to support the view that the passage of SOX in 2002 and the implementation of SOX section 404 in late 2004 led to increased restatements. In addition, the shift in focus for regulators and the SEC to pursuing cases related to the financial crisis in 2008–2010 may account for the reduced number of restatements during this period. The number of discovered financial frauds is considerably lower than that of financial restatements during the analysis period. The incidence of companies with both financial restatements and frauds detected is even lower, except during 2004 and 2005.
Frequency of Financial Statement Restatements versus Frauds
Categories of Financial Statement Restatements versus Frauds
Exhibits 2 and 3 present the annual leading restatement and fraud categories during the analysis period. For financial restatements, the most common reporting issue related to debt and equity accounts or quasi-debt/equity instruments with conversion options (21% of restatements on average); this category ranked first in 11 of the 15 years. The other two common issues were expense recording (i.e., delayed recognition of certain expenses and payables; 15% of restatements) and revenue recognition (14% of restatements). Other restatement issues ranked in the top three for certain years, but their presence was largely due to changing accounting guidance, unraveling of industry-wide improper accounting practices, downward macroeconomic trends, or heightened regulatory scrutiny. For example, lease-related issues and depreciation errors were the second and third leading causes of restatements in 2005 due to an industry-wide discovery of improper lease accounting practices (Lynn E. Turner and Tomas R. Weirich, “A Closer Look at Financial Statement Restatements: Analyzing the Reasons Behind the Trend,” December 2006, http://bit.ly/2kj0vnO). Deferred, stock-based, or executive compensation issues ranked second in 2006 and 2008 because Statement of Financial Accounting Standards (SFAS) 123R, Share-Based Payment, which took effect in 2006, prompted companies to reevaluate their prior-year disclosures relating to share-based compensation and restate them if necessary.
Leading Categories of Financial Statement Restatements
Leading Categories of Financial Statement Frauds
In the years following the Great Recession, errors or irregularities in the determination of various forms of tax obligations or benefits (e.g., foreign tax, specialty taxes, tax planning issues) and in the misclassification of cash flows became the new leading causes for financial restatements. Susan Scholz noted in her 2014 report prepared for the Center for Audit Quality (CAQ), “Financial Restatement Trends in the United States: 2003-2012” (http://bit.ly/2lkPIJL), that the increasing trend for tax-related restatements was likely due to “the inherent and increasing complexity of both the tax code and tax-related GAAP, as well as increased scrutiny of tax reporting.”
The list of common reporting issues for detected financial frauds shares some of the top three leading issues for restatements and includes some other issues unique to financial frauds. The most prevalent category was revenue recognition (40% of fraud cases on average), which claimed the top spot for 8 out of the 15 years. The second most common related to accounting irregularities associated with foreign subsidiaries and affiliates of U.S. companies (29% of cases), and the third related to misclassification of accounts, such as cash, investments, receivables, and changes in allowance for uncollectibles (25%). A considerable number of financial fraud cases related to the inappropriate determination of inventory costs, cost of sales, and the inventory balances at the year-end (19% of cases), expense recording issues (18%), and identification of liabilities on the balance sheet (18%). In contrast to restatements, most leading categories of financial frauds during the analysis period were unaffected by major shifts in corporate accounting and governance standards and the economic slowdown.
In contrast to restatements, most leading categories of financial frauds were unaffected by major shifts in corporate accounting and governance standards and the economic slowdown.
Overall, while some of the leading reporting issues related to restatements or frauds did not change with shifts in corporate reporting rules, others have appeared as new causes for restatements in recent years (specifically, misclassification errors in financial statements that do not impact income). These results are consistent with prior studies on the trends of restatements of financial statements (Deloitte Forensic Center, “Ten Things about Financial Statement Fraud—Third Edition: A Review of SEC Enforcement Releases, 2000–2008,” 2009, http://bit.ly/2lqSsGO; Scholz 2014).
Characteristics of Companies with Financial Restatements and Frauds
Exhibits 4, 5, and 6 present the characteristics of companies with restatements and frauds discovered during the analysis period by six sub-periods demarcated by the passage of SOX, the effective date of SOX section 404, the effective date of AS 5, the onset of the Great Recession, and the enactment of the Dodd-Frank Act. The purpose of examining firms with restatements and frauds by these sub-periods is to further evaluate whether company characteristics, audit and non-audit fees, and the nature of restatements and frauds were affected by the enactment of corporate reporting rules and the macroeconomic climate during the analysis period.
Characteristics of Firms with Financial Restatements and Frauds
Audit and Non-audit Fees of Firms with Financial Restatements and Frauds
Nature and Discovery of Financial Restatements and Frauds
Characteristics of companies with restatements and frauds.
In most of the sub-periods, companies with restatements were smaller than those with frauds in terms of total assets and market capitalization. In addition, at least 50% of companies with restatements were small companies (market capitalization of less than $250 million) in the pre–Dodd-Frank period, whereas at least 50% of companies with frauds were small companies in four out of the six sub-periods. This suggests that small companies are inherently more prone to financial misstatements. Furthermore, in the two-year period following the discovery of restatements or frauds, companies with frauds were more likely to turn profitable than companies with restatements in two sub-periods. Generally, in terms of profitability (i.e., ROA), companies with frauds performed better than companies with restatements in three sub-periods.
Audit and nonaudit fees of companies with restatements and frauds.
In the two-year period following the discovery of restatements or frauds in the six sub-periods, the median percentage of spending on audit services (scaled by average total assets) by companies with frauds exceeded that of companies with restatements in most sub-periods, except for the post-SOX section 404 and pre–AS 5 period, as shown in Exhibit 5. In addition, the median percentage of spending on audit services following the discovery of restatements or frauds was the highest for both companies with restatements and companies with fraud in the post-AS 5 and pre-recession period. The difference in the median percentage of spending on audit services reached its highest point in the post–Dodd-Frank period and its lowest point in the pre-SOX period. If the level of audit fees reflects the level of audit risk, as research indicates (e.g., Vishal Munsif, Kannan Raghunandan, Dasaratha V. Rama, and Meghna Singhvi, “Audit Fees after Remediation of Internal Control Weaknesses,” Accounting Horizons, Sept. 1, 2010, http://bit.ly/2kExXpY), the results suggest that auditors view companies with fraud as posing an inherently higher audit risk than companies with restatements, even after the fraud is detected and remedied. Moreover, the perceived difference in audit risk reached its highest level after the passage of Dodd-Frank.
Regarding the median percentage of spending on nonaudit services (scaled by average total assets), companies with fraud were allocated more or a similar level of resources as companies with restatements in four sub-periods. Nevertheless, the median percentage of spending on nonaudit services peaked in the pre-SOX period and declined in the post-SOX period. The ratio of nonaudit fees to audit fees shows that during the pre-SOX period, companies with restatements and companies with fraud invested a considerable amount in nonaudit services, almost comparable to the amount of resources invested in audit services. After the passage of SOX, companies with restatements and companies with fraud greatly reduced their relative investment in nonaudit services, probably due to the prohibition of certain nonaudit services by SOX. The ratios of nonaudit fees to audit fees in the last four sub-periods were comparable and consistent across companies with fraud and companies with restatements. This is consistent with the findings in prior studies (e.g., Wei Jiang and Jia Wu, “The Impact of PCAOB Auditing Standard 5 on Audit Fees,” The CPA Journal, April 2009, http://bit.ly/2koutJz).
After the passage of SOX, companies with restatements and fraud greatly reduced their relative investment in nonaudit services.
Nature and discovery of restatements and frauds.
Exhibit 6 further presents information about the nature and discovery of restatements and frauds by the six sub-periods. The data shows that the median length of fraud periods was typically longer than that of restatement periods. In addition, the median length of fraud periods fluctuated over time, ranging from 21 months to 36 months, whereas the median length of restatement periods held steady at approximately 12 months over the analysis period. These results suggest that, as corporate reporting rules evolve, companies with fraud engage in even more complicated schemes to achieve their intended goals, which prolongs the time needed to uncover them. On the other hand, more stringent corporate reporting rules and closer inspection by managers and auditors may lead to more discoveries of previously overlooked intentional misstatements, leading to the lengthier fraud periods in the post-SOX and pre-recession sub-periods. The limited resources available to regulators to unravel potential financial frauds may have also played a role in the prolonged fraud periods documented in the post-recession period. The median lag of restatements or frauds stayed fairly stable across all sub-periods, ranging from four to seven months. Overall, it takes about 18 months for a restatement to be discovered and 25–40 months for a fraud to be discovered.
Magnitude of Financial Restatements and Frauds
Exhibit 7 presents the cumulative magnitude of investors’ earnings losses as a result of restatements and frauds over the analysis period. A negative cumulative effect on earnings represents investors’ profits/earnings loss as a result of inflated earnings associated with the restatement or fraud. The accumulated effect on earnings of all restated firms for each sample year was negative, ranging from $1.3 billion to $195.5 billion in lost earnings. The aggregate magnitude of restatements increases and peaked at $195.5 billion in 2004 (post-SOX and pre-SOX section 404) and drastically dropped to and remained at $2–4 billion in the following years. The aggregate magnitude of restatements rose in the post–Dodd-Frank period. The number of companies with restatements that had an identifiable impact on earnings increased in the post-SOX era but fluctuated greatly. Generally, the average cumulative effect on earnings of the companies with restatements follows a similar pattern to that of the aggregate cumulative effect on earnings. Throughout the analysis period, $500.6 billion of investors’ lost earnings resulted from restatements.
Magnitude of Financial Restatements and Frauds
The lower number of restatements and frauds may be driven by some high-risk companies going private or regulators shifting resources from financial fraud to securities fraud.
The aggregate cumulative lost earnings associated with frauds ranged from $73.9 million to $75.5 billion. Altogether, approximately $90 billion of investors’ lost earnings resulted from frauds during the entire sample period. Although the overall cumulative effect on earnings of companies with fraud ($90 billion) was far smaller than that of companies with restatements, the average cumulative effect on investors’ lost earnings of companies with fraud was greater than that of companies with restatements ($677 million versus $79 million, respectively). The above results demonstrate that, while the number of restatements and frauds has decreased, the dollar amounts of losses remain significant. The lower number of restatements and frauds may be driven by some high-risk companies going private or regulators shifting resources from financial fraud to securities fraud (e.g., Ponzi schemes) during the analysis period. Arguably, regulatory changes have improved financial reporting by improving governance, oversight, and penalties mechanisms; however, regulations are imperfect, and ethical behavior is difficult to regulate unless ethics are nurtured and rewarded regardless of the business environment, especially when incentives and opportunities to misstate accounts opportunistically are present.
Analysis of Study Results
This analysis presents a number of observations. First, it appears that increased and improved governance practices under SOX and the enforcement of SOX section 404 may be associated with the increased discovery of financial misstatements and thus an increased number of restatements and frauds. Discretion exercised by regulators during the enforcement process, however, may limit the potential effects of the regulations. As an example, the reduced number of restatements during 2008–2010 may have been driven by the shift of the SEC’s focus to the financial crisis. Second, while most major causes for frauds tend not to vary with shifts in corporate reporting and regulations, it appears that some leading causes for restatements arose due to changing accounting guidance, the unraveling of industry-wide improper accounting practices, the macroeconomic climate, or heightened regulatory scrutiny.
Third, the findings show that at least 50% of the financial misstatement cases are by relatively small companies (market capitalization of less than $250 million), suggesting that smaller companies are of higher risk of financial misstatement. Fourth, the median percentage of spending on non-audit services has declined in the post-SOX period, and the relative investment in non-audit versus audit services has fallen to 15% over time. Finally, the difference between the median reporting lag of restatements and frauds suggests that fraud is harder to detect, although more stringent corporate reporting rules, closer inspection by managers and auditors, and the availability of resources to and discretionary selection of prosecuting cases by regulators may also play a role.
Based upon the data, the authors do not conclude that there have been significant systematic shifts in the characteristics of companies with restatements or companies with fraud. Most of the top reporting issues relating to fraud are not affected by shifts in corporate reporting rules and the macroeconomic environment; however, some new leading categories for restatements did arise due to these factors. Most of the leading categories for financial fraud are in areas where management must exercise judgment and is likely vulnerable to stress, such as beating market expectations. The results suggest that regulation and enforcement may play an important role in deterring, preventing, and detecting financial manipulation, but the level of discretion applied and the resources available to regulators limit the effectiveness of such regulations.