Financial restatements represent reporting failures where companies admit that previous financial representations are not reliable. Such reporting failures have various potential causes which can raise questions about the expertise and integrity of individuals that effect reporting, operations and compliance. Some of the causes include complexity of accounting standards and/or transactions, weak governance and internal controls over financial reporting, lack of transparency, earnings management, fraud misrepresentation or a simple clerical error. The effects of restatements are widespread and contingent on the cause of the restatement. Possible restatement effects include negative market reactions, reduced credit access, class action suits and turnover within management and the board of directors. A negative restatement often shakes investors’ confidence and causes the stock value to decline.

According to the Audit Analytics Report 2011, in the last three years, the quantity of restatements has levelled off and severity has remained low, but restatements have increased from companies trading on the New York Stock Exchange (NYSE) and Nasdaq. During 2009, 65 NYSE companies disclosed restatements, followed by 90 in 2010, and 108 in 2011. During 2011, restatement types being non-reliance on the previously issued financial statements represented about 57 per cent of the overall restatements disclosed by annual filers. This percentage represents the highest percentage calculated since the disclosure requirement came into effect in August 2004.

Restatements may relate to a number of different accounting issues such as revenue recognition, misclassification, equity, capital assets, inventory, acquisitions, reserves, liabilities, accounting of derivatives. One of the potential causes of misstatements is complexity in the application of accounting standards and transactions. Although there is growing push to emphasise principle-based standards, companies in the US still face demands related to rules from an array of authoritative bodies. Earnings management is another cause of misstatement. Management faces tremendous pressure to meet expectations established by various groups (for example, analysts, directors). The alternative treatments available in Generally Accepted Accounting Principles (GAAP) and exercise of judgment in their application provide a great deal of opportunity for earnings management (for example, in areas related to depreciation, reserves, asset valuation, accounting of derivatives) that is subject to abuse and mismanagement. In fact, a Securities and Exchange Commission (SEC) study conducted in April 2011 found that 80 per cent of all restatements that occurred in 2009 were the result of misapplied GAAP.

A number of parties, such as the restatement company, an independent auditor, SEC, or others can prompt financial statement restatements. According to the United States General Accounting Office (GAO) 2002 report, 49 per cent of the 919 announced restatements reported the restating company as the party responsible for recognising the previous misstatements. The company’s management can take up measures to respond to these issues in a way that can limit the damage e.g., accepting the errors and initiating corrective action, communicating openly, governance measures.

The global conglomerate - Enron Corporation, on November 8, 2001, announced that it would restate earnings for the period 1997 through 2000 and the first and second quarters of 2001 to reflect (1) recording the previously announced $1.2 billion reduction to shareholders’ equity reported by Enron in the third quarter of 2001 and (2) various income statement and balance sheet adjustments required as the result of a determination by Enron and its auditors (which resulted from information made available from further review of certain related-party transactions) that three unconsolidated entities should have been consolidated in the financial statements pursuant to GAAP and (3) inclusion of prior-year proposed audit adjustments and reclassifications.

Currently, Indian companies can rectify their accounts for any prior period errors only through prior period adjustment in current year financial statements. However, the new Companies Bill 2012 (the Bill) allows restatement of financial statements on the order by a court of competent jurisdiction of the National Company Law Tribunal to the effect that the relevant earlier accounts were prepared in a fraudulent manner or the affairs of the company were mismanaged during the relevant period, casting a doubt on the reliability of financial statements. The Bill also provides for voluntary revision of financial statements in respect of any of the three preceding financial statements after obtaining approval of the Tribunal, if it appears to the directors of the company that the financial statements are not in compliance with the requirements of the Bill.

Managing the risk of financial restatements requires strong commitment to a long-term focus on financial reporting, governance and internal controls. These processes should include periodic restatement risk assessment and investment in Governance, Risk assessment and Compliance (GRC) frameworks that prioritise financial reporting reliability. Implementation of these processes would require active involvement among a variety of internal and external stakeholder groups. These measures would enable to curtail the number of restatements to the financial statements.

Sunil S. Kothari is Partner and Yogi Patel is Senior Manager, Deloitte Haskins & Sells.

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