Our study on financial restatements provides an indepth

Transcription

1 Highlights of Financial Restatements from 2000 through 2011 By Ping Lin, CMA, Ph.D.; Sophie Lee, Ph.D.; Xiaoying Chen, Ph.D.; and Jasmine Yur-Austin, Ph.D. EXECUTIVE SUMMARY We investigated 11,868 financial restatements from the pre-sox to post-sox eras of 2000 through 2011 with restatements peaking in The majority of the restatement issues were from the Accounting Rule Application Failure category, and five industries accounted for 75% of all restatements. Fraud issues were associated most frequently with revenue recognition. Our study on financial restatements provides an indepth analysis into the landscape of restatements from 2000 through 2011 and reveals many interesting insights to policy makers, auditors, and management accountants. Before we begin, what exactly is a financial restatement? It is a formal revision of previously issued financial statements because of either accounting changes or violations of Generally Accepted Accounting Principles (GAAP). For example, Statement of Financial Accounting Standards (SFAS) No. 154, Accounting Changes and Error Correction, requires a retrospective application of certain changes and correction of errors, hence the restatements. Such changes are in the areas of accounting principles, accounting estimates, and reporting entities. Errors that a company must correct can be either intentional or unintentional violations of GAAP. Financial restatements can impact a firm s earnings retroactively. Investors can view the restatements as indicators of the financial reporting quality and strength of a corporation s internal control. Companies with strong internal control systems and organizational ethics are less likely to have intentional or unintentional reporting errors. Academic evidence suggests that even unintentional GAAP violation restatements can be linked to earnings management, a practice that lowers the quality of financial reporting. 1 M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 19 F A L L , V O L. 1 7, N O. 1

2 In addition, the number and nature of restatements also reflect audit quality. High-quality auditors should catch errors within an accounting or audit period as the errors occur so the restatement of financial results afterward will not be necessary. As a result of restatements, investors, financial analysts, and government agencies closely scrutinize financial restatements. 2 For instance, in 2004 the Securities & Exchange Commission (SEC) investigated Krispy Kreme because of improper revenue and expense recognition. The company eventually restated its pre-tax income for 2001, 2002, and 2003, and, as a result of the SEC probe, Krispy Kreme lost approximately 66% of its market value at that time. The SEC finished its probe in Our study of financial restatements spans 2000 to 2011 and provides the following: an analysis of financial restatement issues frequencies, the peak of restatements and the reason for it, special issues, industry concentration, fraud issues, and the Big 4 effect on restatements. Sarbanes-Oxley Act of 2002 In 2002, Congress enacted the Sarbanes-Oxley Act (SOX) as a direct response to a wave of high-profile financial fraud and accounting scandals such as Enron, WorldCom, and Arthur Andersen. One main purpose of SOX was to tighten companies internal controls and improve the quality of financial reporting. SOX also aimed to improve audit quality and mitigate conflicts of interest by banning audit firms from providing certain fee-based nonaudit services to their audit clients. In addition, SOX created the Public Company Accounting Oversight Board (PCAOB), a private nonprofit organization that aims at self-regulating the audit industry to improve auditor independence and audit quality. Categories and Examples Our research analyzed restatement data from the Audit and Compliance Module of Audit Analytics, a research database specializing in tracking detailed information of restatements. Audit Analytics collects restatement data covering all SEC registrants from various forms of filings including 8-K, 8-K/A, 10-K, 10-Q, 10-Q/A, 10-K/A, 10-KSB, 10-KSB/A, 20-F, 20-F/A, 40-F, 40-F/A, and press releases. The database classifies restatement issues into the following categories: l Accounting rule (GAAP/FASB) application failures; l Financial fraud, irregularities, and misrepresentations; l Errors in accounting and clerical application; and l Other disclosure control weakness. Accounting Rule (GAAP/FASB) Application Failures This category refers to restatements because of accounting rule changes and unintentional errors that result in the misapplication of GAAP rules or provisions in Statements of Financial Accounting Standards (SFAS) promulgated by the Financial Accounting Standards Board (FASB). There are 50 issues in this category from accounts/loans receivable, investments, and cash issues to acquisition, merger, disposal, or reorganization issues and the like. Xerox s 8-K filing on July 12, 2002, provides one example: The restated consolidated financial statements reflect adjustments which are corrections of errors made in the application of U.S. Generally Accepted Accounting Principles (GAAP) and include (i) adjustments related to the application of the provisions of Statement of Financial Accounting Standards No. 13, Accounting for Leases and (ii) adjustments that arose as a result of other errors in the application of GAAP. We will refer to this category as Accounting. Financial Fraud, Irregularities, and Misrepresentations This category includes 40 issues and refers to intentional misinterpretation of GAAP rules, such as fraud. For example, Dell filed its 8-K on November 21, 2002: As previously announced, the U.S. Securities and Exchange Commission (SEC) and the Company s Audit Committee are conducting investigations into certain accounting and financial reporting matters, including the possibility of misstatements in prior period financial reports, and the company previously received a related M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 20 F A L L , V O L. 1 7, N O. 1

3 subpoena from the United States Attorney for the Southern District of New York. We will refer to this category as Fraud. Errors in Accounting and Clerical Application This category, which includes 43 issues, covers unintentional errors that are the result of clerical or technical wrongdoing. For example, Toyota Motor Credit filed its 8-K on July 15, 2008: Toyota Motor Credit Corporation (the Company ) identified a non-cash error in its accounting for certain debt in hedging relationships governed by Statement of Financial Accounting Standards No. 133, Accounting for Debt Instruments and Hedging Activities ( SFAS 133 ) that occurred in periods beginning in fiscal We will refer to this category as Clerical. Other Disclosure Control Weakness This category refers to restatements because of accounting changes, such as a change of accounting principle from GAAP to International Financial Reporting Standards (IFRS), and other disclosure-related issues, such as missing an explicit assertion regarding effectiveness of internal control that SOX requires. Forty issues make up this category, which we will call Disclosure Control. Research Methodology Although prior researchers have investigated financial restatements, most focused on restatement occurrences only, not the causal issues behind them. We will provide insight on both the occurrences of restatements and related issues in each category. By analyzing restatement data from the years 2000 through 2011, we investigated issues and trends of restatements. In addition, we used the companies North American Industry Classification System (NAICS) industry codes to investigate whether the restatement occurrences differ across various industrial sectors. We then paired fraud issues to examine whether specific issues tend to occur concurrently. Finally, we analyzed and reported the roles of Big 4 firms in financial restatements. Analysis of the Frequency of Financial Restatements Issues During the investigation period, the data set consisted of 11,868 unique restatements, 28,401 issues, 7,417 companies, and 810 auditors. A restatement can involve multiple issues across multiple categories. For example, on February 1, 2003, Dell disclosed a restatement through an 8-K filing because of both Accounting and Fraud category issues in liabilities, payables, reserves, and accrual estimate failures. We tallied the frequency of issue occurrences and reported the top issues with 50% of occurrences in each category in Table 1. From the 28,401 issue occurrences, 91.5% were in the Accounting category, most likely because of accounting rule changes. Between 2000 and 2011, the FASB issued many new statements, amendments, and revisions to previous statements, which could potentially result in the initiation of financial restatements. The three most frequently occurring issues in the Accounting category were debt, quasi-debt, warrants, and equity security issues (2,428 occurrences, 9.34%); expense recording issues (1,839 occurrences, 7.07%); and revenue recognition issues (1,679 occurrences, 6.46%). What triggered the high number of debt, quasidebt, warrants, and equity security restated issues was most likely the enactment of Statement of Financial Accounting Standards Nos. 140, 150, 132(R), 154, 155, and 157, all of which became effective after For example, SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, provides guidelines on how to account for certain financial instruments. Accordingly, companies that previously issued these certain financial instruments were likely to restate both liabilities and equity after complying with the rule of SFAS No The other standards are: l SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities a replacement of FASB Statement No. 125; l SFAS No. 132(R), Employers Disclosures about Pensions and Other Postretirement Benefits an amendment of FASB Statements No. 87, 88, and 106; M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 21 F A L L , V O L. 1 7, N O. 1

4 Table 1: Top Restatement Issues by Categories Accounting Rule Application Failures Total: 25,999 Issue # Issue Description Frequency % Cumulative % Ranking A12 Debt, quasi-debt, warrants, and equity (BCF) security issues 2, % 9.34% 1 A18 Expense (payroll, SGA, other) recording issues 1, % 16.41% 2 A37 Revenue recognition issues 1, % 22.87% 3 A2 Acquisition, merger, disposals, reorg acct issues 1, % 29.30% 4 A13 Deferred, stock-based, and/or executive comp issues 1, % 35.10% 5 A30 Liabilities, payables, reserves, and accrual estimate failure 1, % 40.51% 6 A32 PPE intangible or fixed asset (value/diminution) issues 1, % 45.04% 7 A38 Tax expense/benefit/deferral/other (SFAS No. 109) issues 1, % 49.42% 8 Financial Fraud, Irregularities, and Misrepresentations Total: 475 Issue # Issue Description Frequency % Cumulative % Ranking B32 Revenue recognition issues % 16.00% 1 B20 Foreign, related party, affiliated, or subsidiary issues % 27.16% 2 B1 Accounts/loans receivable, investments, and cash issues % 36.21% 3 B21 Foreign, subsidiary-only issues (subcategory) % 43.79% 4 B17 Expense (payroll, SGA, other) recording issues % 50.95% 5 Errors in Accounting and Clerical Applications Total: 954 Issue # Issue Description Frequency % Cumulative % Ranking C19 Expense (payroll, SGA, other) recording issues % 9.43% 1 C28 Inventory, vendor, and/or cost of sales issues % 17.51% 2 C36 Revenue recognition issues % 25.37% 3 C31 Liabilities, payables, reserves, and accrual estimate failure % 32.81% 4 C7 Cash flow statement (SFAS No. 95) classification errors % 38.47% 5 C37 Tax expense/benefit/deferral/other (SFAS No. 109) issues % 44.13% 6 C1 Accounts/loans receivable, investments, and cash issues % 49.06% 7 Other Disclosure Control Weakness Total: 973 Issue # Issue Description Frequency % Cumulative % Ranking 33 Z - Material weakness Section 404 or 302 issues identified % 39.77% 1 24 X - Audit or auditor-related restatements or nonreliance % 57.14% 2 l SFAS No. 154, Accounting Changes and Error corrections a replacement of APB Opinion No. 20 and FASB Statement No. 3; l SFAS No. 155, Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140; and l SFAS No. 157, Fair Value Measurements. Although there were only 475 issue occurrences from the Fraud category, these issues have a far-reaching social impact and a negative effect on the audit profession. The most frequent fraud issues were revenue recognition (76 occurrences; 16%), followed by foreign, related party, affiliated, or subsidiary (53 occurrences; 11.16%), and accounts/loans receivable, investments, and cash (43 occurrences; 9.05%). The last two categories of restatement issues Clerical (954 occurrences) and Disclosure Control (973 occurrences) had a similar number of occurrences but with different patterns. As Table 1 shows, no issue dominated the Clerical category, but the three most frequent issues had similar percentages: expense M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 22 F A L L , V O L. 1 7, N O. 1

5 Figure 1: Number of Restatements a by Year 2, ,852 1,800 1,791 1,600 1,641 1, Number of Restatements 1,400 1,200 1, ALL RESTATEMENTS , Disclosure Control 70 Fraud Accounting Clerical ,241 1, Number of Restatements by Category a. One restatement can involve issues from multiple categories, hence the sum of restatements by category is more than the total number of restatements in each year. recording (9.43%); inventory, vendor, and/or cost of sales (8.07%); and revenue recognition (7.86%). On the other hand, the top issue in the Disclosure Control category material weakness Section 404 or 302 issues identified accounted for 39.77% of overall occurrences. This finding suggested that, to comply with SOX, many firms had discovered material weakness in their internal controls and restated financial statements accordingly. The second most frequent issues in Disclosure were audit or auditor-related restatements or nonreliance, accounting for 17.37%. Peak of Financial Restatements Figures 1 and 2 depict annual occurrences of restatements and the related issues from 2000 throught As Figure 1 shows, the number of restatements was 526 in This number gradually climbed to 1,000 in 2004 and peaked around 2005 and 2006 by reaching 1,641 and 1,852 restatements, respectively, a 64.1% and 85.2% increase over the 2004 level. The number then declined sharply and returned to 946 restatements by 2008 to approximately the same level of From 2009 onward, it stabilized at a relatively low level of between 700 and approximately 800 restatements per year. The number of restatement issues in Figure 2 exhibited a similar pattern. Years 2005 and 2006 were clearly the peak with 5,007 and 4,736 issues, respectively. The M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 23 F A L L , V O L. 1 7, N O. 1

6 Figure 2: Number of Restatements Issues by Year 5,000 5,007 1,000 4,500 4,000 4,554 4,440 4, Number of Issues 3,500 3,000 2,500 2,000 1,893 ALL ISSUES 2,289 2,095 2,616 2,339 Accounting 2,838 3,001 1, Number of Issues by Category 1,500 1, ,297 1, ,498 1, , Disclosure Control Fraud Clerical , ,297 1,161 1,423 1, ,379 1, number of restatement issues stabilized starting in 2009 with between 1,200 and 1,400 issues per year. This trend of leveled-off restatement issues continuously prevails from 2009 to 2014, according to the 2015 annual report by Audit Analytics. 3 The peak of restatements in 2005 and 2006 was likely a reaction to SOX implementation. Although Congress passed SOX in 2002, Section 404 became effective in November 2004, requiring companies to publish in their annual reports the scope and adequacy of the internal control structure and procedures for financial reporting. It also requires auditors to assess and company executives to testify to the effectiveness of such internal controls and procedures. As a result, in 2005 and 2006 companies filed an overwhelming number of restatements to meet this new requirement. The stabilized numbers after 2009 may possibly indicate that the vast majority of firms had by then complied with Section 404; therefore, companies filed fewer restatements. We also investigated trends by restatement categories. Because the Accounting category made up more than 90% of the total restatement occurrences, it is not surprising that the pattern of restatements in this category closely followed that of total restatement occurrences. The Disclosure Control category also followed the same pattern by showing a peak around 2005 and The Clerical and Fraud categories were relatively small in number and did not follow the trend of having a peak in Instead, the Clerical category restatements and issues peaked in 2005 and 2008, and the Fraud category restatements and issues peaked in 2002 and M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 24 F A L L , V O L. 1 7, N O. 1

7 Figure 3: Effect of Special 4 Issues 2,000 1,800 Total Restatements 1,600 Total Restatements removing Special 4 1,400 Number of Restatements 1,200 1, Special Special 4 Issues After closely examining the trend of financial restatements, we found that four issues, which we will refer to as the Special 4, increased six times in 2005 from prior years and contributed to 22.9% of the peak. These four issues, which Audit Analytics defined, include: A28 Lease, SFA 5, legal, contingency, and commitment ; A16 Depreciation, depletion, or amortization errors ; A29 Lease, leasehold, and FAS 13 (98) only (subcategory) ; and A6 Capitalization of expenditures. Figures 3 and 4 show the effect of the Special 4 and the adjusted restatements as well as issues after removing the Special 4. After removing the Special 4, the trend displayed a clear peak in On February 7, 2005, SEC Chief Accountant Donald T. Nicolaisen published a letter clarifying the staff s interpretation of certain accounting issues and applications under GAAP relating to operating leases. 4 Issues A28, A16, and A29 were related directly to leases, and A6 was affected indirectly because of capital leases. Therefore, we probably can attribute the surge of Special 4 issues in restatements to Nicolaisen s letter. Furthermore, in 2005 the Special 4 issues came primarily from two NAICS industries: Retail Trade (334 issues; 32.02%) and Accommodation and Food Services (180 issues; 17.26%). As companies in both sections were likely to operate with leased facilities, this result was not surprising. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 25 F A L L , V O L. 1 7, N O. 1

8 Figure 4: Effect of Special 4 Restatements 5,000 4,500 Total Issues 4,000 Total Issues removing Special 4 3,500 Number of Issues 3,000 2,500 2,000 1,500 1,000 Special Industry Concentration To investigate industry concentration and possible industry-specific effect of restatements, we combined restatements across the entire sample periods and grouped them by the firms NAICS industry codes. There were 20 industries with restatements during our sample period. We ranked the industries based on number of restatements, and our findings appear in Figure 5. The evidence shows that more than 75% of restatements occurred in five industry sectors: Manufacturing (3,431; 28.91%), Finance and Insurance (2,270; 19.13%), Information (1,413; 11.91%), Mining, Quarrying, Oil, and Gas (1009; 8.50%), and Professional, Scientific, and Technical Service (835; 7.04%). 5 We also investigated restatement issue occurrences in each industry and found a similar pattern, which appears in Figure 6. Restatement issue occurrences also were concentrated in the same five industries as the restatements, with the most issue occurrences in Manufacturing (8,339), Finance and Insurance (4,954), and Information (3,455). As expected, the most frequent restatement issues were in the Accounting category. The common leading issues of restatements were debt, quasi-debt, warrants, and equity security ; expense recording ; revenue recognition ; and acquisition, merger, disposals, and reorg accounting. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 26 F A L L , V O L. 1 7, N O. 1

9 Figure 5: Number of Restatements by NAICS Sector Codes Manufacturing ,431 Finance and Insurance 52 2,270 Information 51 1,413 Mining, Quarrying, and Oil and Gas Extraction 21 1,009 Professional, Scientific, and Technical Services Retail Trade Wholesale Trade 42 Utilities 22 Administrative and Support and Waste Management 56 and Remediation Services Real Estate Rental and Leasing 53 Transportation and Warehousing Accommodation and Food Services 72 Management of Companies and Enterprises 55 Health Care and Social Assistance 62 Arts, Entertainment, and Recreation 71 Construction 23 Other Services (except Public Administration) 81 Educational Services 61 Agriculture, Forestry, Fishing and Hunting 11 Public Administration ,000 1,500 2,000 2,500 3,000 3,500 4,000 Noticeably, there were specific issues that were associated only with certain industries: l Deferred, stock-based, and/or executive compensation in Professional, Scientific, and Technical Services; l Liabilities, payables, reserves, and accrual estimate failures in three sectors Wholesale Trade, Transportation and Warehousing, and Educational Services; l Tax expense/benefit/deferral/other in Real Estate and Rental and Leasing; l Inventory, vendor, and/or cost of sales in Construction; and l Cash flow statement classification errors in Utilities. In addition, in Table 2 we identified issues in Manufacturing with abnormally high frequency. Manufacturing accounted for 29.36% of overall restatement issues between 2000 and But for the issue inventory, vendor, and/or cost of sales, the Manufacturing industry occupied close to half of overall occurrences in the categories of Accounting (51.92%), Fraud (46.88%), and Clerical (58.44%). Compared to M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 27 F A L L , V O L. 1 7, N O. 1

10 Figure 6: Number of Restatement Issues by NAICS Sector Codes Manufacturing ,339 Finance and Insurance 52 4,954 Information 51 3,455 Mining, Quarrying, and Oil and Gas Extraction 21 Professional, Scientific, and Technical Services 54 2,272 2,065 Retail Trade Wholesale Trade 42 Utilities 22 Administrative and Support and Waste Management 56 and Remediation Services Accommodation and Food Services 72 Transportation and Warehousing Real Estate Rental and Leasing 53 Health Care and Social Assistance 62 Management of Companies and Enterprises 55 Arts, Entertainment, and Recreation 71 Construction 23 Other Services (except Public Administration) 81 Educational Services 61 Agriculture, Forestry, Fishing and Hunting 11 Public Administration 92 1, ,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 merchandise and service sectors, manufacturing firms are involved in converting raw material to products and, hence, have more complex inventory valuation. Therefore, management accountants should pay special attention to inventory valuation and cost of sales in manufacturing firms. These findings highlight the unique aspects of the Manufacturing industry that are prone to restatements. Pairings of Fraud Issues Fraud often involves orchestration and altering of multiple accounts. To investigate the pattern of fraud issues, we designed a pairing algorithm that identified the number of paired-issue occurrences. Thirty-six issues in the Fraud category generated 285 unique pairings with at least one occurrence. Table 3 illustrates the top 10 most frequent pairings of fraud issues. We found revenue recognition to be the most frequent in pairing with other fraud issues. Table 3 shows that revenue recognition was often paired with other issues such as foreign, related party, affiliated, or subsidiary ; accounts/loans receivable, investments, and cash ; and inventory, vendor, and/or cost of sales. It seems that fraudulent revenue recognition M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 28 F A L L , V O L. 1 7, N O. 1

11 Table 2: High-Frequency Restatement Issues in the Manufacturing Industry Number of issues Number of issues in Manufacturing in all industry restatements Issue number Issue description a b a/b(%) All issues combined 8,339 28, % A27 Inventory, vendor, and/or cost of sales % B25 Inventory, vendor, and/or cost of sales % B30 Lease, leasehold, and SFAS No. 13(98) only % B6 Capitalization of expenditure issues % C28 Inventory, vendor, and/or cost of sales % C13 Deferred, stock-based, and/or executive comp % C26 Intercompany, investment in subs/affiliates % D31 Loan covenant violations % was concocted most often through transactions with foreign, related party, affiliated, or subsidiary. Enron, for example, created a special form of related parties the special purpose entities to avoid investment loss recognition and hide debt. 6 In the case of pairing with accounts/loans receivable, investments, and cash and inventory, vendor, and/or cost of sales, fraudulent revenue reporting often results in overstated accounts receivable and inflated cost of sales. Fictitious sales, channel stuffing, and recognizing revenue too early are common examples that would result in such pairings. Finally, revenue fraud frequently is tied with inappropriate expense recording. In the WorldCom case, the company not only inflated revenue but also capitalized rather than expensed line cost. The Big 4 Effect We also analyzed the role of auditing firms in restatement filings and found that out of 810 auditors, the Big 4 accounting firms PricewaterhouseCoopers LLP (PWC), Ernst & Young LLP (E&Y), Deloitte & Touche LLP, and KPMG LLP accounted for 5,311 Table 3: Top 10 Pairings of Fraud Issues Issue 1 Issue 2 Freq. Total Percent B21-Foreign, subsidiary-only issues (subcategory) B20-Foreign, related party, affiliated, or subsidiary issues % B32-Revenue recognition issues B20-Foreign, related party, affiliated, or subsidiary issues % B32-Revenue recognition issues B1-Accounts/loans receivable, investments, and cash issues % B32-Revenue recognition issues B25-Inventory, vendor, and/or cost of sales issues % B32-Revenue recognition issues B17-Expense (payroll, SGA, other) recording issues % B32-Revenue recognition issues B21-Foreign, subsidiary-only issues (subcategory) % B20-Foreign, related party, affiliated, or subsidiary issues B1-Accounts/loans receivable, investments, and cash issues % B32-Revenue recognition issues B28-Liabilities, payables, reserves, and accrual estimate failure % B17-Expense (payroll, SGA, other) recording issues B1-Accounts/loans receivable, investments, and cash issues % B21-Foreign, subsidiary-only issues (subcategory) B1-Accounts/loans receivable, investments, and cash issues % M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 29 F A L L , V O L. 1 7, N O. 1

12 Table 4: Percent of Restatements Reported by Big 4 Auditors Category Auditor Average Accounting Fraud Clerical Control Disclosure 1 PricewaterhouseCoopers LLP 12.65% 12.51% 22.75% 15.59% 23.26% 2 Ernst & Young LLP 10.25% 10.11% 11.64% 12.03% 9.36% 3 Deloitte & Touche LLP 12.81% 12.75% 17.99% 13.39% 12.57% 4 KPMG LLP 9.05% 8.94% 14.29% 12.03% 10.70% Total 44.76% 44.31% 66.67% 53.04% 55.89% (44.75%) of all reported restatements. The next three audit firms with the most number of restatements include Grant Thornton, BDO Seidman LLP, and Malone & Bailey LLP. Further analysis into categories of restatements revealed that the Big 4 accounting firms detected 66.7% of the Fraud category restatements. In particular, PWC accounted for 22.75% of financial restatements in Fraud. Further, the Big 4 also reported more issues for each restatement. PWC ranked number one by discovering, on average, 2.85 issues per restatement or 19.13% more than the overall average of 2.39 issues. Following PWC was KPMG LLP s average of 2.71 issues per restatement (13.11% over average), Deloitte & Touche LLP s average of 2.57 issues per restatement (7.38% over average), and Ernst & Young LLP s average of 2.46 issues per restatement (or 2.99% over average). Tables 4 and 5 summarize the previous analyses. Our data analysis corroborates the findings of Ken Y. Chen, Randal J. Elder, and Shengmin Hung, who reported firms in the post-sox era adopted more conservative accounting reporting systems after their financial restatements. 7 Firms experiencing the most severe market reaction tended to switch to Big 4 firms to restore their credibility in the post-sox period. Their findings support our evidence that suggests a Big 4 audit is of higher quality in detecting restatement issues. Implications We found that more than 90% of the restatements were concentrated in the Accounting Rule Application Failure, which refers to restatements because of accounting rule changes and unintentional errors that result in the misapplication of GAAP. This finding indicates that financial statement preparers should pay special attention to changes and gray areas in GAAP. If a company is determined to avoid the financial and reputational cost of restatement, its firm accountants should keep up with GAAP changes and be extra diligent in applying GAAP rules. When in doubt, the accountants can seek help from external experts, consult the company s auditor, and/or directly ask the SEC Table 5: Average Number of Issues per Restatement Number of Number of Number of Issues per Poplulation Percent Auditors Issues Restatements Restatement Average Over 1 PricewaterhouseCoopers LLP 4,279 1, % 2 Ernst & Young LLP 2,997 1, % 3 Deloitte & Touche LLP 3,906 1, % 4 KPMG LLP 2,907 1, % M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 30 F A L L , V O L. 1 7, N O. 1

13 staff for GAAP clarification. If a company can eliminate rule application failure in its financial reports, the chance of restatement would be highly unlikely. In addition, we also found that among 50 issue types in the Accounting category, the top eight accounted for approximately 50% of all occurrences. This finding suggests that certain issues, such as debt valuation, expense recording, revenue recognition, and acquisitions issues, deserve more attention from accountants and auditors. Our results also revealed characteristics of restatements in different industries. We found that more than 75% of restatements are concentrated in five industry sectors: Manufacturing; Finance and Insurance; Information; Mining, Quarrying, Oil, and Gas; and Professional, Scientific, and Technical Services. The common leading issues of restatements across industries were debt, quasi-debt, warrants, and equity security ; expense recording ; revenue recognition ; and acquisition, merger, disposals, and reorg accounting. Specific issues were associated with certain industries. For example, manufacturing firms should pay special attention to inventory valuation and cost of sales. The Professional, Scientific, and Technical Services sector had high risk of restatement on issues related to deferred, stock-based, and/or executive compensation. Other findings include liabilities, payables, reserves, and accrual estimate failures in three sectors Wholesale Trade, Transportation and Warehousing, and Educational Services; tax expense/benefit/deferral/ other showed the most restatements in Real Estate and Rental and Leasing; inventory, vendor, and/or cost of sales reflected the most risk in Construction; and cash flow statement classification errors led in Utilities. These findings suggest areas or issues to which accountants in certain industries should pay close attention in order to avoid potential restatement. Although there were only 475 issue occurrences from the Fraud category, we examined them closely because of their significant social impact. Evidence showed that revenue recognition is the most common form of financial statement fraud, followed by foreign, related party, affiliated, or subsidiary issues and accounts/ loans receivable, investments, and cash. We conducted pairings of fraud issues and identified red flag pairings associated with the occurrence of revenue recognition ; foreign, related party, affiliated, or subsidiary ; accounts/loans receivable, investments, and cash ; inventory, vendor, and/or cost of sales ; expense recording ; and foreign, subsidiary-only issues. Therefore, abnormalities in these issues along with suspicious revenue recognition can be used as red flags in fraud detection. Further analysis about auditing firms revealed that the Big 4 public accounting firms accounted for 44.75% of all reported restatements. More importantly, the Big 4 detected 66.67% of the Fraud category restatements and also reported more issues for each restatement. These figures suggest that Big 4 auditors had delivered high auditing quality and had diligently complied with the stringent requirements of SOX. This finding suggests that for companies that desire close scrutiny and high-quality assurance of their financial statements, the Big 4 are probably a good choice of auditors. A financial restatement is detrimental to all of a company s stakeholders. Stockholders shoulder the financial cost of restatement and may endure volatile stock returns. Government may collect fewer taxes, and bondholders can be affected if the financial restatement triggers the violation of debt covenants. We studied and summarized the key features of restatements between 2000 and 2011 because of the number of them. Management accountants should study our findings for potential issues and areas to focus on to avoid financial restatements. Ping Lin, CMA, Ph.D., is an associate professor of accountancy at California State University in Long Beach and is a member of IMA s South Bay Chapter. You can reach her at (562) or ping.lin@csulb.edu. Sophie Lee, Ph.D., is a professor of information systems at California State University in Long Beach. She can be reached at (562) or sophie.lee@csulb.edu. Xiaoying Chen, Ph.D., is an associate professor of finance at California State University in Long Beach. You can reach her at (562) or cindy.chen@csulb.edu. Jasmine Yur-Austin, Ph.D., is a professor of finance at M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 31 F A L L , V O L. 1 7, N O. 1

14 California State University in Long Beach. She can be reached at (562) or Endnotes 1 Michael Ettredge, Lili Sun, Kevin R. Smith, and Susan Scholz, How Do Restatements Begin? Evidence of Earnings Management Preceding Restated Financial Reports, Journal of Business Finance & Accounting, February 2010, pp Paul A. Griffin, A League of Their Own? Financial Analysts Responses to Restatements and Corrective Disclosures, Journal of Accounting, Auditing & Finance, October 2003, pp Audit Analytics, Financial Restatements Trend Report, April 23, 2015, bulletin.php. 4 cpcaf htm. 5 Percentages are based on the total of 11,868 unique restatements. Out of that total, 21 restatements belong to companies that do not have a valid NAICS Industry Sector Code. Figure 5 includes the totals for all companies with a valid code. 6 Paul M. Healy and Krishna G. Palepu, The Fall of Enron, Journal of Economic Perspectives, Spring 2003, pp Ken Y. Chen, Randal J. Elder, and Shengmin Hung, Do Post- Restatement Firms Care about Financial Credibility? Evidence from the Pre- and Post-SOX Eras, Journal of Accounting and Public Policy, March-April 2014, pp M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 32 F A L L , V O L. 1 7, N O. 1