Financial Restatements: Update of Public Company Trends, Market
Impacts, and Regulatory Enforcement Activities (24-JUL-06,
GAO-06-678).
In 2002, GAO reported that the number of restatement
announcements due to financial reporting fraud and/or accounting
errors grew significantly between January 1997 and June 2002,
negatively impacting the restating companies' market
capitalization by billions of dollars. GAO was asked to update
key aspects of its 2002 report (GAO-03-138). This report
discusses (1) the number of, reasons for, and other trends in
restatements; (2) the impact of restatement announcements on the
restating companies' stock prices and what is known about
investors' confidence in U.S. capital markets; and (3) regulatory
enforcement actions involving accounting- and audit-related
issues. To address these issues, GAO collected restatement
announcements meeting GAO's criteria, calculated and analyzed the
impact on company stock prices, obtained input from researchers,
and analyzed selected regulatory enforcement actions.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-06-678
ACCNO: A57449
TITLE: Financial Restatements: Update of Public Company Trends,
Market Impacts, and Regulatory Enforcement Activities
DATE: 07/24/2006
SUBJECT: Accounting procedures
Accounting standards
Auditing standards
Corporations
Financial management
Financial statements
Internal controls
Investments
Stock exchanges
Strategic planning
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GAO-06-678
* [1]Report to the Ranking Minority Member, Committee on Banking,
Housing, and Urban Affairs, U.S. Senate
* [2]July 2006
* [3]FINANCIAL RESTATEMENTS
* [4]Update of Public Company Trends, Market Impacts, and
Regulatory Enforcement Activities
* [5]Contents
* [6]Results in Brief
* [7]Background
* [8]The Number of Restatements Has Continued to Grow and New
Trends Have Emerged
* [9]The Number of Restatement Announcements Grew since 2002,
as Did the Number of Listed Companies Restating
* [10]The Percentage of Large Companies Restating Has
Continued to Grow
* [11]Restatement Announcements Most Frequently Were Made for
Cost- or Expense-Related Reasons
* [12]Internal Parties Prompted the Majority of Restatements
Announced from 2002 through 2005
* [13]While SEC Revised Its Forms to Make Disclosures of
Certain Restatements More Uniform, Many Companies Continue
to File in Other Formats
* [14]Market Capitalization of Restating Companies Decreased by
Billions in the Days Surrounding Restatement Announcements, but
Was Less Severe Than in Our Prior Report
* [15]On Average, Stock Prices Fell over the Days Surrounding
the Initial Restatement Announcement
* [16]Reasons That Could Involve Reporting Fraud or Other
Unspecified Issues, and Revenue Recognition Issues Continued
to Significantly Impact Market Capitalization; but Cost or
Expense Issues Produced Greater Dollar Losses
* [17]Restatement Announcements Continued to Have Some
Longer-Term Impact on the Market Capitalization of Restating
Companies
* [18]Certain Restatements Appear to Affect Investor Confidence but
Trends in Restatements Complicate Analysis
* [19]Researchers Have Suggested Numerous Reasons for Why
Investors May Have Reacted Both Positively and Negatively to
Restatements since 2002
* [20]UBS/Gallup Index of Investor Confidence Reveals Investor
Confidence Remains Low but Accounting Issues Appear to Be of
Less Concern
* [21]Yale Indexes Shows Mixed Results for Changes in Stock
Market Confidence since 2002
* [22]Accounting- and Auditing-Related Enforcement Actions Have
Continued to Grow
* [23]Financial Fraud and Issuer Reporting Issues Accounted
for a Significant Number of SEC's Actions
* [24]SEC's Enforcement Resources Have Grown
* [25]Accounting- and Auditing- Related Actions Included a
Variety of Entities and Individuals
* [26]Newly Created PCAOB Also Took Variety of Enforcement
Actions
* [27]Conclusions
* [28]Recommendations
* [29]Agency Comments and Our Evaluation
* [30]Objectives, Scope, and Methodology
* [31]Identifying the Number of and Reasons for Restatements
* [32]Determining the Impact of Restatements on Market Values of
Restating Companies
* [33]Determining the Impact of Restatements on Investor Confidence
* [34]Analysis of SEC's Accounting-Related Enforcement Activities
* [35]Comments from the Securities and Exchange Commission
* [36]Comments from the Public Company Accounting Oversight Board
* [37]Summary of Selected Sarbanes-Oxley Act Provisions Affecting Public
Companies and Registered Accounting Firms
* [38]GAO-06-1053R
* [39]Comparison of Our Restatement Database to Those of Glass, Lewis &
Co. LLC and the Huron Consulting Group
* [40]Our Methodology Focused on Determining the Impact of
Restatement Announcements on Market Capitalization
* [41]Comparison with Outside Studies Suggested That Our Database
Was a Comprehensive Listing of Publicly-Listed Companies, but Did
Not Capture a Number of the Smallest Publicly-Traded Companies
* [42]SEC Enforcement Process
* [43]Case Study Overview
* [44]Business Overview
* [45]Restatement Data
* [46]Accounting/Audit Firm
* [47]Stock Prices
* [48]Securities Analysts' Recommendations
* [49]Credit Rating Agency Actions
* [50]Legal and Regulatory Actions Taken
* [51]American International Group, Inc. Case Study
* [52]Business Overview
* [53]Restatement Data
* [54]Accounting/Audit Firm
* [55]Stock Prices
* [56]Securities Analysts' Recommendations
* [57]Credit Rating Agency Actions
* [58]Legal and Regulatory Actions Taken
* [59]Dynacq Healthcare, Inc. Case Study
* [60]Business Overview
* [61]Restatement Data
* [62]Accounting/Audit Firm
* [63]Stock Prices
* [64]Securities Analysts' Recommendations
* [65]Credit Rating Agency Actions
* [66]Legal and Regulatory Actions Taken
* [67]Federal National Mortgage Association (Fannie Mae) Case Study
* [68]Business Overview
* [69]Restatement Data
* [70]Accounting/Audit Firm
* [71]Stock Prices
* [72]Security Analysts' Recommendations
* [73]Credit Rating Agency Actions
* [74]Legal and Regulatory Actions Taken
* [75]Qwest Communications International, Inc. Case Study
* [76]Business Overview
* [77]Restatement Data
* [78]Accounting/Audit Firm
* [79]Stock Prices
* [80]Securities Analysts' Recommendations
* [81]Credit Rating Agency Actions
* [82]Legal and Regulatory Actions Taken
* [83]Starbucks Corporation Case Study
* [84]Business Overview
* [85]Restatement Data
* [86]Accounting/Audit Firm
* [87]Stock Prices
* [88]Securities Analysts' Recommendations
* [89]Credit Rating Agency Actions
* [90]Legal and Regulatory Actions Taken
* [91]Sterling Bancshares, Inc. Case Study
* [92]Business Overview
* [93]Restatement Data
* [94]Independent Auditor
* [95]Stock Prices
* [96]Securities Analysts' Recommendations
* [97]Credit Rating Agency Actions
* [98]Legal and Regulatory Actions Taken
* [99]GAO Contact and Staff Acknowledgments
* [100]Glossary
* [101]Asset write-down/write off
* [102]Derivative
* [103]Goodwill
* [104]Impairment
* [105]Option
* [106]Round-trip transactions
* [107]Warrant
Report to the Ranking Minority Member, Committee on Banking, Housing, and
Urban Affairs, U.S. Senate
July 2006
FINANCIAL RESTATEMENTS
Update of Public Company Trends, Market Impacts, and Regulatory
Enforcement Activities
Contents
Tables
Figures
July 24, 2006Letter
The Honorable Paul S. Sarbanes
Ranking Minority Member
Committee on Banking, Housing, and Urban Affairs
United States Senate
Dear Senator Sarbanes:
Public confidence in financial reporting is critical to the effective
functioning of the securities markets. However, restatements have resulted
in billions of dollars of lost market capitalization, as markets react to
news that companies plan to restate their prior financial statements or
earnings reports. For example, in a 2002 report, we estimated that
restatements of financial statements or other financial information
resulted in approximately $100 billion decline in market capitalization in
the days surrounding the restatement announcement.^1 Moreover, we found
that from January 1997 through June 2002, 845 public companies announced
the need to restate their financial information because of financial
reporting fraud and/or accounting errors.^2
Responding to corporate failures and the financial reporting fraud that
resulted in substantial losses to institutional and individual investors,
Congress passed the Sarbanes-Oxley Act in 2002 (Sarbanes-Oxley Act).^3 The
act contains provisions affecting the financial reporting of public
companies, including management assessment and auditor attestation about
the effectiveness of internal controls. Industry observers expected that
the number of public companies restating their financial statements would
increase for some period of time because of increased scrutiny of internal
controls over financial reporting, and then eventually level off as
companies improved their controls.
You asked that we update our 2002 report on restatements. In this report,
we (1) determine the number of, reasons for, and other trends in
restatements of previously reported financial information; (2) analyze the
impact of restatement announcements on the restating companies' stock
market capitalization; (3) research available data to determine the impact
of restatements on investors' confidence in the existing U.S. system of
financial reporting and capital markets; and (4) analyze Securities and
Exchange Commission (SEC) enforcement actions involving accounting- and
audit-related issues.
To identify restatements, we used Lexis-Nexis, an online information
service, to systematically search for restatement announcements using
variations of "restate" and other relevant words. We then identified and
collected information on 1,390 restatements announced by 1,121 public
companies--984 of which were listed companies on the New York Stock
Exchange (NYSE), Nasdaq, and American Stock Exchange (Amex)--from July 1,
2002, to September 30, 2005, that involved corrections of previously
reported financial results.^4 Throughout the report, we refer to the
subset of companies with stock listed on NYSE, Nasdaq, and Amex as
"listed." Our database generally excludes announcements involving stock
splits, changes in accounting principles, and other announced restatements
that were not made to correct errors in the application of accounting
principles.^5 We classified each of the 1,390 announced restatements we
identified into one of nine categories: revenue recognition; cost- or
expense; acquisitions and mergers; in-process research and development
(IPR&D); reclassification; related-party transactions; restructuring,
assets, or inventory; securities related; and "other" restatements. This
classification process involved some degree of judgment and other
researchers could interpret certain restatements differently. While
several other studies have used a similar methodology, we know of no
publicly available restatement list against which to compare the
completeness of our list. However, we did review companies' SEC filings
and Web sites to verify the accuracy of particular restatement
announcement dates and reasons. We also compared some qualitative features
of our database with proprietary information provided by financial
consulting firms. We also compared companies in our database with a list
of companies that had filed Form 8-K, Item 4.02, disclosures with SEC
between August 2004 and September 2005 to identify companies that
warranted further review concerning how they disclosed their restatement
announcements.
To determine the immediate impact on stock prices, as in our prior report,
we used the standard event study methodology, which is widely accepted in
the academic literature. We were able to analyze 1,061 of the 1,390
restatements that were announced from July 1, 2002, through September 30,
2005; we also collected information on other characteristics of
restatement trends. We were unable to include 329 in our primary analysis
because (1) they involved stocks not listed on NYSE, Nasdaq, or Amex; or
(2) they were missing data for the relevant period for causes including
trading suspensions, bankruptcies, and mergers. For the 1,061 cases, we
analyzed the company's stock price from the trading day before through the
trading day after the announcement date to assess the immediate impact and
calculate the change in market capitalization. We analyzed the
intermediate impact (20 trading days before and after the restatement
announcement date) for 991 of the 1,390 restatements to capture any
potential information leakage concerning potential restatements.^6 We also
analyzed the longer-term impact (60 trading days before and after the
restatement announcement date) for 928 of the 1,390 restatements to gauge
whether the company's stock prices rebounded over time.^7 In the
immediate-, intermediate-, and longer-term calculations, we adjusted for
overall market movements. Additionally, we performed a separate immediate
impact analysis of the 329 announcements that we were unable to analyze in
the primary event study, which was limited to a simple assessment of any
changes in unadjusted market capitalization. To analyze the impact of
restatements on investor confidence, we identified a number of indexes,
reviewed quantitative research on the issue, conducted structured
interviews with (and collected information) from experts in accounting and
financial markets, and collected data on a variety of proxy measures.
To obtain information about the recent enforcement actions SEC has taken
involving accounting- and auditing-related issues, which may or may not
involve a restatement, we collected information on SEC's enforcement
process, reviewed available SEC information, and collected enforcement
case data from over 800 Accounting- and Auditing-Related Enforcement
Releases (AAER) issued from March 1, 2002, through September 30, 2005
posted on SEC's Web site as of July 1, 2006. We also interviewed officials
from SEC and the Public Company Accounting Oversight Board (PCAOB), which
was established by the Sarbanes-Oxley Act to oversee the audits of public
companies subject to the securities laws.
We conducted our work between June 2005 and August 2006 in accordance with
generally accepted government auditing standards. For additional
information on our scope and methodology, see appendix I.
Results in Brief
While the number of companies announcing financial restatements from 2002
through September 2005 rose from 3.7 percent to 6.8 percent, restatement
announcements identified grew about 67 percent over this period. Of the
restatements identified, cost- or expense-related issues were the primary
reason for restatements during this period and most were prompted by
internal parties, such as management or internal auditors. Some industry
observers commented that increased restatements were the expected
byproduct of the greater focus--by company management, audit committees,
external auditors, and regulators--on the quality of financial reporting.
The cumulative totals were 919 restatements over a 66-month period that
ended June 30, 2002, and 1,390 restatements over the 39-month period that
ended September 30, 2005. Over the period of January 1, 2002, through
September 30, 2005, the total number of restating companies (1,084)
represents 16 percent of the average number of listed companies from 2002
to 2005, as compared to almost 8 percent during the 1997-2001 period. The
median size (by market capitalization) of restating companies increased
from $277 million in 2002 to $682 million in 2005. For the July 2002
through September 2005 period, the 1,121 restating companies we identified
(accounting for 1,390 restatement announcements) announced that they would
restate their financial information for many reasons--for example, to
adjust revenue, costs or expense, or address securities-related issues.
Cost- or expense-related issues were the primary reason for restatements,
which included numerous lease accounting issues in early 2005; overall
cost- or expense related issues accounted for 35 percent of the 1,390
announced restatements during this period. Internal parties (e.g.,
management or internal auditors) prompted a majority (58 percent) of the
announced restatements, while external parties (e.g., external auditors or
regulators) prompted nearly one-quarter (24 percent) of them; we were
unable to identify the prompter in the remaining 18 percent.
The market capitalization of the companies--those we were able to analyze
from among the listed companies that we identified as announcing
restatements of previously reported information between July 2002 and
September 2005--decreased an estimated $36 billion when adjusted for
overall market movements (nearly $18 billion unadjusted) in the days
around the initial restatement announcement.^8 For the restating companies
we analyzed, stock prices fell almost 2 percent on average (market
adjusted) from the trading day before through the trading day after an
initial restatement announcement. This short-term impact ($36 billion), if
realized, may have been significant for the companies and shareholders
involved, but represents about 0.2 percent of the combined total market
capitalization of NYSE, Nasdaq, and Amex, which was $17 trillion in 2005.
Although capturing the impact of a restatement announcement over
intermediate and longer periods (20 and 60 trading days before and after
the event, respectively) is more difficult, our analyses suggest that
restatement announcements have had a somewhat negative effect on stock
prices beyond their immediate impact. The announced reasons for
restatements also were a factor in how great an impact a restatement
announcement had on stock prices. In a change from our previous report,
cost- or expense-related issues were the most frequently cited reasons for
restating and had the greatest impact on market capitalization in dollar
terms, but as was the case in our previous report, restatements involving
revenue issues and financial reporting fraud and/or accounting errors
generally led to greater market losses than restatements for other
reasons.
Although researchers generally agree that restatements can have a negative
effect on investor confidence, the surveys, indexes, and other proxies for
investor confidence that we reviewed did not indicate definitively whether
investor confidence increased or decreased since 2002. To illustrate, some
researchers noted that, since 2002, investors may have had more difficulty
discerning whether a restatement represented a response to: aggressive or
abusive accounting practices, the complexity of accounting standards, the
remediation of past accounting deficiencies, or technical adjustments.
However, several survey-based indexes and other proxies for investor
sentiment did not indicate a consensus on the direction of investor
confidence since 2002. For example, a periodic UBS/Gallup survey, aimed at
measuring investor confidence indicated that while concerns over corporate
accounting practices still existed, overall investor confidence remained
low primarily because of concerns such as high energy prices and the
federal budget deficit. In contrast, the Yale confidence indexes, which
found investor confidence levels were largely unaffected by the accounting
scandals prior to 2003, more recently showed that institutional investors
have slightly more confidence in the stock market--but results for
individual investors were unclear.^9 Finally, other measures and proxies
for investor confidence indicated that increased financial restatements
may not have had a negative impact on overall confidence or, if they had,
any negative impact had been counterbalanced by other, more positive
forces.
The number of SEC enforcement cases involving financial fraud and issuer
reporting issues increased from 79 in fiscal year 1998 to 185 in fiscal
year 2005--a more than a 130 percent increase. Moreover, in fiscal year
2005, cases involving financial fraud and issuer reporting issues
constituted the largest category of enforcement actions. The resources SEC
devoted to enforcement grew as well. The financial debacles of the late
1990s and early 2000s spurred Congress to increase SEC's resources to help
SEC better manage its increased workload. This resulted in a 22 percent
increase in SEC's enforcement resources between fiscal years 2002 and
2003. Of the enforcement actions SEC resolved between March 1, 2002, and
September 30, 2005, SEC brought about 90 percent against public companies
or their directors, officers, and employees; the other 10 percent of the
cases involved accounting firms and individuals affiliated with accounting
firms. To address such violations, SEC sought a variety of penalties
against these companies and individuals, including monetary sanctions,
cease-and-desist orders, and bars on individuals appearing before SEC or
serving as officers or directors in public companies. In addition, the
newly created PCAOB also has broad investigative and disciplinary
authority over public accounting firms that have registered with it and
persons associated with such firms; PCAOB has initiated several
enforcement actions since its inception.
This report includes recommendations to SEC to help ensure compliance with
its Form 8-K reporting requirements and make consistent existing SEC
guidance on public company disclosures of restatements that result in
non-reliance on previously issued financial statements. This would include
investigating the instances of potential noncompliance that we identified
and take any necessary actions to correct them. Moreover, to improve the
consistency and transparency of information provided to markets about
restatements, we recommend that SEC harmonize existing instructions and
guidance concerning Item 4.02 by amending the instructions to Form 8-K and
other relevant periodic filings to clearly state that an Item 4.02
disclosure on Form 8-K is required for all determinations of non-reliance
on previously issued financial statements (Item 4.02), irrespective of
whether such information has been disclosed on a periodic report or
elsewhere.
We requested comments on a draft of this report from the Chairmen of SEC
and PCAOB. SEC and PCAOB provided written comments. In response to our
recommendations, SEC noted that it would (1) continue its practice of
examining instances of potential noncompliance and take appropriate
actions, and (2) carefully consider our recommendation that it harmonize
certain instructions and guidance related to restatements. PCAOB noted
that as the overseer of the audit of public companies, it is very
interested in the trends in financial restatements identified in the
report and the impact on public companies and investors and thinks that
the report will advance an understanding of this important issue. We
reprinted SEC's and PCAOB's written comments in appendixes II and III,
respectively, and discuss them in greater detail near the end of this
report. Both SEC and PCAOB provided technical comments that were
incorporated into the report as appropriate. We also obtained comments
from officials at several of the companies selected as case studies in
this report and have incorporated their comments as appropriate.
Background
Public confidence in the reliability of financial reporting is critical to
the effective functioning of the securities markets, and various federal
laws and entities help ensure that the information provided meets such
standards. Federal securities laws help to protect the investing public by
requiring public companies to disclose financial and other information.
SEC was established by the Securities Exchange Act of 1934 (the Exchange
Act) to operationalize and enforce securities laws and oversee the
integrity and stability of the market for publicly traded securities. SEC
is the primary federal agency involved in accounting requirements for
publicly traded companies. Under Section 108 of the Sarbanes-Oxley Act,
SEC has recognized the accounting standards set by the Financial
Accounting Standards Board (FASB)--generally accepted accounting
principles (GAAP)--as "generally accepted" for the purposes of the federal
securities laws. SEC reviews and comments on registrant filings and issues
interpretive guidance and staff accounting bulletins on accounting
matters.
To issue securities for trading on an exchange, a public company must
register the securities offering with SEC, and to register, the company
must meet requirements set by the Exchange Act, as amended, including the
periodic disclosure of financial and other information important to
investors. The regulatory structure of U.S. markets is premised on a
concept of corporate governance that makes officers and directors of a
public company responsible for ensuring that the company's financial
statements fully and accurately describe its financial condition and the
results of its activities. Company financial information is publicly
disclosed in financial statements that are to be prepared in accordance
with standards set by FASB and guidance issued by SEC. The integrity of
these financial statements is essential if they are to be useful to
investors and other stakeholders.
In addition to the requirements and standards previously discussed, the
securities acts and subsequent law set requirements for annual audits of
the financial statements by registered public accounting firms to help
ensure the integrity of financial statements. The applicable standards
under these laws require that auditors plan and perform the audit to
obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes an examination, on a test
basis, of evidence supporting the amounts and disclosures in the financial
statements; an assessment of the accounting principles used and
significant estimates made by management; and an evaluation of the overall
financial statement presentation. The purpose of the auditor's report is
to provide reasonable assurance about whether the financial statements
present fairly, in all material respects, the financial position of the
company, the results of its operations, and its cash flows, in conformity
with U.S. GAAP.
The Sarbanes-Oxley Act reinforces principles and strengthens requirements
(established in previous law), including measures for improving the
accuracy, reliability, and transparency of corporate financial reporting.
Specifically, Section 302 requires that the chief executive officer (CEO)
and chief financial officer (CFO) must certify for each annual and
quarterly report filed with SEC that they have reviewed the report; the
report does not contain untrue statements or omissions of a material fact;
and the financial information in the report is fairly presented. In
addition, Section 404 requires company management to annually (1) assess
its internal control over financial reporting and report the results to
SEC and (2) have a registered public accounting firm attest to and report
on management's assessment of effectiveness of internal control over
financial reporting. While larger public companies have implemented
Section 404, most companies with less than $75 million in public
float--about 60 percent of all public companies--have yet to complete this
process.^10 (See app. IV for further discussion of the act.)
To oversee the auditing of publicly traded companies, the Sarbanes-Oxley
Act established PCAOB, a private-sector nonprofit organization. Subject to
SEC oversight, PCAOB sets standards for, registers, and inspects the
independent public accounting firms that audit public companies and has
the authority to conduct investigations and disciplinary proceedings and
impose sanctions for violations of law or PCAOB rules and standards.
Specifically, Section 105 of the Sarbanes-Oxley Act granted PCAOB broad
investigative and disciplinary authority over registered public accounting
firms and persons associated with such firms. In May 2004, SEC approved
PCAOB's rules implementing this authority. According to the rules, PCAOB
staff may conduct investigations concerning any acts or practices, or
omissions to act, by registered public accounting firms and persons
associated with such firms, or both, that may violate any provision of the
act, PCAOB rules, the provisions of the securities laws relating to the
preparation and issuance of audit reports and the obligations and
liabilities of accountants with respect thereto, including SEC rules
issued under the act, or professional standards. Furthermore, PCAOB's
rules require registered public accounting firms and their associated
persons to cooperate with PCAOB investigations, including producing
documents and providing testimony. The rules also permit PCAOB to seek
information from other persons, including clients of registered firms. See
figure 1 for the existing system of corporate governance and accounting
oversight structures.
Figure 1: Existing System of Corporate Governance and Accounting Oversight
Structures
^aSEC has delegated front-line regulation of broker-dealers to the
self-regulatory organizations. NASD was previously known as the National
Association of Securities Dealers.
^bFAF refers to the Financial Accounting Foundation.
^cSEC has recognized the accounting standards set by the Financial
Accounting Standards Board (FASB) to be "generally accepted" for the
purposes of the securities laws.
^dEITF refers to FASB's Emerging Issues Task Force.
The Number of Restatements Has Continued to Grow and New Trends Have
Emerged
Although the number of public companies restating their publicly reported
financial information due to financial reporting fraud and/or accounting
errors remained a relatively small percentage of all publicly listed
companies, the number of restatements has grown since 2002. For example,
314 companies announced restatements in 2002 and 523 announced
restatements in 2005 (through September). In addition, of the 1,390
announced restatements we identified, the percentage of large companies
announcing restatements has continued to grow since 2002.^11 While large
and small companies restate their financial results for varying reasons,
change in cost- or expense-related items, which includes lease accounting
issues, was the most frequently cited reason for restating. While both
internal and external parties could prompt restatements, internal parties
such as company management or internal auditors prompted the majority of
restatement announcements. Finally, we found that, despite SEC's efforts
to create a more transparent mechanism for disclosing restatements through
revisions to Form 8-K, some companies had not properly filed such
disclosures and continued to announce intentions to restate previous
financial statements results in a variety of other formats.
The Number of Restatement Announcements Grew since 2002, as Did the Number
of Listed Companies Restating
The number of annual announcements of financial restatements generally
increased, from 314 in 2002 to 523 in 2005 (through September)--an
increase of approximately 67 percent (see fig. 2). This constituted a
nearly five-fold increase from 92 in 1997 to 523 in 2005. Furthermore,
from July 2002 through September 2005, a total of 1,121 public companies
made 1,390 restatement announcements.^12 Some industry observers noted
that several factors may have prompted more U.S. publicly traded companies
to restate previously reported financial results, including (1) the
financial reporting requirements of the Sarbanes-Oxley Act, especially the
certification of financial reports required by Section 302 and the
internal controls provisions of Section 404; (2) increased scrutiny from
the newly formed PCAOB through its inspections of registered public
accounting firms; and (3) increased staffing and review by SEC.
Figure 2: Total Number of Restatement Announcements Identified, January
1997-September 2005
Notes: Includes restatement announcements by larger public companies
traded on the Over-the-Counter (OTC) Bulletin Board and on the National
Quotation Service Bureau's Pink Sheets (Pink Sheets).
As the number of restatement announcements rose, the numbers of listed
companies making the announcements increased as well. While the average
number of companies listed on NYSE, Nasdaq, and Amex decreased about 10
percent from 7,144 in 2002 to 6,473 in 2005, the number of listed
companies restating their financial results increased from 265 in 2002 to
439 in 2005 (through September), representing about a 67 percent increase
(see table 1). On a yearly basis, the proportion of listed companies
restating grew from 3.7 percent in 2002 to 6.8 percent in 2005. Over the
period of January 1, 2002, through September 30, 2005, the total number of
restating companies (1,084) represents 16 percent of the average number of
listed companies from 2002 to 2005, as compared to almost 8 percent during
the 1997-2001 period.
Table 1: Number of Listed Restating Companies as a Percentage of Average
Listed Companies, 2002-September 2005
Year Number of companies Number of listed companies Percent of listed
listed^a restating^b companies restating
2002 7,144 265 3.7
2003 6,780 237 3.5
2004 6,729 294 4.4
2005 6,473 439 6.8
Sources: GAO analysis of restatement announcements; NYSE, Nasdaq and SEC.
^aThe numbers of listed companies (NYSE-, Nasdaq-, and Amex-listed
companies) for each year from 2002 to 2004 are based on year-end totals.
The number of NYSE- and Amex-listed companies for 2005 is through March.
The number of Nasdaq- listed companies for 2005 is through June.
^bCompanies that restated more than one time are counted only once in the
yearly total. Also, note that the number of listed companies restating
differs from the total number of restatements because not all companies
that restated were listed on NYSE, Nasdaq, or Amex, and some companies
restated multiple times. For example, in 2004, there were 370
restatements; however, 46 were attributed to companies not listed on a
major exchange. There were 294 listed companies that were responsible for
324 of the restatement announcements in 2004, with some companies
announcing more than once.
A number of other researchers also found that restatements had increased
since calendar year 2002. The researchers used somewhat different search
methodologies to identify companies that restate previously reported
financial information and included slightly different criteria for
inclusion but arrived at similar conclusions. The Huron Consulting Group
(HCG) identified 1,067 financial statement restatements from 2002 to 2004
and noted that the increase was significant from 2003 to 2004.^13 Also,
Glass, Lewis & Co. LLC (Glass Lewis) identified 2,319 restatements of
previously issued financial information by U.S. public companies from 2003
to 2005 and also found an increase in the number of restatements over that
period.^14 Unlike our work, which included a limited number of companies
traded OTC Bulletin Board or on Pink Sheets, the Glass Lewis study also
included hundreds of smaller companies quoted on the OTC Bulletin Board or
on Pink Sheets that generally lacked analyst coverage. See appendix VI for
a comparison of various restatements studies.
The Percentage of Large Companies Restating Has Continued to Grow
For the restatements we identified, the number of large companies
announcing restatements of their previously reported financial information
due to financial reporting fraud and/or accounting errors has increased.
More specifically, large companies (i.e., companies having over $1 billion
in total assets), as a percentage of the total restating companies have
increased from about 30 percent in 2001 to over 37 percent in 2005.
Likewise, the average market capitalization of a company announcing a
restatement (for which we had data) has grown from under $3 billion (with
a median of $277 million) in the latter half of 2002 to over $10 billion
(with a median of $682 million) through September 2005. While the average
size of listed companies increased about 68 percent from 2002 to 2005, the
average size of companies restating their financials grew almost 300
percent.
Another indication that large public companies announcing restatements has
continued to increase, is the number of companies identified as announcing
restatements that are listed on the NYSE, which has more large companies
than the other U.S. stock exchanges.^15 For example, between 2002 and
September 2005, the number of NYSE-listed companies announcing
restatements had increased 64 percent from 114 to 187.^16 During the same
time, the number of Nasdaq-listed companies announcing restatements
increased 55 percent from 137 to 212, and the number of Amex-listed
restating companies increased more than 175 percent from 14 to 40.^17
While more Nasdaq-listed companies announced restatements than NYSE-listed
companies, the proportion of NYSE-listed companies restating (relative to
the total number of companies listed on the NYSE) surpassed Nasdaq-listed
companies over the period 2002-2005.^18 As figure 3 illustrates, for the
announced restatements we identified, in 2002, about 4 percent of
NYSE-listed companies announced restatements for financial reporting fraud
and/or accounting errors, whereas this percentage rose to more than 7
percent by September 2005. During the same period, the percentage of
Nasdaq-listed restating companies rose from less than 4 percent to almost
7 percent. From 2002 to 2005, the percentage of NYSE- and Nasdaq-listed
companies restating essentially mirrored each other in movement throughout
the period by declining and then increasing. However, the percentage of
Amex-listed restating companies rose each year during the 2002 to
September 2005 period from about 2.0 percent to almost 5.5 percent.
Figure 3: Percentage of Listed Companies Restating, 2002-September 2005
Note: The 2005 figures are based on restatement announcements collected
through September 2005.
Restatement Announcements Most Frequently Were Made for Cost- or
Expense-Related Reasons
Although public companies restate their financial results for a variety of
reasons, cost- or expense-related issues accounted for more than one-third
of the 1,390 restatement announcements identified from July 2002 through
September 2005 (see fig. 4). We classified cost- or expense-related
restatements generally to include a company understating or overstating
costs or expenses, improperly classifying expenses, or any other mistakes
or improprieties that led to misreported costs. Lease accounting issues
that surfaced in early 2005 were also included in this category.
Figure 4: Restatements by Reason, January 1997-June 2002 and July 2002-
September 2005
Note: Our database includes announced restatements that were being made to
correct material misstatements of previously reported financial
information. Therefore, our database excludes announcements involving
stock splits, changes in accounting principles, and other restatements
that were not made to correct mistakes in the application of accounting
standards. For this report, we found only one restatement announcement
resulting from IPR&D.
Our analysis also shows a significant drop in restatements announced for
revenue recognition reasons, which had accounted for almost 38 percent of
the restatements in our 2002 report. Cost- or expense-related issues
surpassed revenue recognition issues as the most frequently identified
cause of restatements primarily because of a large number of announcements
made in early 2005 to correct accounting for leases by the
retail/restaurant industry and tax-related issues. For example, 135 public
companies announced restatements involving issues solely related to
accounting for leases in 2005 after SEC chief accountant's February 7,
2005, letter regarding the treatment of certain leases and leasehold
improvements.^19 However, revenue recognition remained the second most
frequently identified reason for restatements from July 2002 through
September 2005, accounting for 20 percent of all the restatements. Actions
that we classified under "revenue recognition" included a company
recognizing revenue sooner or later than would have been allowed under
GAAP, or recognizing questionable or invalid revenue. (See table 2 for a
description of each reason.)
Table 2: Financial Restatement Category Descriptions
Category Description
Cost or expense Restatements due to improper accounting for
costs or expenses. This category generally
includes a company understating or overstating
costs or expenses, improperly classifying
expenses, or any other number of mistakes or
improprieties that led to misreported costs. It
also includes improper treatment of expenses
related to tax liabilities and tax reserves. In
addition, it includes improper treatment of
financing arrangements, such as leases, when a
related asset was improperly capitalized or
expensed as part of the financing arrangement.
Improperly reserved litigation restatements are
also included in this category.
Revenue recognition Restatements due to improper revenue accounting.
This category includes instances in which:
revenue was improperly recognized, questionable
revenues were recognized, or any number of other
mistakes or improprieties that led to
misreported revenue. Also included in this
category are transactions with non-related
parties that artificially inflate volume and
revenues, through the simultaneous purchase and
sale of products between colluding companies.
These are known as round-trip transactions.
Securities-related Restatements due to improper accounting for
derivatives, warrants, stock options and other
convertible securities.
Restructuring, assets, or Restatements due to asset impairment, errors
inventory relating to accounting treatment of investments,
timing and amount of asset write-downs, goodwill
and other intangibles, restructuring activity
and inventory valuation, and inventory quantity
issues.
Reclassification Restatements due to improperly classified
financial statement items, i.e., current
liabilities classified as long-term debt on the
balance sheet, or cash flows from operating
activities classified as cash flows from
financing activities on the statement of cash
flows.
Other Any restatement not covered by the listed
categories. Includes restatements due to
inadequate loan-loss reserves, delinquent loans,
loan write-offs, or other allowances for
doubtful accounts or accounting estimates; and
restatements due to fraud or accounting errors
that were left unspecified.
Acquisition and merger Restatements due to improper accounting for--or
a complete lack of accounting for--acquisitions
or mergers. These include instances in which the
wrong accounting method was used, or losses or
gains related to the acquisition were
understated or overstated.
Related-party transaction Restatements due to inadequate disclosure or
improper accounting of revenues, expenses,
debts, or assets involving transactions or
relationships with related parties.
In-process research and Restatements resulting from instances in which
development improper accounting methodologies were used to
value in-process research and development at the
time of an acquisition.
Source: GAO.
Note: We excluded announcements involving stock splits, changes in
accounting principles, and other financial statement restatements that
were made for reasons other than correcting for financial reporting fraud
and/or accounting errors.
Internal Parties Prompted the Majority of Restatements Announced from 2002
through 2005
While both internal and external parties--such as the restating company's
management or internal auditor, an external auditor, SEC, or others--can
prompt restatements, about 58 percent of the 1,390 announced restatements
were prompted by internal parties. This was an increase from about 49
percent in our 2002 report. However, in both our prior report and this
report, external parties may have been involved in discovering some of
these misstatements, even if the companies may not have made that
information clear in their restatement announcements or SEC filings. The
external auditor, SEC, or some other external party such as the media (as
in the case of an August 2002 restatement announcement by AOL Time Warner
Inc. (AOL)), was identified as prompting the restatement in 24 percent of
the announcements (compared to 16 percent in our 2002 report). In the
remaining 18 percent of the announcements (compared with 35 percent in our
2002 report), we were not able to determine who prompted the restatement
because the announcement or SEC filing did not clearly state who
discovered the misstatement of the company's prior financial results.
Figure 5: Who Prompted Restatements, January 1997-June 2002 versus July
2002-September 2005
While SEC Revised Its Forms to Make Disclosures of Certain Restatements
More Uniform, Many Companies Continue to File in Other Formats
SEC has revised Form 8-K, in part, to make information on financial
restatements more uniform and apparent to investors, but many companies
appeared to have filed potentially deficient filings. In addition,
conflicting instructions and guidance resulted in some companies
disclosing similar financial information in varying degrees and formats.
In a 2003 report required by the Sarbanes-Oxley Act, SEC proposed to
address the lack of uniformity by amending several of its periodic
disclosure forms--essentially to make issuers' public notification of
financial information uniform.^20 Specifically, in its report, SEC
proposed to amend Form 8-K to add a specific line item for public
companies to disclose what was restated and why.
In March 2004, consistent with its proposal in the 2003 report, SEC
amended Form 8-K to, among other things, add a new line item (Item 4.02),
which requires public companies to file the Form 8-K (Item 4.02) within 4
business days if management or the company's independent auditors
determine that previously issued financial statements should not be relied
upon.^21 This alerts investors to potentially important company events
that may impact their investment decision. This change became effective
August 23, 2004. This change to Form 8-K included a limited safe harbor
for failure to timely file an 8-K in certain situations, including in a
situation in which the company makes the determination the financial
statements may not be relied upon, but not in a situation when the
independent auditor makes such a determination.
In November 2004, SEC issued additional guidance to address questions
concerning the revised disclosures. This "Frequently Asked Questions"
guidance states that a Form 8-K is required for Item 4.01 (Change in
Accountant) and Item 4.02 events, even if a periodic report such as a Form
10-K or 10-Q disclosing such information is filed during the 4 business
days following the event. The amended forms and the amended rules do not
make this Form 8-K filing requirement clear, and instead indicate that the
filing of a Form 8-K may not be required if previously reported.
Specifically, the instructions for Form 8-K state that a public company is
not required to file a Form 8-K when, substantially the same information
has been previously disclosed on a periodic report.
Between August 23, 2004, and September 30, 2005, about 17 percent of
restating companies (111 companies) did not appear to file a Form 8-K for
restatements as required by SEC guidance.^22 According to our analysis,
about 30 percent of restating companies (34 companies), during this same
time period, failed to file a Form 8-K disclosing their restatements. It
appears that these companies either failed to disclose the announced
restatement at all or disclosed it in a Form 10-K or 10-Q or an amended
form. The remaining 77 companies filed a Form 8-K disclosing their
restatement, but under items other than the required 4.02--such as 2.02
(Results of Operations and Financial Condition) or 8.01 (Other Events).
Furthermore, we found that the companies filing these potentially
deficient filings included a mix of large and small companies. For
example, over one-third of the 111 companies we identified were large
companies (as measured by market capitalization, asset size, or revenue).
Moreover, a study by Glass Lewis found that about one-third of companies
restating in calendar year 2005 did not file a Form 8-K (Item 4.02) to
notify investors, or the public in general, about such a corporate event.
Market Capitalization of Restating Companies Decreased by Billions in the
Days Surrounding Restatement Announcements, but Was Less Severe Than in
Our Prior Report
We estimated that--from the trading day before through the trading day
after an initial restatement announcement--stock prices of the restating
companies decreased by an average of almost 2 percent, compared with an
average decline of nearly 10 percent in our 2002 report.^23 In addition,
we estimated that the market capitalization of restating companies
decreased by over $36 billion when adjusted for overall market movements
(nearly $18 billion unadjusted) compared to adjusted and unadjusted
declines of around $100 billion reported in 2002. These declines, while
potentially significant for the investors involved, if realized,
represented about 0.2 percent of the total market capitalization of the
three securities exchanges, which was about $17 trillion in 2005. The
reasons for restatements also appear to have affected the severity of the
impact on market capitalization, with restatements for reasons that could
involve financial reporting fraud or other unspecified causes resulting in
the most severe size-adjusted market reaction on average. However, revenue
issues continued to have a sizeable impact and, in a change from our
previous report, cost- or expense-related restatements had the greatest
impact in dollar terms because there are more of them. We also found that
the market impact of restatement announcements on restating companies over
longer periods was mixed, in contrast to our prior report, in which we
found larger, more persistent stock price and market capitalization
declines for restating companies.
On Average, Stock Prices Fell over the Days Surrounding the Initial
Restatement Announcement
We estimated that, for the 1,061 cases we were able to analyze from July
1, 2002, to September 30, 2005, the stock prices of companies making an
initial restatement announcement fell by almost 2 percent
(market-adjusted), on average, from the trading day before through the day
after the announcement (the immediate impact). Unadjusted losses in the
market capitalization of restating companies totaled nearly $18 billion,
ranging from a net gain of almost $9 billion from July through December
2002 to a loss of about $16 billion for 2004 (see table 3). But, when the
losses were adjusted for general movements in the overall market, the
market capitalization of the restating companies decreased an estimated
$36 billion.
Table 3: Summary of Immediate Impact of Restatement Announcements on
Restating Companies' Market Capitalization, July 2002-September 2005
Period Percent of Total Total Number of
market-adjusted unadjusted market-adjusted restatement
increase increase increase announcements
(decrease) in (decrease) in (decrease) in analyzed
stock price market market
capitalization capitalization
(dollars in (dollars in
billions) billions)
July-December (4.1 %) $8.7 $2.1 121 of 189
2002
2003 (1.6) (13.6) (20.1) 242 of 308
2004 (2.5) (16.4) (16.6) 297 of 370
January-September (1.0) 3.7 (1.9) 401 of 523
2005
Total (July (1.9) ($17.7) ($36.5) 1,061 of
2002-September 1,390
2005)
Sources: GAO, NYSE's TAQ, and SEC.
Notes: The changes in stock prices (measured by average holding period
abnormal returns) were statistically different from zero at the 5 percent
level of significance for all periods except 2003. We excluded 329
restatement announcements because they involved companies that were not
listed on NYSE, Nasdaq, or Amex, or had missing data because of trading
suspensions, delistings, bankruptcies, mergers, or other reasons noted in
appendix I. Numbers may not sum due to rounding.
In our prior report, we found that the immediate impact was an average
decline in stock price of nearly 10 percent and a decline, both adjusted
and unadjusted, in market capitalization of around $100 billion. Thus, in
total, the immediate impact for July 2002-2005 appeared to be less severe.
The smaller average decline in stock price (a 2 percent decline compared
with a nearly 10 percent decline) suggested that the market's reaction for
each company, on average, was not as severe. On an annual basis, and when
not adjusted for market movements, in the current report the average
annual decline was $5.4 billion, compared with $18.2 billion, in our 2002
report. However, when market-adjusted, the average decline was $11.2
billion over the analysis period for this report, compared with an average
$17.4 billion decline for the period covered in our prior report. The
increased severity of the market-adjusted immediate impact on market
capitalization likely reflected the more negative reaction to a
restatement announcement given the generally positive overall market
movement during the 2003-2005
period, and could also reflect the fact that more, larger companies
announced restatements in the July 2002-2005 period.
The immediate impact on the market capitalization of restating companies,
while potentially large for the investors involved, if realized, generally
was less than 0.2 percent of the total market capitalization of companies
listed on NYSE, Nasdaq, and Amex for a given year during 2002-2005,
ranging in magnitude from 0.01 percent to 0.14 percent (see table 4). That
the immediate impact--as a percentage of total market
capitalization--would appear relatively small is not surprising,
considering the short trading day interval that we analyzed. We chose the
3-trading-day window to focus as much as possible on the restatement
announcement, to the exclusion of other factors.^24 Later in this report,
we examine losses over longer periods, as well as the effects of
restatements on overall market confidence.
Table 4: Summary of Immediate Impact on Restating Company Market
Capitalization as a Percentage of Total Market Capitalization, July
2002-September 2005
Period Total market Total adjusted Total adjusted increase
capitalization increase (decrease) in market
of listed (decrease) in capitalization as a
companies market percentage of total
capitalization market-capitalization
(dollars in of restating
billions) companies
(dollars in
billions)
July-December 2002 $11,055 $2.1 0.02%
2003 14,266 (20.1) (0.14)
2004 16,324 (16.6) (0.10)
January-September 17,001 (1.9) (0.01)
2005
Total (July $14,662 ($36.5) (0.25)
2002-September
2005)
Sources: GAO, NYSE's TAQ, SEC, and World Federation of Exchanges.
Notes: Data on the total market capitalization of listed companies are as
of year-end. We excluded 329 restatement announcements for a variety of
reasons, including cases that involved companies that were not listed on
NYSE, Nasdaq, or Amex; and announcements that involved missing data
because of trading suspensions, delistings, bankruptcies, and mergers.
Numbers may not sum due to rounding.
While our analysis generally showed declines in market capitalization, the
results for the second half of 2002 were positive and can be explained in
large part by the influence of two large companies--Tyco International
Ltd. (Tyco) and AOL. The market reactions to the restatement announcements
of the two companies resulted in adjusted market capitalization gains of
$4.5 billion. In the cases of Tyco and AOL, both of which involved revenue
recognition issues, the restatement announcements came weeks or months
after initial news of potential accounting fraud and errors surfaced, and
so the market had likely already anticipated these announcements and
factored the information into the companies' stock prices well before the
restatement announcement. Over the 3 trading days surrounding the
announcement dates that we identified, Tyco's market capitalization
increased by around $2.8 billion and AOL's market capitalization increased
by around $1.6 billion.
We also conducted a separate analysis of the immediate impact of
restatement announcements for the 329 announcements that we were unable to
analyze in the primary event study. This group included 159 announcements
that were attributed to companies with stock not listed on the exchanges.
We limited this additional analysis to a simple assessment of the
unadjusted change in market capitalization over the three trading days
surrounding the restatement announcement, generally relying on data we
obtained from SEC's and Nasdaq's Web sites. We were able to gather
sufficient data to analyze 242 of the 329 announcements (114 announcements
made by listed companies and 128 announcements made by unlisted
companies).^25 We estimated that, on average, these restatement
announcements resulted in an average decline in market capitalization of
1.5 percent from the trading day before the announcement through the
trading day after the announcement, reflecting an unadjusted decline of
about $3.7 billion in addition to the nearly $18 billion decline estimated
in the primary event study.
Reasons That Could Involve Reporting Fraud or Other Unspecified Issues,
and Revenue Recognition Issues Continued to Significantly Impact Market
Capitalization; but Cost or Expense Issues Produced Greater Dollar Losses
Announcements made for reasons that could involve financial reporting
fraud or other unspecified causes, which we classified in the Other
category, as well as restructuring and revenue recognition-related issues,
had the largest negative impact on market capitalization when adjusted for
the size of a restating company (see fig. 6); however, when measured in
dollars, cost- or expense-related restatement announcements accounted for
more of the immediate decline in market capitalization than each of the
other reasons, over our analysis period.^26 These results are different
from the findings in our earlier report, suggesting that the nature of the
market response to restatements may have changed in some respects. (We
discuss how different types of restatements may have affected investor
confidence in another section of this report.) To assess the immediate
market impact of a given type of restatement on a restating company's
market capitalization, we computed the ratio of the estimated change in
the company's market capitalization to the company's total market
capitalization over the 3 trading days surrounding the announcement of a
restatement. We then averaged these impacts for each reason.
Figure 6: Immediate Market-Adjusted Impact on Market Capitalization of
Restating Companies by Restatement Reason, July 2002-September 2005
Notes: Company size is measured by market capitalization. This figure
illustrates the average change in market capitalization (the immediate
impact) as a percentage of restating company market capitalization. The
single observation categorized as IPR&D was omitted from this figure.
While restatement announcements involving related-party transactions,
which can revolve around revenue issues, appeared to have the largest
negative impact, this result was not statistically different from zero.
This category accounted for a relatively small number of restatements, and
the results were heavily influenced by three announcements that had
sizeable market reactions.^27
In contrast to our previous report, in which positive responses to two
large restatements attributed to restructuring, asset impairment, and
inventory issues led to market gains in that category, restatements made
for these reasons in 2002-2005 represented about 29 percent of the
market-adjusted market capitalization losses. These reasons accounted for
about 11 percent of the cases we analyzed, and the median size of a
company restating for these reasons was $504 million.
The effect of restatements announced for revenue recognition issues on
market capitalization initially appeared weaker than in our previous
report. Restatements involving revenue recognition accounted for almost 20
percent of the cases, but only around 10 percent of the market-adjusted
market capitalization losses. The median size of a company restating for
this reason was $321 million; thus it appears that companies announcing
restatements for revenue recognition reasons tended to be smaller.
However, when adjusted by the size of the restating company, restatement
announcements involving revenue recognition issues (more than many other
reasons) resulted in an average loss that represented a larger percentage
of a restating company's market capitalization.
Cost- or expense-related restatements had a greater effect on market
capitalization than in our previous report, and were distinguished from
restatements for other reasons in three ways. First by dollars, cost- or
expense-related restatement announcements accounted for more of the
immediate declines in market capitalization than other reasons over our
analysis period. More specifically, cost- or expense-related restatement
announcements accounted for $15.2 billion, or about 42 percent, of the
$36.5 billion in total losses (market-adjusted) over our analysis period.
This decline was driven in large part by the January 9, 2004, restatement
announcements by Shell Transport and Trading Company, plc, and Royal Dutch
Petroleum Company, which represented a decline in estimated market
capitalization attributed to the cost- or expense category of over $4
billion. Second, when measured by median market capitalization, companies
announcing restatements involving cost or expense issues were the largest.
The median size of a company restating for cost or expense
reasons was $632 million. Furthermore, of the 1,061 cases analyzed, cost
or expense was the most frequently cited reason for restating (38
percent).^28
Finally, the market did not perceive all restatements negatively. We found
that announcements involving the acquisition and merger category--with a
median company size of $318 million--resulted in an overall increase of
over $1.5 billion in market capitalization. The positive results are in
significant contrast to our previous report, in which we attributed more
than $19 billion in market capitalization decline to this category.
Restatement Announcements Continued to Have Some Longer-Term Impact on the
Market Capitalization of Restating Companies
Our analysis of restatement announcements showed mixed results over
intermediate and longer periods, but these announcements overall tended to
have some longer-term impacts. On a market-adjusted basis, from 20 trading
days before through 20 trading days after a restatement announcement (the
intermediate impact), we estimated that the stock prices of restating
companies declined by nearly 2 percent on average, and their market
capitalization declined by over $78 billion in aggregate; whereas, on an
unadjusted basis, the market capitalization of restating companies
decreased around $5 billion (see table 5).^29 This suggests that the
reaction was more negative than expected given the movement in the overall
market.
Table 5: Summary of Intermediate Impact of Restatement Announcements on
Restating Companies' Market Capitalization, July 2002-September 2005
Period Percent of Total Total Number of
market-adjusted unadjusted market-adjusted restatement
increase increase increase announcements
(decrease) in (decrease) in (decrease) in analyzed
stock price market market
capitalization capitalization
(dollars in (dollars in
billions) billions)
July-December (4.7%) ($8.7) ($13.7) 116 of 189
2002
2003 0.5 (25.7) (49.4) 225 of 308
2004 (3.8) (2.6) (34.6) 273 of 370
January-September (0.6) 31.7 19.1 377 of 523
2005
Total (July (1.7) ($5.2) ($78.6) 991 of 1,390
2002-September
2005)
Sources: GAO, NYSE's TAQ, and SEC.
Notes: We excluded 399 restatement announcements for a variety of reasons,
including those cases that involved companies not listed on NYSE, Nasdaq,
or Amex; and announcements that involved missing data resulting from
trading suspensions, delistings, bankruptcies, and mergers.
On a market-adjusted basis, from 60 trading days before through 60 trading
days after the announcement (the longer-term impact), we estimated that
the stock prices of restating companies decreased by less than 2 percent
on average and their market capitalization decreased by over $126 billion
in aggregate (see table 6). Unadjusted, the longer-term impact was an
increase of about $34 billion in the market capitalization of restating
companies.^30 In our 2002 report, we estimated that the unadjusted market
capitalization of restating companies that we analyzed decreased by close
to $240 billion from 60 trading days before through 60 trading days after
the announcement. This large difference may be the result of the generally
positive overall market movement during 2003-2005, an increased number of
restatements that the market did not view negatively, or the possibility
that the financial markets have grown increasingly less sensitive to
restatement announcements since 2002.
Table 6: Summary of Longer-Term Impact of Restatement Announcements on
Restating Companies' Market Capitalization, July 2002-September 2005
Period Percent of Total Total Number of
market- unadjusted market-adjusted restatement
adjusted increase increase announcements
increase (decrease) in (decrease) in analyzed
(decrease) market market
in stock capitalization capitalization
price (dollars in (dollars in
billions) billions)
July-December 2002 (12.6%) ($70.7) ($14.2 ) 113 of 189
2003 5.3 82.4 (14.1) 199 of 308
2004 (4.7) 39.7 (32.4) 258 of 370
January-September (0.1) (17.3) (65.5) 358 of 523
2005
Total (July (1.7) $34.1 ($126.3) 928 of 1,390
2002-September
2005)
Sources: GAO, NYSE's TAQ, and SEC.
Notes: We excluded 462 restatement announcements for a variety of reasons,
including announcements that involved companies that were not listed on
NYSE, Nasdaq, or Amex; and announcements that involved missing data
resulting from trading suspensions, delistings, bankruptcies, and mergers.
As we considered longer event time frames, this increased the possibility
that other factors and events may have affected a restating company's
stock price. Nevertheless, expanding the event window beyond the immediate
trading days around the restatement announcement date allowed us to assess
the longer-term impact of restatement announcements. The longer time frame
also allowed us to capture any impact from earlier company announcements,
which may have signaled restatements (for example, a company's CFO
departing a company suddenly, its outside audit firm resigning, or the
notice of an internal or SEC investigation at the company). With such
events, investors may sense that more negative news is forthcoming and
drive the company's stock price lower. For example, speculation about
potential accounting problems at AOL first appeared publicly in mid-July
2002 in The Washington Post; however, it was not until mid-August that the
company announced that it would restate. Our immediate impact analysis
around the August 14, 2002, announcement date revealed a sizeable positive
impact. However, our intermediate impact analysis showed that the market
reacted negatively to the release of the news over this event window.
Finally, our analysis only attempts to control for overall market
movements, and so for these longer periods we cannot adjust for other
factors such as company-specific news unrelated to the restatement. For
example, several weeks after announcing a restatement a company could win
a lucrative contract or be the target of an acquisition, both of which
would likely have a positive impact on its stock price. We subsumed the
impacts of any additional, unrelated events that occurred during this time
period, which would attribute them to the restatement announcement.
Appendix I provides additional details about these measures, along with
information about their limitations.
Certain Restatements Appear to Affect Investor Confidence but Trends in
Restatements Complicate Analysis
Although researchers generally agree that restatements can have a negative
effect on investor confidence, the surveys and indexes of investor
confidence that we reviewed did not indicate definitively whether investor
confidence increased or decreased since 2002. Researchers noted several
reasons for the inconclusive results about the effects of restatements on
investor confidence. For example, some researchers have noted that, since
2002, investors may have had more difficulty discerning whether a
restatement represented a response to aggressive or abusive accounting
practices, constituted remediation of past accounting deficiencies, or
merely represented technical adjustments. Furthermore, investor confidence
remains difficult to quantify because it cannot be measured directly and
because investors consider a variety of factors when making investment
decisions. However, we identified several survey-based indexes that use a
variety of methods to measure investor confidence; we also identified
empirical work by academics and financial industry experts. A periodic
UBS/Gallup survey-based index aimed at gauging investor confidence found
that, although investor confidence remains low, accounting issues appear
to be of less concern. In contrast, according to the Yale index, which
asks a different set of questions, institutional investors have had
slightly more confidence in the stock market since 2002; the index
produced uncertain results for individual investors.
Researchers Have Suggested Numerous Reasons for Why Investors May Have
Reacted Both Positively and Negatively to Restatements since 2002
Although researchers generally have agreed that restatement announcements
could send unfavorable messages about restating companies to the capital
markets, an analyst with whom we spoke expressed less agreement about the
causes and effects of restatement announcements on investors (and investor
confidence) since 2002.^31 While we found some evidence in our 2002 report
that suggested that restatement announcements prior to July 2002 may have
led to widespread concerns about the perceived unreliability of financial
reports, the impact of restatements since July 2002 on investor confidence
has been more uncertain because the driving forces behind the increase in
restatements have been less clear. For example, some analysts have
suggested that investors may not have been able to discern whether
restatements since 2002 represented a response to: aggressive or abusive
accounting practices, the complexity of accounting standards, the
remediation of past accounting deficiencies, or just technical
adjustments.^32
Some analysts indicated that the increase in the restatements is a serious
problem with negative consequences on investor confidence. Other analysts
have said that restatements might have minimal (or positive) effects on
confidence if investors saw them as a remediation of accounting problems
existing prior to the passage of the Sarbanes-Oxley Act, recognizing some
restatements as the expected byproduct of a greater focus on the quality
of financial reporting by management, audit committees, external auditors,
and regulators since 2002. Although accounting issues discovered at one
company could cause capital market participants to reassess the
credibility of financial statements issued by other companies, researchers
also noted the absence, so far, of large numbers of restatements that
represent deliberate violations of GAAP--the same kind of restatements
many believed produced widespread effects on investor confidence in 2001
and 2002 (e.g., Enron, WorldCom, and Adelphia). In that vein, others noted
that the Sarbanes-Oxley Act, the collapse of Arthur Andersen, and
perceived litigation risks have encouraged more conservative approaches
that resulted in restatements to correct small errors or technical
adjustments that likely were irrelevant to investors. Some believed that
at least a portion of the restatements since 2002 have resulted from
excessive complexity in accounting principles or the second-guessing of
legitimate judgment calls that did not appear relevant to the valuations
of the companies involved. One expert expressed concern that restatements
may have lost their salience to market participants because they now occur
so frequently, while others noted that investor confidence would be
negatively affected if the number of restatements did not decline in the
near future.
UBS/Gallup Index of Investor Confidence Reveals Investor Confidence
Remains Low but Accounting Issues Appear to Be of Less Concern
Directly measuring the effect of restatements on investor confidence
remains difficult because so many factors go into any investment decision
and the reasons for restatements, which can affect investor response,
often are unclear. However, we have highlighted results from two respected
survey-based indexes of investor confidence, obtained from UBS Americas,
Inc. and the International Center for Finance at the Yale School of
Management. The UBS Index has been acknowledged for its accuracy and
timeliness, and the Yale School of Management Indexes are considered to be
the longest-running effort to measure investor confidence.
The UBS/Gallup Index of Investor Optimism suggests that investor
confidence remains well below the March 2002 level, when investor optimism
had started to rebound following the Enron scandal.^33 As shown in figure
7, according to the survey, concerns about accounting practices and
corporate governance started to affect investor optimism, which were
heightened following the WorldCom restatement announcement in June 2002.
The index continued to decline until March 2003 when it reached an
all-time low of 5--mirroring a similar decline in stock markets. However,
in April, the survey indicates that investors where becoming more
confident in the U.S. economic recovery throughout most of 2003. By
January 2004, the index was back up to 108 before experiencing another
steep decline by September 2005 as markets reacted, in part, to a sharp
increase in energy prices. While the Index increased over the reminder of
2005, it remained below the March 2002 level through the second quarter of
2006.^34
Figure 7: UBS/Gallup Investor Optimism Index, October 1996-May 2006
These trends are consistent with various proxies for investor confidence.
For example, since April 2003, net new cash flows to equity mutual funds
have been positive. And, according to "Barron's Confidence Index,"
investor confidence returned to its historical average by mid-2004
and--despite a decline in investor confidence in 2005--has remained above
its lows in 2002 and 2003.^35
While the 2002 and 2003 surveys reported that the leading concern
expressed by investors was the negative impact of questionable accounting
practices on the market, in 2005 and 2006, investors identified a number
of other reasons as more significant for the decline in investor optimism.
The major reasons cited for the decline were (1) the price of energy,
including gas and oil; (2) the outsourcing of jobs to foreign countries;
(3) the federal budget deficit; (4) the situation in Iraq; and (5) the
economic impact of Hurricane Katrina and other storms. While some of these
reasons reflect current events, others consistently were viewed as less
important than accounting issues in the 2002, 2003, and 2004 surveys.
However, it should be noted that accounting issues continue to be viewed
as more important than a variety of other forces affecting the investment
climate such as expectations regarding inflation, the value of dollar, and
the threat of more terrorist attacks.
While a significant portion of all investors surveyed continue to believe
that accounting issues were negatively affecting the market, according to
the UBS/Gallup survey the percent of investors feeling this way has
decreased (see fig. 8). While 91 percent of all investors surveyed in 2002
felt that accounting issues were negatively impacting the market, about 71
percent felt that way in May 2006. Moreover, the percentage of investors
indicating that accounting issues were hurting the investment climate in
the United States "a lot" fell from 80 percent in July 2002 to 39 percent
in May 2006.
Figure 8: Effect of Accounting Concerns on Investor Confidence in the
Stock Market, March 2002-May 2006
The results of UBS surveys were consistent with the findings of the
Securities Industry Association's (SIA) annual investor surveys.^36 SIA
found that, although accounting at U.S. corporations was still a major
concern among investors in 2004, concern had declined significantly from
2002. Moreover, in 2004, investors seemed more concerned with the
political environment and the state of the U.S. economy than accounting
fraud and corporate governance issues. What has happened since 2004 is
unclear because no survey was conducted for 2005. However, a newer index,
the State Street Investor Confidence Index, which attempts to measure
investors' risk appetite by measuring the percent of risky assets
investors hold in their portfolio, found that investor confidence remained
relatively unchanged throughout 2005 and into 2006.^37
Yale Indexes Shows Mixed Results for Changes in Stock Market Confidence
since 2002
In our 2002 report, we noted the Yale Indexes suggested significantly
different impacts of restatements on investor confidence than the
UBS/Gallup Index of Investor Optimism; however, since the 2003, the
differences in the indexes have become less significant. The International
Center for Finance at the Yale School of Management calculates four
indexes that are based on survey questions directed to both wealthy
individual and institutional investors.^38 Although the indexes do not all
move in the same direction over time, or even approximately so, the
indexes generally show a small improvement in institutional investor
confidence over the value for June 2002, but a slight decline in
individual investor confidence with one exception. Some of the Yale
indexes show pronounced volatility in short-term confidence. In fact,
there were periods during 2003, 2004, and 2005, where some measures of
confidence declined significantly before rebounding in 2006. Although
these confidence indexes did not directly measure the impact of
restatements on investor confidence, they illustrate the difficulty in
attempting to gauge general confidence in the market and how different
classes of investors can interpret and respond to events in different
ways.
As in 2002, we focused on the three indexes that most directly measured
investor confidence. The first Yale index is the One-Year Confidence
Index, which indicated that institutional investor confidence fluctuated
between June 2002 and May 2006, but ended higher than 2002 levels.^39
During the same periods, individual investor confidence also fluctuated,
but continued to trend downward. This implies a divergence in opinion
between individual and institutional investors, but it is unclear what
this difference means for overall confidence in the stock market and how
restatements affect confidence. These findings do appear to suggest that
developments during 2004 and 2005 had some longer-term negative effect on
individual investors' confidence, but that any negative effect on
institutional investors' confidence was temporary.
The second Yale index is the Buy on Dip Confidence Index, which suggests
confidence has been virtually unaffected despite fluctuations in both
directions from 2004 to 2005.^40 Since the period immediately after
September 11, 2001, and the beginning of the Enron scandal, a few months
later individual and institutional confidence that the stock market would
rise the day after a sharp fall has diverged, with institutional dropping
and individual confidence rising somewhat. However, between December 2003
and May 2006, institutional investor confidence increased from 57 to 68
percent, somewhat above its June 2002 value (62 percent), while individual
investor confidence fluctuated up and down but eventually settled just 1
percentage point below its June 2002 value. The price-to-earnings ratio
functioned as an indicator supporting the finding of unchanged confidence;
in January 2006, the ratio was equivalent to its June 2002 value, and has
remained valued at more than the historical average.
The third Yale index is the Crash Confidence Index, which suggested that
confidence generally has been low--less than 50 percent--for both
individual and institutional investors, providing the only evidence of a
similar movement.^41 Despite remaining low since October 2002, when the
market reached its lowest point in 6 years, confidence has shown a
distinct increase for both individual and institutional investors.
Specifically, by May 2006 this index showed an improvement from June 2002
values, with a 43 percent and a 17 percent increase for institutional and
individual investors, respectively. However, confidence in the probability
that a catastrophic stock market crash would not occur in the United
States may provide very little insight into whether market participants
are confident in the reliability of financial information transmitted to
investors, because not even the accounting scandals of 2001 and 2002
triggered a major collapse in market valuations. Instead, the increase in
confidence observed may merely be a vote of general confidence in the
resiliency of U.S. capital markets.
Accounting- and Auditing-Related Enforcement Actions Have Continued to
Grow
The number of SEC enforcement cases involving financial fraud and issuer
reporting issues increased more than 130 percent from fiscal year 1998 to
2005. Moreover, in fiscal year 2005, cases involving financial fraud and
issuer reporting issues constituted the largest category of enforcement
actions. The resources SEC devoted to enforcement grew as well. Of the
enforcement actions SEC resolved between March 1, 2002, and September 30,
2005, most of the actions were taken against companies or their directors,
officers, employees, and other related parties. Finally, the newly created
PCAOB also has broad investigative and disciplinary authority over public
accounting firms that have registered with it and persons associated with
such firms; PCAOB has brought several enforcement actions since its
inception.
Financial Fraud and Issuer Reporting Issues Accounted for a Significant
Number of SEC's Actions
SEC's Division of Enforcement investigates possible violations of
securities laws, including those related to financial fraud and issuer
reporting issues. Between fiscal years 2001 and 2005, these types of cases
have increased as a percent of SEC's total enforcement cases from 23 to
almost 30 percent (see fig. 9). From fiscal years 2002 to 2005, SEC has
initiated an average of about 588 enforcement actions per year, compared
to an average of 497 for fiscal years 1998 to 2001. Of these actions, an
average of about 135 per year involved financial fraud or issuer reporting
issues compared to an average of 97 per year for the prior period.
Figure 9: Number of SEC Enforcement Actions and Financial Reporting and
Issuer Disclosure Issues Initiated, Fiscal Years 1998-2005
In fiscal year 2005, cases involving financial fraud and issuer reporting
issues were the largest category of enforcement actions accounting for
almost one-third of the cases, followed by broker-dealer and investment
company cases. For examples of some of the cases involving accounting-
and/or auditing-related issues see our detailed case studies on American
International Group Inc., (app. IX), Federal National Mortgage Corporation
( app. XI), and Qwest Communications International, Inc. (app. XII).
SEC's Enforcement Resources Have Grown
In our 2002 report, we found that SEC's enforcement function was strained
because of resource challenges and an increased workload; however, as a
result of several high-profile corporate failures, and financial reporting
fraud, among other things, the Sarbanes-Oxley Act authorized a 65 percent
increase in SEC's 2003 appropriations, which directed the additional
funding to be used in certain areas. Specifically, no fewer than 200
positions were to be used to strengthen existing program areas, including
enforcement. In fiscal year 2003, enforcement resources increased over 20
percent, including 194 staff in Washington, D.C. and SEC's regional and
district offices. Moreover, between fiscal years 2003 and 2004,
enforcement staffing increased about 29 percent.
Accounting- and Auditing-Related Actions Included a Variety of Entities
and Individuals
SEC has taken a variety of accounting- and audit-related enforcement
actions against various entities and individuals, ranging from public
companies and audit firms to CEOs and CPAs. Accounting-related violations
identified included fraud, lying to auditors, filing misleading
information with SEC, and failing to maintain proper books and records.
Investigations can lead to SEC-prompted administrative or federal civil
court actions. Depending on the type of proceeding, SEC can seek sanctions
that include injunctions, civil money penalties, disgorgement,
cease-and-desist orders, suspensions of registration, bars from appearing
before the Commission, and bars from participating as an officer or
director of a public company. As previously reported, most enforcement
actions are settled, with respondents generally consenting to the entry of
civil, judicial, or administrative orders without admitting or denying the
allegations against them. We found this to be true of the auditing- and
accounting-related cases we reviewed as well. For a more detailed
discussion of SEC's enforcement process, see appendix VII.
About 90 percent of the more than 750 actions resolved between March 2002
and September 2005 were brought against companies or their directors,
officers, employees, or other parties.^42 Another 10 percent involved
audit firms and individuals associated with firms, including audit
managers, partners, and engagement auditors. In the cases involving public
companies and their officials and related persons, we found that SEC has
taken a variety of actions against a wide range of officials and
employees. Historically, SEC was reluctant to seek civil monetary
penalties against companies in financial fraud cases because such costs
would be passed along to shareholders who had already suffered as a result
of the violations. In the AAERs reviewed from March 2002 to September
2005, we found that SEC started to take increasingly aggressive actions
against public companies, including the levy of millions of dollars in
civil money penalties in 2003 and 2004. However, SEC's position on civil
money penalties against public companies continued to evolve. In January
2006, SEC outlined its position on this issue when it announced the filing
of two settled actions against McAfee, Inc. and Applix, Inc. In one case
the company paid a civil money penalty and in the other, the company did
not. According to the release, SEC thought it was important to "provide
the maximum possible degree of clarity, consistency, and predictability in
explaining the way that its corporate penalty authority will be
exercised." The release discussed how the Sarbanes-Oxley Act changed the
ultimate disposition of penalties, because SEC can now take penalties paid
by individuals and entities in enforcement actions and add them to
disgorgements for the benefit of victims through the Fair Funds
provision.^43 Under this provision, civil money penalties that SEC
collects no longer go to the Department of Treasury; instead, they can be
used to help compensate victims for the losses they experienced, which
would include harmed shareholders.
The Commission announced that it planned to more closely review actions
involving civil money penalties against public companies and laid out the
principles it planned to follow in making such determinations. The
overarching principle appears to be that corporate penalties are an
essential part of an aggressive and comprehensive enforcement program. In
addition, SEC's view of the appropriateness of the penalty against
corporations versus the individuals who actually commit the violations is
to be based on two considerations. First, SEC considers whether the
corporation received a direct benefit as a result of the violations (e.g.,
the violation resulted in reduced expenses or higher revenues). Second,
the degree to which the penalty will recompensate or further harm injured
shareholders. Other factors, SEC will consider are:
othe need to deter the particular type of offense,
othe extent of the injury to innocent parties,
owhether complicity in the violation is widespread throughout the
corporation,
othe level of intent on the part of perpetrators,
othe degree of difficulty in detecting the particular type of offense,
othe presence or lack of remedial steps by the corporation, and
othe extent of cooperation with the Commission and other law enforcement
In our 2002 report, we also noted that Congress, market participants, and
others, had questioned the lack of severity of many of the sanctions given
the level of investor harm. At least one SEC official, at the time, felt
that because monetary penalties are often paid by officer and director
insurance policies, or are considered insignificant in relation to the
violation, SEC should pursue more officer and director bars. However, the
test for imposing officer and director bars was viewed as too restrictive.
Since that time, the Sarbanes-Oxley Act changed the threshold for seeking
officer and director bars by amending the securities acts' requirement
from "substantial unfitness" to "unfitness," thereby making it easier for
SEC to pursue officer and director bars. From March 2002 through September
2005, SEC obtained officer and director bars against hundreds of
officials. Specifically, SEC resolved charges against hundreds of CFOs or
chief accounting officers and CEOs with securities fraud or issuer
reporting violations between March 2002 and December 2005. See appendixes
IX, XI, and XII for a summary of the actions taken by SEC in three of the
six cases we analyzed.
SEC may also bring an enforcement action against other individuals such as
officers and principals who are not part of top management (other
participants and responsible parties). In the AAERs we reviewed, SEC
charged such individuals with accounting-related violations that resulted
in injunctions, civil monetary penalties, disgorgements, cease-and-desist
orders; and officer and director bars. For example, SEC and in some cases
the Department of Justice, have filed suit against several senior officers
at public companies--including chairmen, chief operating officers,
controllers, directors, vice presidents, and clients. These executives
have been charged with securities law violations such as fraud, reporting
violations, record-keeping violations, and insider trading.
Although the Sarbanes-Oxley Act provided PCAOB enforcement authority over
registered public accounting firms and their associated persons (which we
discuss below), SEC continues to have the authority to bring actions
against accounting firms. In addition to investigating violations of the
securities laws, Enforcement investigates improper professional conduct by
accountants and other professionals who appear before SEC, and the agency
may pursue administrative disciplinary proceedings against these
professionals under SEC's Rules of Practice 102(e). If SEC finds that
securities laws have been violated or improper professional conduct has
occurred, it can prohibit professionals from appearing before SEC
temporarily or permanently. A licensed accountant engages in improper
professional conduct if he or she intentionally or knowingly violates an
applicable professional standard or engages in either of the two types of
negligent conduct defined under the rule. From March 2002 to September
2005, SEC has taken action against numerous firms and dozens of
individuals.^44 The actions included injunctions, civil monetary
penalties, bars or suspensions from appearing before the Commission,
cease- and-desist orders, officer and director bars, and censures.
Newly Created PCAOB Also Took Variety of Enforcement Actions
As mentioned previously, the Sarbanes-Oxley Act authorized PCAOB to
conduct investigations concerning any acts or practices, or omissions to
act, by registered public accounting firms and persons associated with
such firms, or both, that may violate any provision of the act, PCAOB's
rules, the provisions of the securities laws relating to the preparation
and issuance of audit reports and the obligations and liabilities of
accountants with respect thereto, including SEC rules issued under the
act, or professional standards. In May 2004, SEC approved PCAOB's rules
implementing this authority. When PCAOB alleges a violation, it has the
authority after an opportunity for a hearing, to impose appropriate
sanctions. The sanctions can range from revoking a firm's registration or
barring a person from participating in audits of public companies, to
imposing monetary penalties or requirements for remedial measures, such as
training, new quality control procedures, or the appointment of an
independent monitor.
Between May 2005 and July 2006, PCAOB has instituted and settled five
disciplinary proceedings against registered public accounting firms and
associated persons. These proceedings dealt with cases involving
concealing information from PCAOB and submitting false information to it,
in connection with a PCAOB inspection; noncompliance with PCAOB rules,
independence standards, and auditing standards in auditing the financial
statements; and failing to take prompt and appropriate steps in response
to indications that an issuer audit client may have committed an illegal
act. The associated sanctions ranged from revoking the firm's
registration, barring the involved individual from being an associated
person of a registered public accounting firm, and censuring firms and
associated persons.
Conclusions
A variety of factors appear to have contributed to the increased trend in
restatements, including increased accountability requirements on the part
of company executives; increased focus on ensuring internal controls for
financial reporting; increased auditor and regulatory scrutiny (including
clarifying guidance); and a general unwillingness on the part of public
companies to risk failing to restate, regardless of the significance of
the event. Given the new regulatory and oversight structure, and the
current operating environment, it is unclear if and when the current trend
toward increasing restatements will subside. The number of restatements
may continue to increase in the immediate future, as new areas of scrutiny
(for example, small public company implementation of the Sarbanes-Oxley
Act internal control requirements and hedge accounting rules), by SEC and
others, may trigger future restatements similar to the trends experienced
after the focus on accounting for leases or income taxes in early 2005.
Currently, approximately 60 percent of public companies--generally smaller
public companies--have yet to fully implement the internal control
requirements of the Sarbanes-Oxley Act, which could also impact the number
of restatements. In recent years, the larger public companies'
implementation of Section 404 requirements resulted in many companies
announcing financial restatements. Alternatively, the number of
restatement announcements could subside after the regulatory and firm
changes called for in the Sarbanes-Oxley Act have been fully implemented
and allowed to play through.
Companies that announce restatements generally continue to experience
decreases in market capitalization in the days around the initial
announcement; however, the magnitude of the impact has significantly
decreased from the period analyzed in our 2002 report. The exact reason
for this decline is unclear, but may include a variety of factors such as
investors' inability to discern the reason for the restatement, varying
reactions by investors about what the restatement means (e.g., whether the
company is improving its disclosures), or investors' growing insensitivity
to financial statement restatement announcements. These views, in part,
are supported by some investor confidence data and research including
that, while investor confidence seems to have increased, investors often
are unable to decipher the reason for the restatement; restatements may be
viewed in various ways by investors, depending on whether they believe
that the trend is part of a "cleansing process" (i.e., public companies
strengthening their internal controls), or whether they merely reflect
technical adjustments for compliance.
SEC improved disclosure of restatement announcements in 2004 by requiring
additional information on Form 8-K. However, some public companies
continue to announce restatements that result in non-reliance on prior
financial statements outside of the required Form 8-K (Item 4.02) filing
process. That is, about 17 percent of companies announcing restatements
that resulted in non-reliance between August 2004 and September 2005
failed to disclose this information under the appropriate item or failed
to file an 8-K at all. While most filed the information under an item
other than 4.02 in the Form 8-K, some appeared to have disclosed the
information in a Form 10-K or 10-Q, which raises questions inconsistencies
between the Form 8-K instructions versus staff questions-and-answers
discussion concerning filing requirements under Item 4.02. The result of
the potential noncompliance is that some companies continue to restate
without consistently informing investors and the general public that such
restatements have occurred and that previously issued financial statements
should not be relied upon--which raises concerns about compliance with
SEC's revised Form 8-K disclosure requirements and the ongoing
transparency and consistency of public disclosures.
Recommendations
To better enable SEC to enforce its regulations and improve the
consistency and transparency of information provided to investors about
financial restatements, we recommend that SEC take specific actions to
improve oversight and compliance of disclosures of certain restatements.
First, SEC should direct the head of the Division of Corporation Finance
to investigate the instances of potential noncompliance we, and Glass
Lewis, identified, and take appropriate corrective action against any
companies determined to have filed a deficient filing. Second, SEC should
harmonize existing instructions and guidance concerning Item 4.02 by
amending the instructions to Form 8-K and other relevant periodic filings
to clearly state that an Item 4.02 disclosure on Form 8-K is required for
all determinations of non-reliance on previously issued financial
statements (Item 4.02), irrespective of whether such information has been
disclosed on a periodic report or elsewhere.
Agency Comments and Our Evaluation
We provided a draft of this report to the Chairmen of SEC and PCAOB, for
their review and comment. We received written comments from SEC and PCAOB
that are summarized below and reprinted in appendixes II and III. Both SEC
and PCAOB provided technical comments that were incorporated into the
report as appropriate.
In response to our first recommendation that the Division of Corporation
Finance investigate the instances of potential noncompliance identified
and take appropriate corrective action, the Director of the Division of
Corporation Finance stated that SEC appreciated the recommendation and
that it will continue its long history of examining instances of potential
noncompliance with federal securities laws. Finally, in response to our
recommendation that SEC harmonize existing instructions and guidance, SEC
stated that it will carefully consider our recommendation to harmonize
existing instructions and guidance related to a company's need to notify
the public that previously issued financial statements or results should
not be relied upon.
In commenting on the draft report, the Chairman of PCAOB stated that as
the organization charged by the Sarbanes-Oxley Act with overseeing the
audit of public companies, the report's findings on the causes of, and
trends in restatements by public companies would be useful to PCAOB's
oversight efforts.
As agreed with your office, we plan no further distribution of this report
until 30 days from its issuance unless you publicly release its contents
sooner. At that time, we will send copies of this report to the Chairman
of the Senate Committee on Banking, Housing, and Urban Affairs; the
Chairman and Ranking Minority Member of the Senate Subcommittee on
Securities and Investment, Senate Committee on Banking, Housing, and Urban
Affairs; the Chairman and Ranking Minority Member, Senate Committee on
Governmental Affairs; the Chairman and Ranking Minority Member, House
Committee on Financial Services; and other interested congressional
committees. We will also send copies to the Chairman of the SEC and the
Chairman of the PCAOB and will make copies available to others upon
request. In addition, this report is also available on GAO Web site at no
charge at http://www.gao.gov.
If you have any questions concerning this report, please contact Orice M.
Williams at (202) 512-5837 or [email protected]. Contact points for
our Offices of Congressional Relations and Public Affairs may be found on
the last page of this report. See appendix XV for a list of other staff
who contributed to the report.
Sincerely yours,
Orice M. Williams
Director, Financial Markets and
Community Investment
Jeanette M. Franzel
Director, Financial Management
and Assurance
Thomas J. McCool
Director, Center for Economics Applied Research and
Methods
Appendix I
Objectives, Scope, and Methodology
As agreed with your staff, our objectives were to (1) determine the number
of, reasons for, and other trends in restatements since our 2002 report;
(2) analyze the impact of restatement announcements on the restating
companies' stock market capitalization; (3) research available data to
determine the impact of restatements on investors' confidence in the
existing U.S. system of financial reporting and capital markets; and (4)
analyze the Securities and Exchange Commission (SEC) enforcement actions
involving accounting- and auditing-related issues.
Identifying the Number of and Reasons for Restatements
To determine the number of and reasons for restatements since 2002, we
employed substantially the same methodology used in our prior report, in
which we analyzed the period from January 1997 through June 2002.^1 We
identified restatements of previously reported financial results announced
from July 1, 2002, through September 30, 2005, using the Lexis-Nexis
online information service to search for press releases and other media
coverage on restatements. When developing our search methodology for
identifying restatements for our prior report, we reviewed the approaches
used in several academic and nonacademic research papers.^2 Our search
methodology was constructed to maximize the number of potentially relevant
articles (and minimize the potentially irrelevant articles) for our
consideration, given the focus of our research. Using the Lexis-Nexis
"Power Search" command and the "US Newspapers and Wires" database, we
performed keyword searches using variations of "restate" as well as the
terms, "adjust," and "amend," and "revise"--all within 50 words of
"financial statement" or "earning."
As was the case in our prior report, to our knowledge, no comprehensive,
authoritative database of financial statement restatement announcements
exists that is publicly available. While several researchers have
constructed and maintained their own financial statement restatement
databases, these lists are generally proprietary and are not publicly
available. Moreover, these researchers may have a different focus from
ours and may use different methods and criteria for constructing their
databases, as well as different sample periods, making it difficult to
directly compare the database of restatements that we constructed with the
databases that others have compiled. However, we were able to compare
descriptive statistics from our database with proprietary information
provided by Huron Consulting Group (HCG) and Glass, Lewis & Co. LLC (Glass
Lewis). In comparing our list to Glass Lewis' database of actual
restatement filings, it is clear that our database, while providing a
comprehensive list of companies listed on the major exchanges, excludes a
large number of small, over-the-counter companies with limited analyst and
press coverage (see app. V). As a result, our database, which included
1,390 restatement announcements, should be viewed as a sample of
restatements by publicly traded companies identified using our particular
search methodology, and the results of our analysis should be viewed in
this context. Specifically, users of this report should note that our
figures likely do not reflect the number of smaller public companies that
have restated over the 2002-2005 period. Our database was constructed
using a methodology that reflects our focus on the impact on companies'
market capitalization.^3 In many cases, the report discusses statistics as
they pertain to publicly listed companies, since our database is fairly
comprehensive in this regard. We reviewed filings in SEC's Electronic Data
Gathering, Analysis, and Retrieval (EDGAR) system, and companies' Web
sites, to verify the accuracy of particular restatement announcement dates
and reasons.
Although there are many reasons for restatements, most restatements
involve more routine reporting issues (such as a merger or stock split)
and are not symptomatic of financial reporting fraud. Consistent with our
prior report, we generally specified financial reporting fraud and
accounting errors--previously referred to as accounting irregularities in
our prior report--to include so-called "aggressive" accounting practices,
intentional and unintentional misuse of facts applied to financial
statements, oversight or misinterpretation of accounting rules, and fraud.
Given the general change in attitude toward what issues may warrant
restatements in the post Sarbanes-Oxley Act environment, we also included
restatements that involved computational errors--a departure from our
prior report. Exclusion of such restatements likely had a negligible
impact on our prior report's results since we encountered very few such
instances. Also, we included in our database each restatement that met our
criteria, regardless of its impact (positive or negative) on the restating
company's financials.
We excluded restatement announcements that resulted from normal corporate
activity or simple presentation issues--unless we determined that there
was some financial reporting fraud and/or accounting errors involved. For
example, we excluded financial statement restatements resulting from
mergers and acquisitions, discontinued operations, stock splits, issuance
of stock dividends, currency-related issues (for example, converting from
Japanese yen to U.S. dollars), changes in business segment definitions,
changes due to transfers of management, changes made for presentation
purposes, general accounting changes under generally accepted accounting
principles (GAAP), and litigation settlements. As a general rule, we also
excluded restatements resulting from accounting policy changes.^4 We
excluded these financial statement restatements because they did not
necessarily reveal previously undisclosed, economically meaningful data to
market participants.
Consistent with our prior report, once a relevant restatement was
identified, we classified it into one or more of nine categories--(1)
acquisition and merger related, (2) cost- or expense related, (3)
in-process research and development related, (4) reclassification related,
(5) related-party transaction related, (6) restructuring, assets, or
inventory related, (7) revenue recognition related, (8) securities
related, and (9) other.^5 Our classification, as developed for our prior
report, closely resembles that employed by the Financial Executives
International and Wu (2001) and HCG (2002).
Determining the Impact of Restatements on Market Values of Restating
Companies
To analyze the impact of restatement announcements involving financial
reporting fraud and/or accounting errors on the stock market value of
restating companies, we used the standard event study approach. The event
to be measured was the initial announcement within the period from July 1,
2002, to September 30, 2005, of a financial statement restatement
involving financial reporting fraud and/or accounting errors by a publicly
traded company with common stock issued on the New York Stock Exchange
(NYSE), Nasdaq, American Stock Exchange (Amex), or quoted on the
Over-the-Counter (OTC) Bulletin Board or the National Quotation Service
Bureau's "Pink Sheets." Throughout this report, we refer to the subset of
companies with stock traded on NYSE, Nasdaq, and Amex as "listed." We
obtained historical stock price data for the relevant listed companies
from NYSE's Trade and Quote (TAQ) database. This database contains
detailed records of all quotes and transactions made for all NYSE, Nasdaq,
and Amex issues.^6
Although we identified 1,390 restatement announcements from July 1, 2002,
to September 30, 2005, we excluded some restatements from our event study
for a number of reasons. First, we excluded restatements by companies with
common stock that was not listed (that is, with stock only quoted on the
OTC Bulletin Board or Pink Sheets) because we did not have consistent
access to reliable historical price data for these stocks. We estimated
that the exclusion of these unlisted companies would have a negligible
impact on our market capitalization results. Companies with stock only
quoted on the OTC Bulletin Board or Pink Sheets tend to be smaller in
terms of market capitalization, but it is not clear whether their
exclusion will introduce positive or negative bias in our average holding
period "abnormal returns" results (the realized rate of return of a stock
over an event window minus the expected return of that stock over the same
period). We also excluded from our analysis any restatement by a company
that had extensive portions of data missing for the relevant time around
the restatement announcement. Missing data were generally attributable to
extended trading suspensions, stock delistings, stock
deregistrations, bankruptcies, and mergers.^7 However, TAQ was also
missing data for several listed companies; and thus, we excluded these
companies from our analysis. We cannot estimate the impact that these
exclusions would have on our reported results. To the extent a company's
stock price declined following delisting, our analysis would be biased
toward understating the impact of financial statement restatement
announcements. To address these issues, we performed a separate analysis
on a particular subset of these cases using alternative stock price data.
To determine the impact of the restatement announcement on a company's
stock price, we identified the trading day that corresponded with the
initial announcement date. We found that companies would frequently issue
public announcements in which they suggested that they might restate their
financial statements. Our criteria for selection required that a company
disclosed that a restatement was, at a minimum, "likely." We found that
some companies announced their restatements during or before normal
trading hours on a trading day, while others publicly announced their
financial statement restatement after the close of trading or on a
nontrading day. Precise measurement of the time of an announcement was
generally not possible; however, for those cases in the latter category
that we were able to identify, we defined the announcement day as the next
trading day. We then identified the relevant trading days before and after
the restatement announcement, collectively known as the event window. To
analyze the immediate impact of restatement announcements, we specified
the immediate event window as the period from the trading day before the
announcement through the trading day after the announcement. To analyze
the longer-term impact of restatement announcements, we also specified an
intermediate event window of approximately 2 calendar months, which
included 20 trading days (1 month) before the announcement through 20
trading days (1 month) after the announcement; and a longer event window
of approximately 6 calendar months, which
included 60 trading days (3 months) before the announcement through 60
trading days (3 months) after the announcement.^8
To assess the impact of the restatement announcement on a company's stock
price, we calculated the "abnormal return"--the market-adjusted increase
(or decrease) in stock price--of the stock over the event window. The
abnormal return is the realized rate of return of a stock over the event
window minus the expected return of that stock over the same period. The
realized, or actual, rate of return of a stock of company i from date t-1
to date t is defined as
in which P sub n is the closing price of the stock at date t, and P sub i,t-1
is the closing price of the stock at date t-1. The expected return is defined
as the rate of return of the stock (predicted by some valuation model) that is
expected under the assumption that the event does not occur. In this way,
the abnormal return is designed to capture the impact of the event on the
stock. For any company i and date t,
in which is the abnormal return of the stock of company i on date t, is
the realized return of the stock of company i on date t, and is the
expected return of the stock of company i on date t conditioned on some
information set, . We used the rate of return of the Wilshire Total Market
Index on date t as our conditioning information,.^9
To calculate the abnormal return, we first specified a statistical model
for estimating the expected return of the stock of company i on date t. We
used a standard market model, which relates the rate of return of the
stock of i to the return of the overall market as
in which is an error term and and are the parameters of the market model.
In this specification, and are the intercept and slope, respectively, of
the linear relationship between the return of the stock of company i on
date t and the return of the market on date t.^10 The parameter,, is a
measure of the co-variation between the returns of the stock of i and the
returns of the market. In this way, the expected return is risk-adjusted,
taking into account the risk of stock i relative to the overall market.
Next, we estimated the parameters of the model using a subset of the data.
This subset, referred to as the "estimation window,"generally included at
least 120 trading days (typically about 6 calendar months) of daily
closing price data through the day prior to the initial restatement
announcement.^11 We estimated the market model using the ordinary
least-squares estimation procedure for each of the companies for which we
had sufficient data. Each estimation produced parameter estimates,and, for
the given company and estimation window. The parameter estimates were
subsequently used to generate an estimate of the expected return,, for
each stock i at each date t using the market model. This estimate of the
expected return,, was determined as
Using this expected return, we also calculated an estimate of the expected
stock price for each stock i at each date t,, as
We then calculated the abnormal return for each stock based on the results
of our estimation. For any company i and date t, the estimated abnormal
return,, was
We also calculated the estimated unexpected, or market-adjusted, change in
the stock price of i from t-1 to t,, as
To measure the impact of the restatement announcement on the stock of
company i, we calculated the abnormal return over the holding period from
day -1 to day +1 to capture the immediate impact; we calculated the
abnormal return over the holding period from day -20 to day +20 to capture
the intermediate impact; and we calculated the abnormal return over the
holding period from day -60 to day +60 to capture the longer-term impact.
We also calculated the immediate impact on the market capitalization of
company i by multiplying the difference between the actual stock price on
day +1 and the expected price on day +1 (the immediate market-adjusted
change in price) by the number of shares outstanding; and we calculated
the intermediate and longer-term impact on the market capitalization of
company i by multiplying the difference between the actual stock price on
days +20 and +60 and the expected price on days +20 and +60 (the
intermediate and longer-term market-adjusted change in price) by the
number of shares outstanding.^12 To assess the overall impact of the
general event of a restatement announcement, we averaged individual
holding period abnormal returns over all restatement announcement events
in our sample for each of the event windows, and we summed all of the
unadjusted and adjusted market changes in price for each of the event
windows.
The usual interpretation of abnormal returns over an event window is that
they measure the impact of the event on the value of a company's stock.
This interpretation may be misleading due to other firm specific or market
factors. Our simple market model attempted to account for only the overall
market's effect on the stock. One of the more relevant factors in this
event study was the simultaneous release of a restatement announcement and
scheduled financial statements to the market. (For example, a company
could have issued its first quarter 2005 earnings that missed, met, or
exceeded the market's expectations while also announcing that it was
restating previously issued financial statements from prior periods
including 2003 and 2004.) To the extent that this was an issue, our
results could be biased in either direction and, hence, attributing
abnormal returns solely to the restatement announcement could be
misleading. Another potential factor is information leakage. Events such
as the announcement of an SEC inquiry, internal or external accounting
review, or the abrupt departure of a company's chief executive officer or
chief financial officer may be an early indication that a financial
restatement is forthcoming. Furthermore, it is important to note that
because we increased the period over which we attempted to assess the
impact of the restatement on a particular stock, many other factors
influencing the behavior of the stock price can come into play. To the
extent that other influences on the price are significant, our
intermediate results reflect not only the impact of the restatement
announcement but these factors as well.
Additionally, there are potential sources of bias in our estimation
procedure. Some of the more important involve event-date uncertainty,
violations of our statistical assumptions, and using daily closing stock
prices. While our event study methodology assumes that we are able to
precisely identify the event date, this sometimes involved a certain
amount of judgment. The announcement of a financial statement restatement
typically only provides the date of the announcement; whether the
announcement was made before, during, or after trading on that date may
not be clear. We used the 3-day event window technique to address this
issue. Another possible source of bias stems from violation of our
standard statistical assumptions.^13 A further potential source of bias in
our estimation involves using the daily closing prices of stocks. In the
event study framework, we implicitly assumed that these daily closing
prices were recorded at identical time intervals each day. However, this
assumption is easily violated because the last transaction for a given
stock, can and generally does, occur at a different time each day.
Additionally, some of the stocks in our event study were "thinly" or
infrequently traded, and several days could elapse between transactions.
Referring to the last recorded prices as daily closing prices assumed that
closing prices are equally spaced at 24-hour intervals, which is not the
case. To the extent that this assumption is violated, our results may be
biased.
Overall, our analysis focused on the impact of a company's restatement
announcement on its market capitalization. Therefore, we did not take into
account the effects on market participants with short positions or various
options positions, nor did we gauge the impact on the company's
bondholders. To whatever extent--whether positively or negatively--these
market participants were affected by restatements, our results are
necessarily incomplete.
Determining the Impact of Restatements on Investor Confidence
To analyze the impact of restatements on the confidence of market
participants, we relied principally on outside sources. Namely, we
identified indexes of investor confidence, located quantitative research
on the issue, conducted interviews with experts in the field, and
collected data on mutual fund flows and other proxies for investor
sentiment. The survey-based indexes of investor confidence were obtained
from UBS Americas, Inc. and the International Center for Finance at the
Yale School of Management. The Nobel Laureate economist, Dr. Lawrence
Klein, acknowledged the UBS Index for its accuracy and timeliness. The
Yale School of Management Indexes are considered to be the longest-running
effort to measure investor confidence and the project is directed by one
of the leading experts in the field, Dr. Robert Shiller. In addition, we
obtain an investor confidence index from State Street Corporation. This
index measures confidence quantitatively by assessing the changes in
investor holdings or risky assets, implementing a research model developed
by Harvard Professor Kenneth Froot and State Street Managing Director,
Paul O'Connell. The index uses the principles of modern financial theory
to model the underlying behavior of global investors. Unlike other
survey-based confidence measures that focus on expectations for future
prices and returns, the Index provides a quantitative measure of the
actual and changing levels of risk contained in investment portfolios
representing about 15 percent of the world's tradable assets.
Unfortunately, while the global confidence measure dates back to 1998, the
time series for confidence in North America only spans 2005 and 2006. We
also were able to collect survey results about the direct impact of
restatements on investor confidence from UBS Americas and the Securities
Industry Association.
Although the literature on the impact of restatements on investor
confidence is limited, we identified a number of studies. The results of
studies are consistent with the hypothesis that, while financial
restatements elicit different responses from the market depending on the
type, certain financial restatements can have negative effects on investor
confidence. However, these studies were based on restatement data prior to
the period under examination in this report and the evidence of effects on
the broader market is limited. To gain further insight, we also
interviewed some experts in the field and summarized their responses to a
set of questions regarding accounting practices, restatements, and
investor confidence. Finally, we collected data on mutual fund flows from
the Investment Company Institute, a popular source for statistical data on
the mutual fund industry, and data on holdings of corporate equities and
bond yields from the Board of Governors of the Federal Reserve System.
Analysis of SEC's Accounting-Related Enforcement Activities
To analyze SEC enforcement actions involving accounting- and
auditing-related issues, we reviewed more than 800 SEC-identified
Accounting- and Auditing-Enforcement Releases (AAER)^14 issued from March
1, 2002, through September 30, 2005, posted on SEC's Web site as of July
1, 2006. We collected information on all actions sought or brought but
only counted actions against the same organization or individual once for
purposes of analysis. We also collected other common information disclosed
in the AAERs, such as the individuals and companies charged in the cases
and the sanction levied. To describe the process that SEC uses to develop
an enforcement case, including whom to include as a defendant in the case
and penalties to assess, we used a variety of information provided by SEC.
To obtain historical general enforcement and accounting-related
enforcement actions, we downloaded the information from SEC's Web site,
and where there were gaps in the data made direct requests for information
from SEC. To the extent possible, to determine the roles that key players,
such as auditors and company senior management, played in fostering
misleading financial information upon investors, we selected six financial
restatements for in-depth case study. The cases were selected based on
asset size, restatement period, reason for the restatement, market where
stock traded and industry. (See app. VIII for an overview of the case
studies; the individual studies are presented in appendixes IX-XIV.)
We performed our work in Washington, D.C., between June 2005 and July
2006, in accordance with generally accepted government auditing standards.
Appendix II
Comments from the Securities and Exchange Commission
Appendix III
Comments from the Public Company Accounting Oversight Board
Appendix IV
Summary of Selected Sarbanes-Oxley Act Provisions Affecting Public
Companies and Registered Accounting Firms
Responding to corporate failures and fraud that resulted in substantial
financial losses to institutional and individual investors, Congress
passed the Sarbanes-Oxley Act in 2002. As shown in table 7, the act
contains provisions affecting the corporate governance, auditing, and
financial reporting of public companies, including provisions intended to
deter and punish corporate accounting fraud and corruption.^1 The
Sarbanes-Oxley Act generally applies to those companies required to file
reports with SEC under the Securities Exchange Act of 1934.^2
Table 7: Summary of Selected Sarbanes-Oxley Act Provisions Affecting
Public Companies and Registered Accounting Firms
Provision Main requirements
Section 101: Public Company Establishes PCAOB to oversee the audit of
Accounting Oversight Board public companies that are subject to the
(PCAOB) Establishment securities laws.
Section 102: Registration Requires accounting firms that prepare or
with the Board issue audit reports for public companies to
register with PCAOB.
Section 103: Auditing, Requires PCAOB, by rule, to establish auditing
Quality Control, and and other professional standards to be used by
Independence Standards and registered public accounting firms in the
Rules preparation and issuance of audit reports.
Section 104: Inspections of Requires PCAOB to annually inspect registered
Registered Public public accounting firms with more than 100
Accounting Firms issuer audit clients and triennially inspect
registered public accounting firms with 100 or
less issuer audit clients.
Section 105: Investigations Requires PCAOB to establish fair procedures
and Disciplinary for investigating and disciplining registered
Proceedings public accounting firms and associated persons
and authorizes PCAOB to investigate and
discipline such firms and persons.
Section 201: Services Registered accounting firms cannot provide
Outside the Scope of certain nonaudit services to a public company
Practice of Auditors if the firm also serves as the auditor of the
financial statements for the public company.
Examples of prohibited nonaudit services
include bookkeeping, appraisal or valuation
services, internal audit outsourcing services,
and management functions.
Section 301: Public Company Listed company audit committees are
Audit Committees responsible for the appointment, compensation,
and oversight of the registered accounting
firm, including the resolution of
disagreements between the registered
accounting firm and company management
regarding financial reporting. Audit committee
members must be independent.
Section 302: Corporate For each annual and quarterly report filed
Responsibility for with SEC, the CEO and CFO must certify that
Financial Reports they have reviewed the report and, based on
their knowledge, the report does not contain
untrue statements or omissions of material
facts resulting in a misleading report and
that, based on their knowledge, the financial
information in the report is fairly presented.
Section 304: Forfeiture of The CEO and CFO of the issuer have to
Certain Bonuses and Profits reimburse the issuer for any bonus or profits
from sale of securities during the 12 month
period following the filing of a financial
document that required an issuer to prepare an
accounting restatement due to misconduct.
Section 308: Fair Funds for The civil penalties can be added to the
Investors disgorgement fund for the benefit of the
victims of a security law violation.
Section 404: Management This section consists of two parts. First, in
Assessment of Internal each annual report filed with SEC, company
Controls management must state its responsibility for
establishing and maintaining an internal
control structure and procedures for financial
reporting; it must also assess the
effectiveness of its internal control
structure and procedures for financial
reporting. Second, the registered accounting
firm must attest to, and report on,
management's assessment of the effectiveness
of its internal control over financial
reporting.
Section 407: Disclosure of Public companies must disclose in periodic
Audit Committee Financial reports to SEC whether the audit committee
Expert includes at least one member who is a
financial expert and, if not, the reasons why.
Source: GAO.
Title I of the act establishes PCAOB as a private sector non-profit
organization to oversee the audits of public companies that are subject to
the securities laws. PCAOB is subject to SEC oversight. The act gives
PCAOB four primary areas of responsibility:
oregistration of accounting firms that audit public companies in the U.S.
securities markets;
oinspections of registered accounting firms;
oestablishment of auditing, quality control, and ethics standards for
registered accounting firms; and
oinvestigation and discipline of registered accounting firms for
violations of law or professional standards.
Title II of the act addresses auditor independence. It prohibits the
registered external auditor of a public company from providing certain
nonaudit services to that public company audit client. Title II also
specifies communication that is required between auditors and the public
company's audit committee (or board of directors) and requires periodic
rotation of the audit partners managing a public company's audits.
Titles III and IV of the act focus on corporate responsibility and
enhanced financial disclosures. Title III addresses listed company audit
committees, including responsibilities and independence, and corporate
responsibilities for financial reports, including certifications by
corporate officers in annual and quarterly reports, among other
provisions. Title IV addresses disclosures in financial reporting and
transactions involving management and principal stockholders, and other
provisions such as internal control over financial reporting. More
specifically, section 404 of the act establishes requirements for
companies to publicly report on management's responsibility for
establishing and maintaining an adequate internal control structure,
including controls over financial reporting and the results of
management's assessment of the effectiveness of internal control over
financial reporting. Section 404 also requires the firms that serve as
external auditors for public companies to attest to the assessment made by
the companies' management, and report on the results of their attestation
and whether they agree with management's assessment of the company's
internal control over financial reporting.
Appendix V
GAO-06-1053R
Appendix VI
Comparison of Our Restatement Database to Those of Glass, Lewis & Co. LLC
and the Huron Consulting Group
A number of other research studies have suggested that a significant
number of companies continue to announce restatements of their financial
statements as a result of financial reporting fraud, accounting errors,
and the increased disclosure and internal control requirements introduced
by the Sarbanes-Oxley Act of 2002. To provide a better understanding of
companies announcing restatements of previous results, we analyzed
Lexis-Nexis press releases and news articles, related SEC filings, and
company press releases to determine the total number of restatement
announcements, restating companies, and the reasons for announcements made
from July 2002 through September 2005.^1 See appendix I for a detailed
discussion of our scope and methodology. This appendix provides a
comparison of our database with those that Glass Lewis and the Huron
Consulting Group (HCG) produced and discusses some of the studies'
limitations.
Our Methodology Focused on Determining the Impact of Restatement
Announcements on Market Capitalization
We identified restatements announced from July 1, 2002, through September
30, 2005, using the Lexis-Nexis online information service to search for
press releases and other media coverage on restatements. Because the focus
of our research was on the impact on market capitalization due to
restatement announcements, we concentrated on publicly listed companies
trading on the major securities markets--NYSE, Nasdaq, and Amex. As figure
10 shows, companies trading on the major securities markets represented
approximately 98-99 percent of total market capitalization.
Other securities markets accounted for the remaining 1-2 percent of market
capitalization. For example, OTC Bulletin Board makes up a little more
than 1 percent of the total market capitalization of all publicly traded
companies. It should be noted that figure 12 does not include the Pink
Sheets because we could not find reliable market capitalization data for
companies traded on this market. However, the aggregate market
capitalization of these companies is widely held to be very small and many
of the companies trading on this venue are not registered with SEC, and
therefore would not meet our criteria for inclusion. Companies that trade
on the OTC Bulletin Board and Pink Sheets generally are very small and
therefore have limited or no analyst coverage. As a result, our
methodology did not capture many restatements announced by these
companies, as they may not always have been announced in the business
press and therefore archived by Lexis-Nexis.
Figure 10: Total Market Capitalization by Trading Market, 2005
Comparison with Outside Studies Suggested That Our Database Was a
Comprehensive Listing of Publicly-Listed Companies, but Did Not Capture a
Number of the Smallest Publicly-Traded Companies
While several researchers have constructed and maintained their own
databases of financial statement restatements, these lists generally are
proprietary and not publicly available. We were able to evaluate the
completeness of our listing by comparing descriptive statistics from our
database with propriety information provided by HCG and Glass Lewis. ^2
Although there were differences in the search methodologies, construction
criteria, and types of companies included, each study found similar trends
and reached similar conclusions (see fig. 11).
However, the uniqueness of our announcement database rendered it difficult
to make strict, year-to-year comparisons of companies and dates. For
example, restating companies were tracked in both the HCG and Glass Lewis
databases based on the filing date of the actual amended restatements,
whereas our listing was based on when the restatement was announced. As a
result, a company that announced the intention to restate in 2003, but did
not file the amended return until 2004, would be captured differently.
More importantly, HCG restatement numbers were based primarily on a search
of amended annual (SEC Form 10-K/A) and quarterly (SEC Form 10-Q/A)
filings, while our total restatement numbers were based primarily on the
announcement of the restatement in business and financial press--when the
markets are likely to receive and react to the information. The Glass
Lewis search methodology combines elements of both our techniques and HCG
techniques, including a search of SEC filings (including Forms 10-K and
10-Q) and also a search of information sources similar to Lexis-Nexis
(e.g., Capital IQ and the Wall Street Journal) to capture restatements
that were not included on an amended filing. As a result, Glass Lewis
captured a larger number of restatements for the years in which they
collected this data.
Figure 11: Number of Restatements, by Research Study
Notes: Our numbers for 2005 include only restatements from January through
September. Our numbers were based on restatement announcement dates, while
the HCG and Glass Lewis numbers were based on restatement filings. Glass
Lewis numbers exclude their data on foreign foreign companies.
Comparison of our database of restating companies for 2003 and 2004 with
Glass Lewis' database of actual restatement filings suggests that our
database provides a comprehensive list of companies listed on the major
U.S. securities markets. As figure 12 shows, both databases contain
similar number of NYSE- and Nasdaq-listed restatements. NYSE and Nasdaq
companies make up 97 percent of the total market capitalization of all
publicly traded companies.^3 However, a comparison of our database with
Glass Lewis' database also shows that we do not include a large number of
small, OTC-traded companies with limited analyst and press coverage. To a
smaller extent, our capture rate of Amex-listed companies also reflected
that Amex lists a relatively higher proportion of smaller companies than
NYSE. Although we did not capture these companies, the impact of the
related losses in market capitalization due to restatements is likely not
significant. Collectively, Amex and OTC Bulletin Board companies make up 3
percent of the total market capitalization of publicly traded companies.
Nevertheless, users of this report should note that our database was
constructed using a methodology that reflects our focus on the impact on
market capitalization, and that our figures did not reflect a number of
smaller public companies that restated over the 1997-2005 period.
Figure 12: Number of Companies Restating, 2003-2004, GAO versus Glass
Lewis
Notes: Companies issuing multiple restatements were counted only once per
year. Glass Lewis dates were based on restatement filings, while our dates
were based on the date of restatement announcements. Glass Lewis numbers
exclude their data on foreign companies.
Appendix VII
SEC Enforcement Process
SEC investigates possible violations of securities laws, including those
related to accounting issues. As figure 13 illustrates, if the evidence
gathered merits further inquiry, SEC will prompt an informal investigation
or request that SEC issue a formal order of investigation. Investigations
can lead to SEC-prompted administrative or federal civil court actions.
Depending on the type of proceedings, SEC can seek sanctions that include
injunctions, civil money penalties, disgorgement,^1 cease-and-desist
orders, suspensions of registration, bars from appearing before the
Commission, and officer and director bars. After an investigation is
completed, SEC may institute either type of proceeding against a person
or entity that it believes has violated federal securities laws.^2 Because
SEC has only civil enforcement authority, it may also refer appropriate
cases to the Department of Justice (DOJ) for criminal investigation and
prosecution. According to SEC, most enforcement actions are settled, with
respondents generally consenting to the entry of civil judicial or
administrative orders without admitting or denying the allegations against
them.
Figure 13: Flowchart of SEC's Enforcement Process
Appendix VIII
Case Study Overview
Our objective in reviewing individual restatements was to provide detailed
information on selected topics for six companies.^1 The purpose of this
appendix is to explain how each case study is structured and what
information is being provided. Specifically, each of the cases discussed
in appendixes IX-XIV provides information on (1) the company's operations;
(2) the chronology of the restatement, including who initiated the
restatement; (3) its independent auditor; (4) the market's reaction to the
restatement; (5) the analysts' recommendations; (6) credit ratings and
credit rating agency actions; and (7) what legal and regulatory actions
were taken against the company, its executives, directors, independent
auditors, or others. The six companies are listed in table 8.
Table 8: Six Case Studies of Public Companies That Announced Restatements
from July 2002 through September 2005
Appendix Company Industry
IX American International Group Inc. Insurance
X Dynacq Healthcare, Inc. Healthcare
XI Federal National Mortgage Corporation (Fannie Housing finance
Mae)
XII Qwest Communications International, Inc. Telecommunications
XIII Starbucks Corporation Retail
XIV Sterling Bancshares, Inc. Banking
Source: GAO.
Our analysis was based on only publicly available information, including
company press releases and filings with SEC such as Forms 10-K, 10-Q, and
8-K; SEC press releases, complaints, and settlement agreements; public DOJ
documents; analysts' recommendations; credit agency ratings; historical
company rating information maintained by research sources; newspaper
articles; and congressional testimonies. Although we did not interview
company officials to obtain information about the restatements, we
requested comments on the case studies from each of the six companies and
incorporated any technical comments they had, as appropriate.
Business Overview
Each case begins with an overview of the business in which the company
engages, and generally provides information on its size (total revenue and
number of employees).
Restatement Data
Each of the companies restated their financial statements at least once
from July 2002 through September 2005. This section discusses the nature
of the misstated information and the resulting restatement decision by the
companies' management. We include previously reported or announced
financial results, and the revised or restated financial data, for
selected information, such as revenue and net income (or losses). We also
identify those companies that have announced a restatement, but have not
yet filed the restated financial statements with SEC.
Accounting/Audit Firm
This section provides information on who the independent auditor was
during the restatement period and whether the restating company changed
auditor before, during, or after the restatement. We also provide
information about civil and criminal actions taken against the auditors.
Stock Prices
To illustrate the impact of a restatement announcement on a company's
stock prices, we provide selected historical closing stock price
information for each company. We also discuss how stock prices were
affected in the days surrounding the restatement announcement and discuss
other events that also positively or adversely affected the companies'
stock price. In many of the cases, the company had lost a significant
amount of its stock price before the restatement announcement; often they
had missed an earnings target or announced an internal investigation.
Securities Analysts' Recommendations
Given the criticism that many securities analysts have faced in 2002 about
their optimistic ratings of companies in the face of adverse financial
results and condition, we were asked once again to focus on the role
played by analysts in recommending securities. Therefore, in this section,
we provide historical information on securities analysts' ratings in the
months leading up to-and after-financial statement restatements, and other
announcements about the financial condition of the covered (researched)
company. We found no single authoritative source for historical analyst
recommendations and relied on a variety of sources for this data, such as
Yahoo! Finance.
Analysts use different rating systems and a variety of terms, including
strong buy, buy, near term or long-term accumulate, near term or long term
over-perform or under-perform, neutral, hold, reduce, sell, strong sell.
Critics often point to the large disparity between analysts' buy
recommendations and sell recommendations. However, the terms have been
criticized as being misleading because "hold" may mean that investors
should sell the stock versus holding it. Although we do not attempt to
determine the definition of each term for each firm, we provide the
recommendations because they illustrate the range of rating systems that
analysts use. We generally focused on changes in ratings around certain
key dates to provide some indication of what signals analysts were sending
the markets.
Credit Rating Agency Actions
Along with analysts, credit ratings agencies have been questioned in the
past about the quality of the information they provided, and this scrutiny
heightened after the rapid failure of Enron Corporation. To determine the
information credit rating agencies were providing to the market about the
condition of these companies, we collected credit rating information on
companies when such information was available. In this section, we again
focus on changes in ratings around certain key dates, such as the
restatement announcement date, the actual restatement date, announcements
of internal investigations, and bankruptcy filings.
Legal and Regulatory Actions Taken
To determine the legal and regulatory actions taken, we searched for
evidence of any shareholder actions taken and whether SEC and/or DOJ had
taken any action in connection with the restatement of a company's
financial results. We found that many of the cases resulted in shareholder
lawsuits and that SEC, and in some cases the DOJ, had taken action against
the company, its officials, and its independent auditor.
Appendix IX
American International Group, Inc. Case Study
Business Overview
American International Group, Inc. (AIG), a Delaware corporation, is a
holding company, which, through its subsidiaries, is engaged in a broad
range of insurance and insurance-related activities in the United States
and abroad. AIG's primary activities include both general and life
insurance operations. Other significant activities include financial
services, retirement services, and asset management. For the year that
ended December 31, 2004, AIG had total (revised) revenues of almost $98
billion and approximately 92,000 employees.
Restatement Data
On February 14, 2005, AIG announced that it had received subpoenas from
the Office of the Attorney General for the State of New York (NYSOAG) and
SEC. Both entities were conducting investigations into AIG's use of
nontraditional insurance products, other assumed reinsurance transactions,
and AIG's accounting for these transactions.^1 (For more detailed
information on legal and regulatory actions affecting AIG, please see the
last section of this app.)
Furthermore, on March 14, 2005, AIG's chairman and CEO retired and on
March 21, 2005, its vice chairman and CFO were fired.
On March 30, 2005, AIG announced that the filing of its 2004 Form 10-K
(annual report) would be delayed beyond the already extended due date of
March 31, 2005, to provide AIG, its Board of Directors, and its new
management adequate time to complete their extensive review of books and
records. The internal review resulted from the pending NYSOAG and SEC
investigations. At that time, AIG was not able to determine whether
adjustments already identified through the review would require
restatements of prior period results or adjustments to fourth quarter 2004
published, unaudited information.
On May 1, 2005, AIG announced in a press release that, as a result of its
internal review of its books and records conducted in conjunction with its
2004 annual audit, it had decided (in consultation with
PricewaterhouseCoopers LLP (PwC), its independent auditors) to restate its
financial statements for the years ended December 31, 2000-2003; the first
three quarters of 2003 and 2004; and the fourth quarter of 2003. AIG noted
that its prior financial statements for those periods--and previously
announced unaudited financial results for the year and quarter ended
December 31, 2004--should not be relied upon. The press release noted that
the company planned to file its restated financials on Form 10-K for the
year ended December 31, 2004, no later than May 31, 2005.
As a result of the internal review, AIG concluded that consolidated
shareholders' equity at December 31, 2004, would be reduced by about $2.3
billion due to the following adjustments: corrections of accounting errors
totaling about $1.1 billion and/or fourth quarter changes in estimates
totaling about $1.2 billion for tax accruals, deferred acquisition costs,
and other contingencies and allowances. These adjustments would lead to a
reduction of about 2.7 percent in AIG's unaudited consolidated
shareholders' equity of $82.87 billion at year-end 2004, which was
previously disclosed in the company's February 9, 2005, earnings release.
Also, AIG determined that it had incorrectly accounted for certain
derivatives under the Financial Accounting Standards Board's (FASB)
Statement of Financial Accounting Standard No. 133--Accounting for
Derivatives and Hedging Activities; this would lead to an increased
adjustment of about $1 billion to consolidated shareholders' equity at
December 31, 2004.
On May 31, 2005, AIG filed its 2004 Form 10-K with SEC. In that filing,
AIG indicated that it had restated its financial statements for the years
2003, 2002, 2001, and 2000. It also restated previously reported estimates
of results for the fourth quarter of 2004. The restatements, according to
the Form 10-K, resulted from certain accounting adjustments made after an
internal review of AIG's operations during 2000-2004. Table 9 shows the
effects of the adjustments on AIG's major balance sheet and income
statement items.
Table 9: Selected Financial Data for AIG, 2000-2004
(Dollars in millions;
negative values in
parentheses)
Fiscal years
Affected financial data 2000 2001 2002 2003 2004
Total assets, as reported $426,671 $493,061 $561,229 $678,346 $804,607
Adjustment (2,820) (614) 327 (4,193) (5,947)
Total assets, as restated 423,851 492,447 561,556 674,153 798,660
Net income, as reported 6,639 5,363 5,519 9,274 11,048
Adjustment (498) (1,191) 347 (1,265) (1,317)
Net income, as restated $6,141 $4,172 $5,866 $8,009 $9,731
Source: SEC filing.
AIG had accounted for various reinsurance transactions and associated cash
flows as either revenues or expenses when the transactions involved
insufficient transfer of insurance risk to the assuming reinsurer. When
there is insufficient risk transfer, such cash flows are accounted for as
either deposit assets or liabilities (and not as revenues or expense).
AIG's internal review determined that its insurance loss reserves had been
misstated as a result of unsupported adjustments to incurred, but not
reported, reserves. AIG made other adjustments based on its reclassifying
of capital gains to net investment income, conversion of underwriting
losses to capital losses, and its accounting for derivatives. In November
2005, AIG announced that it again would restate previously reported
results, primarily to correct errors relating to accounting for
derivatives and hedged items.
Accounting/Audit Firm
PwC, AIG's independent auditor, audited AIG's financial statements for
fiscal years 2000-2004. In AIG's 2004 Form 10-K, which was issued in May
2005, PwC agreed with AIG management's assessment that the company did not
maintain effective internal control over financial reporting as of
December 31, 2004.
Stock Prices
AIG's stock trades on the NYSE under the ticker symbol AIG. From February
through May 2005, the price of company stock was affected more by the
February 14, 2005, announcement of the subpoenas it received from NYSOAG
and SEC than by the March 30, 2005, announcement of the delay in
submitting and the possible restatement of its financial statements; or
the May 31, 2005, filing of the restated financial statements. On February
11, 2005, the last trading day before the date the subpoenas were
announced, AIG's stock closed at $73.12. On February 14, the date the
subpoenas were announced, AIG's stock closed at $71.49. Soon after, AIG's
stock price began a downward trend that lasted through the March 30, 2005,
announcement of the delay in AIG's filing with SEC of its Form 10-K for
2004. The closing stock price reached a low of $50.35 on April 22, 2005,
after which it exhibited a generally upward trend through January 2006. On
January 11, 2006, AIG's stock closed at $70.83. The trends in AIG's stock
price are shown in figure 14.
Figure 14: Daily Stock Prices for AIG, July 1, 2004-February 28, 2006
Note: The restatement announcement actually occurred on a May 1, 2005 (a
Sunday).
Securities Analysts' Recommendations
Recommendations of six securities research analysts from October 2004
through June 2005 showed no set pattern surrounding the news, of the legal
proceedings and restatements involving AIG. For example, in October 2004,
shortly before the legal proceedings by NYSOAG became news two research
firms upgraded AIG while another firm downgraded AIG. In January 2005,
before the news of the subpoenas, that same firm downgraded AIG. In
mid-March 2005, about a month after news of the subpoenas, another
research firm downgraded AIG. During April 1-6, 2005, shortly after news
of the filing delay, two research firms downgraded AIG and two other
research firms upgraded AIG. In June 2005, after AIG's 2005 Form 10-K was
issued, one firm upgraded AIG. A February 2006 article in the financial
press reported that AIG would pay in excess of $1.6 billion to settle
legal claims against it; despite the news, the majority of analysts
following AIG's stock still rated it favorably.
Credit Rating Agency Actions
From March through early June 2005, the major rating agencies downgraded
AIG's ratings. Standard & Poor's lowered AIG's long-term senior debt
rating and placed a negative credit watch on the ratings.^2 Moody's
Investors Service Inc. (Moody's) lowered AIG's long-term senior debt
rating and placed the ratings on review for a possible downgrade. Fitch
Ratings downgraded the long-term senior debt ratings of AIG and placed the
ratings on a negative watch.
According to AIG's 2004 annual report, these rating actions have affected
and will continue to affect AIG's business and results of operations. For
example, the annual report noted the following:
oThe downgrades and any future downgrades in AIG's debt ratings, will
increase AIG's borrowing costs and therefore adversely affect AIG's
profitability.
oThe downgrade in AIG's long-term senior debt ratings will adversely
affect the AIG Financial Products (AIGFP) unit's ability to compete for
certain business. Credit ratings are very important in the derivative and
structured transaction marketplaces, where AIG's ratings historically
provided AIG a competitive advantage. The downgrades will reduce this
advantage because specialized financial transactions generally are
conducted only by triple-A rated financial institutions. Counterparties
may be unwilling to transact business with AIGFP except on a secured
basis. This could require AIGFP to post more collateral to counterparties
in the future.
Legal and Regulatory Actions Taken
In February 2005, AIG received subpoenas from NYSOAG and SEC relating to
investigations into the use of nontraditional insurance products, certain
assumed reinsurance transactions, and AIG's accounting for such
transactions. DOJ and the New York State insurance regulator also were
investigating AIG on related issues. On February 9, 2006, AIG agreed to
settle charges that it committed securities fraud and other violations of
the law. The settlement was part of a global resolution of federal and
state actions under which AIG would pay over $1.6 billion to resolve the
claims related to improper insurance accounting, bid rigging, and other
practices involving workers' compensation funds.
Specifically, SEC's complaint alleged that in December 2000 and March
2001, AIG entered into two "sham" reinsurance transactions with Gen Re
Corporation (Gen Re) that had no economic substance, but were designed to
allow AIG to improperly add a total of $500 million in phony loss reserves
to its balance sheet in the fourth quarter of 2000 and the first quarter
of 2001. AIG allegedly initiated the transactions to quell analysts'
criticism of AIG for a prior reduction in reserves. In addition, the
complaint alleges that in 2000, AIG structured a sham transaction with
Capco Reinsurance Company, Ltd. (Capco) to conceal approximately $200
million in underwriting losses in its general insurance business by
improperly converting them to capital (or investment) losses to make those
losses less embarrassing to AIG. The complaint further alleges that in
1991, AIG established Union Excess Reinsurance Company Ltd. (Union
Excess), an offshore reinsurer, to which it ultimately ceded approximately
50 reinsurance contracts for its own benefit. According to the complaint,
although AIG controlled Union Excess, it improperly failed to consolidate
Union Excess's financial results with its own, and in fact took steps to
conceal its control over Union Excess from its auditors and regulators. As
a result of these actions and other accounting improprieties, SEC alleged
that AIG fraudulently improved its financial results. SEC's complaint
further alleges that AIG, directly or indirectly, singly or in concert,
engaged in acts, practices, and courses of business that constitute
violations of Sections 17(a)(l), l7(a)(2), and 17(a)(3) of the Securities
Act of 1933 (Securities Act); Sections 10(b), 13(a), 13(b)(2)(A),
13(b)(2)(B), and 13(b)(5) of the Securities Exchange Act of 1934 (Exchange
Act); and Rules 10b-5(a), 10b-5(b), 10b-5(c), 12b- 20, 13a-1,13a-13, and
13b2-1.
In settling its case, AIG agreed, without admitting or denying the
allegations of the complaint, to the entry of a court order enjoining it
from violating the antifraud, books and records, internal controls, and
periodic reporting provisions of the federal securities laws. The order
also requires that AIG pay a civil penalty of $100 million and disgorge
ill-gotten gains of $700 million, all of which the Commission will seek to
distribute to injured investors. AIG also has agreed to certain
undertakings designed to assure the Commission that future transactions
will be properly accounted for and that senior AIG officers and executives
receive adequate training concerning their obligations under the federal
securities laws. AIG's remedial measures include (1) appointing a new CEO
and CFO; (2) putting forth a statement of tone and philosophy committed to
achieving transparency and clear communication with all stakeholders
through effective corporate governance, a strong control environment, high
ethical standards and financial reporting integrity; (3) establishing a
regulatory, compliance, and legal committee to provide oversight of AIG's
compliance with applicable laws and regulations; and (4) enhancing its
"Code of Conduct" for employees and mandating that all employees complete
special formal ethics training. This proposed settlement is subject to
court approval.
According to SEC's press release, the settlement takes into consideration
AIG's cooperation during the investigation and its remediation efforts in
response to material weaknesses identified by its internal review. From
the outset of the investigation, AIG gave complete cooperation to the
investigation by the Commission's staff. Among other things, AIG (1)
promptly provided information regarding any relevant facts and documents
uncovered in its internal review; (2) provided the staff with regular
updates on the status of the internal review; and (3) sent a clear message
to its employees that they should cooperate in the staff's investigation
by terminating those employees, including members of AIG's former senior
management, who chose not to cooperate in the staff's investigation.
In June 2005, SEC also charged a Gen Re executive with aiding and abetting
AIG in committing securities fraud. In its complaint, SEC alleged that
John Houldsworth, a former senior executive of Gen Re, helped AIG
structure two sham reinsurance transactions (see above). SEC's complaint
charges this executive with aiding and abetting the violations by AIG and
others of Sections 10(b), 13(a), 13(b)(2) and 13 (b)(5); and Rules 10b-5,
12b-20, 13a-1, 13a-13 and 13b2-1 of the Exchange Act. Mr. Houldsworth, in
addition to undertaking to cooperate fully with SEC, consented to the
entry of a partial final judgment permanently enjoining him from future
violations of these provisions, barring him from serving as an officer or
director of a public company, and deferring the determination of civil
penalties and disgorgement to a later date. In settling the charges, he
also consented to SEC's order that suspends him from practicing as an
accountant. Other remedial sanctions are still to be determined. In
addition, Mr. Houldsworth agreed to SEC's administrative order, based on
the injunction, barring him from appearing or practicing before SEC as an
accountant, under Rule 102(e) of SEC's Rules of Practice.
In February 2006, SEC filed an enforcement action against other former
senior executives of Gen Re and AIG for helping AIG mislead investors
through the use of fraudulent reinsurance transactions. Four of the former
executives, Ronald Ferguson, Elizabeth Monrad, Robert Graham, and
Christopher Garand, were with Gen Re; the fifth, Christian Milton, was
with AIG. The complaint alleges that the defendants and others aided and
abetted AIG's violations of the antifraud provisions, and other
provisions, of the federal securities laws, by helping AIG structure two
sham reinsurance transactions (see above). Messrs. Ferguson, Graham, and
Garand; Ms. Monrad; and others at Gen Re worked with Mr. Milton and others
at AIG to fashion two sham reinsurance contracts between Cologne Re Dublin
(a Gen Re subsidiary in Dublin, Ireland) and an AIG subsidiary.
The complaint makes allegations regarding conversations among the
defendants and the existence of other evidence reflecting the planning and
implementation of the sham transaction. The complaint charges that the
defendants understood from the beginning that they were structuring a sham
transaction involving the creation of phony documents for the purpose of
providing apparent support for false accounting entries AIG made on its
books. The defendants, and others at Gen Re and AIG, allegedly knew that
AIG accounted for the sham transactions as if they were real reinsurance
contracts that transferred risk from Gen Re to AIG, when all parties
involved knew that was not true. As a result of AIG's accounting treatment
for these transactions, the company's financial results showed false
increases in reserves that AIG touted in the company's quarterly earnings
releases for the fourth quarter of 2000 and the first quarter of 2001.
According to the complaint, without the phony loss reserves, AIG's
financial results in both quarters would have shown further declines in
its loss reserves.
SEC's complaint charges Messrs. Ferguson, Graham, and Garand; and Ms.
Monrad, with aiding and abetting AIG's violations of Sections 10(b), 13
(a), 13(b)(2) and 13(b)(5); and Rules 10b-5, 12b-20, 13a-1, 13a-13 and
13b2-1 of the Exchange Act. The complaint seeks permanent injunctive
relief, disgorgement of ill-gotten gains, if any, plus prejudgment
interest, civil money penalties, and orders barring each defendant from
acting as an officer or director of any public company. In connection with
the same conduct alleged in SEC's complaint, DOJ has filed federal
criminal charges against Messrs. Ferguson, Graham, and Milton; and Ms.
Monrad, in the U.S. District Court for the Eastern District of Virginia.
In a separate matter, NYSOAG and the Superintendent of Insurance of the
State of New York are suing former AIG executives Mr. Greenberg, former
CEO, and Mr. Smith, former CFO, for directing and approving various
fraudulent business practices, including the sham reinsurance transactions
with Gen Re. The lawsuit, filed on May 26, 2005, in State Supreme Court in
Manhattan attributes the misconduct at AIG directly to Mr. Greenberg and
alleges that he directed others at AIG to develop and implement the
schemes underlying various misleading transactions. The lawsuit, among
other judgments, seeks to enjoin the defendants from future violations of
New York State laws, disgorge all gains, and pay all restitution and
damages caused directly or indirectly by the fraudulent and deceptive
acts.
Appendix X
Dynacq Healthcare, Inc. Case Study
Business Overview
Dynacq Healthcare, Inc. (Dynacq) is a holding company. Through its
subsidiaries, the company develops and manages general acute hospitals
that provide specialized general surgeries. Dynacq's hospitals include
operating rooms, pre- and post-operative space, intensive care units,
nursing units, and modern diagnostic facilities. Dynacq's facilities are
designed to handle complex orthopedic and general surgeries, such as spine
and bariatric surgeries. Dynacq was incorporated in Nevada in June 1989.
In November 2003, the company reincorporated in Delaware and changed its
name from Dynacq International, Inc. to Dynacq Healthcare, Inc. For the
fiscal year ended August 31, 2005, Dynacq had total revenues of $55.3
million and approximately 302 employees.
Restatement Data
On April 6, 2004, Dynacq issued a press release announcing that, in
connection with an ongoing review by SEC of the company's periodic
reports, it would restate its financial statements for the fiscal years
ended August 31, 2001, and 2002. According to its press release, these
restatements would reclassify certain accounts receivable to long-term
status, to the extent that cash collections were expected more than 12
months after such dates. The restatements also would correct an error in
the application of an accounting principle related to income tax effect of
the exercise of stock options, where the income tax benefit of $794,000
from the exercise stock options was treated as a tax benefit rather than
as an increase in stockholders' equity, during the fiscal year ending in
2001. Dynacq also said that it corrected this error in the fiscal year
ending August 31, 2002, where the tax provision was increased by $794,000,
with a corresponding increase to stockholders' equity. Dynacq further
noted that the restatement would increase the income tax provision for the
fiscal year ending August 31, 2001, by $794,000, and reduce the income tax
provision for the fiscal year ending August 31, 2002, by the same amount,
and that there would be no cumulative effect on retained earnings as of
August 31, 2002.
On July 14, 2004, Dynacq announced that it had substantially completed the
reaudit and restatements for the fiscal years ending August 31, 2001, and
2002, the restatements of the company's selected financial information for
fiscal years 1999 and 2000, and the audit of its financial statements for
fiscal year 2003. See table 10.
Table 10: Selected Financial Data for Dynacq, Fiscal Years 1999-2002
(Dollars in millions)
Affected financial data 2000 2001 2002
Additional paid-in capital, as reported $4.3 $6.7 $9.8
Additional paid-in capital, as restated 5.4 11 13.7
Retained earnings, 11.4 22.4 37.9
as reported
Retained earnings, 12.6 20.4 35.2
as restated
Net income, as reported N/A 11.1 15.4
Net income, as restated N/A $7.7 $14.8
Source: SEC filings.
Note: N/A means not applicable.
Accounting/Audit Firm
As of May 31, 2002, Ernst & Young, LLP (E&Y) was the company's independent
auditor. On December 15, 2003, E&Y orally communicated to certain officers
of Dynacq its concerns relating to the company's disclosure controls,
accounting controls, and controls over safeguarding of assets. On December
17, 2003, E&Y notified Dynacq that it resigned as the company's
independent auditor effective immediately. E&Y also orally informed Dynacq
that the company lacked the internal controls necessary to develop
reliable financial statements.
In a letter dated December 23, 2003, E&Y advised the Board of Directors of
its conclusion that material weakness in internal controls had come to its
attention during the course of performing its audit of the company's
financial statements for the fiscal year ending August 31, 2003.
Specifically, E&Y noted inadequate communication lines and internal
controls relating to the authorization, recognition, capture, and review
of transactions, facts, circumstances, and events that may have a material
impact on the company's financial reporting process. E&Y further noted a
lack of supervision, review, and quality control related to the accounting
for income taxes, including the preparation of the federal income tax
provision
in accordance with Statement of Financial Accounting Standards No 109,
Accounting for Income Taxes.
On January 19, 2004, the audit committee of the Board of Directors of the
company engaged Killman, Murrell & Company, P.C. as the company's new
independent accountant for the fiscal year ending August 31, 2003.
Stock Prices
Dynacq's stock trades on Nasdaq under the ticker symbol DYII. The stock
peaked at more than $ 29 per share on January 7, 2002, and closed at less
than half that price by year's end (see fig. 15). On December 18, 2003,
the day Dynacq issued announcements regarding delays in filing its annual
report on Form 10-K as a result of the sudden resignation of its
independent auditor E&Y, its stock closed at $8.95--down from $10.99 the
day before. The following day, December 19, 2003, the stock closed at
$4.09, a decline of almost 63 percent, but it traded at less than $8 per
share for the remainder of 2003. Then on March 26, 2004, the stock fell
slightly to $5.19, down from $5.23 the previous day, as the company
announced that it would not be releasing its financial results for the
quarter ending February 2004 by April 2004, the normal filing date for the
report.
The restatement announced on April 6, 2004, had apparently no immediate
impact on the stock price, as the market had already received bad news
from the company on February 4, 2004, when it released preliminary
financial estimates. In the preliminary estimates issued, the company
indicated that net patient service revenue, net income, and fully diluted
earnings per share for the fiscal quarter ended November 30, 2003,
decreased in excess of 50 percent from the previous comparable quarter.
However, on April 15, 2004, when Dynacq announced that the Nasdaq Listing
Qualifications Panel had notified the company that its stock would be
delisted from the Nasdaq as of the opening of business on Friday, April
16, 2004, its stock decreased to $3.90 down from $7.10 the day before--a
decline of 45 percent. Finally, on Friday April 16, 2004, the day the
stock was set to be delisted, it closed at $3.33.
Following the delisting, Dynacq common stock was quoted on the Pink Sheets
for unsolicited trading and from November 10, 2004, to May 2, 2005, it was
quoted on the OTC Bulletin Board under the symbol "DYII.OB" as well as on
the Pink Sheets. On May 3, 2005, the company's common stock was relisted
on the Nasdaq Capital Market System and continues to trade under the
symbol "DYII".
Figure 15: Daily Stock Prices for Dynacq, January 2, 2002-May 31, 2005
Securities Analysts' Recommendations
Based on historical analyst research we were able to find, one brokerage
firm covered Dynacq at the time of the restatement. However, the firm did
not make an investment recommendation because of too much uncertainty
about the company's long-term viability. In the fall of 2004, the firm
stopped covering Dynacq.
Credit Rating Agency Actions
No credit rating agency information was available.
Legal and Regulatory Actions Taken
Eight lawsuits were filed in the U.S District Court for the Southern
District of Texas (Houston Division) from December 24, 2003, through
January 26, 2004, alleging federal securities law causes of action against
the company and various current and former officers and directors. The
cases were filed as class actions brought on behalf of persons who
purchased shares of company common stock in the open market, generally
from January 14, 2003, through December 18, 2003. Under the procedures of
the Private Securities Litigation Reform Act, certain plaintiffs have
filed motions asking to consolidate these actions and be designated as
lead plaintiff. The court consolidated the actions and appointed a lead
plaintiff in the matter. An amended complaint was filed on June 30, 2004,
asserting a class period of November 27, 2002, to December 19, 2003, and
naming additional defendants, including E&Y. The amended complaint sought
certification as a class action and alleged that the defendants violated
Sections 10(b), 20(a), 20(A), and Rule 10b-5 under the Securities Exchange
Act of 1934, by (1) publishing materially misleading financial statements
that did not comply with GAAP; (2) making materially false or misleading
statements or omissions regarding revenues and receivables, operations and
financial results; and (3) engaging in an intentional fraudulent scheme
aimed at inflating the value of Dynacq's stock. According to Dynacq, the
company planned to vigorously defend the allegations and would file a
motion to dismiss all or some of the claims. The company further noted it
could not predict the ultimate outcome of the lawsuit, or whether the
lawsuit would have a material adverse effect on the company's financial
condition.
On December 18, 2003, Dynacq received a notice of an informal
investigation from SEC's Fort Worth, Texas, District Office requesting its
voluntary assistance in providing information regarding reporting of its
financial statements, recognition of costs and revenue, accounts
receivable, allowances for doubtful accounts, and its internal controls.
The company said that it had been cooperating fully with the continuing
informal SEC investigation. As of July 2006, no additional action has been
taken by SEC against the company or any of its officials.
Appendix XI
Federal National Mortgage Association (Fannie Mae) Case Study
Business Overview
The Federal National Mortgage Association (Fannie Mae) is a
government-sponsored company that buys residential mortgage loans from
lenders and packages them into securities. They retain some of those
securities and sell others to investors. Its customers are primary
mortgage lenders including mortgage companies, savings and loan
associations, savings banks, commercial banks, credit unions, and state
and local housing finance agencies. It provides liquidity in the secondary
mortgage market through its Credit Guaranty business and through its
Portfolio Investment business. The Portfolio Investment business has two
principal components, a mortgage portfolio and liquid investments. To
manage the credit risk of their mortgages, the Credit Guaranty business
uses credit enhancements, active management of the mortgage credit book of
business, and loan management. It also shares mortgage credit risk with
third parties. Fannie Mae has not filed annual or quarterly financial
statements since August 9, 2004. For the 6 months ending June 30, 2004,
interest income (revenue) decreased 4 percent to $24.4 billion. Net income
from continuing operations totaled $3.012 billion for the 6 months ended
June 30, 2004.
Restatement Data
On October 29, 2003, Fannie Mae announced that it would file a revised
Form 8-K with SEC correcting certain "computational errors" made primarily
in the implementation of Financial Accounting Standard No. 149--an
amendment to Financial Accounting Standard 133 on Derivative Instruments
and Hedging activities. Correction of these errors had no impact on Fannie
Mae's income statement, but did result in increases to several balance
sheet items, including unrealized gains on securities, accumulated other
comprehensive income, and total stockholder's equity as of September 30,
2003. The company discovered these errors during the course of a standard
review in preparation of their form 10-Q for the third quarter of 2003.
Fannie Mae's regulator, the Office of Federal Housing Enterprise Oversight
(OFEHO), issued a statement saying the error underscored the need for a
special review that they were about to begin into the accounting policies,
practices, and internal controls of the company.
On September 22, 2004, OFHEO made public a report that was highly critical
of accounting methods at Fannie Mae. OFHEO charged Fannie Mae with not
following generally accepted accounting practices in two critical areas:
(1) amortization of discounts, premiums, and fees involved in the purchase
of home mortgages, and (2) accounting for financial derivatives contracts.
According to OFHEO, management intentionally developed
accounting policies and selected and applied accounting methods to
inappropriately reduce earnings volatility and to provide themselves with
inordinate flexibility in determining the amount of income and expense
recognized in any accounting period. In this regard, the amortization
policies that management developed, and the methods they applied, created
a "cookie jar" reserve. In 1998, management inappropriately deferred $200
million of estimated amortization expense, which allowed for Fannie Mae to
pay out the maximum in bonus awards to Fannie Mae executives. According to
OFHEO, these deviations from standard accounting rules--Statement of
Financial Accounting Standards (SFAS) 91 "Accounting for Nonrefundable
Fees and Costs Associated with Originating or Acquiring Loans and Initial
Direct Costs of Leases" and SFAS 133 "Accounting for Derivative
Instruments and Hedging Activities" respectively--allowed Fannie Mae to
reduce volatility in reported earnings, present investors with an
artificial picture of steadily growing profits, and in one case, to meet
financial performance targets that triggered the payment of bonuses to
Fannie Mae's senior executives. That same day, Fannie Mae acknowledged
that OFHEO's review found serious accounting problems and earnings
manipulation, and disclosed the existence of a SEC investigation into the
company's accounting. The following week a criminal investigation by DOJ
was made public.
On October 6, 2004, Fannie Mae's CEO and chairman, and CFO, defended the
company's accounting in sworn testimony at a congressional hearing,
stating that allegations of accounting improprieties and management
misdeeds were a matter of interpreting complex rules. A month later, on
November 15, 2004, Fannie Mae missed an SEC deadline for filing its
third-quarter financial results. Press sources indicated that its
independent auditor, KPMG LLP (KPMG), refused to sign off on a review of
the company's unaudited quarterly financial statements. The company
acknowledged that some of its accounting practices did not comply with
GAAP and announced it would show a net loss of $9 billion if SEC decided
it had improperly accounted for derivatives.
On December 15, 2004, SEC's chief accountant announced that an agency
review determined that Fannie Mae must restate earnings back to 2001
because it violated accounting rules for derivatives and certain prepaid
loans. SEC became involved in Fannie Mae's financial reporting after its
CEO--motivated by a report issued by the company's regulator, which
highlighted irregularities in its accounting policies--requested that the
Commission render an opinion about the company's historical financial
statements. Shortly after SEC's December announcement, the company's CEO
and CFO resigned. Estimates suggested that earnings since 2001 will be
revised downwards by as much as $12 billion, but the formal restatement of
earnings is not expected before late 2006.
Almost two years after SEC's determination, Fannie Mae is in the final
stages of completing its restatement--an undertaking that cost the company
$800 million in 2005 alone. Fannie Mae has filed neither annual nor
quarterly reports since August 9, 2004. The restated financial statements
are expected to be filed with SEC in late 2006.
Accounting/Audit Firm
In November of 2004, Fannie Mae's independent auditor, KPMG, advised the
firm that it would be unable to complete its review of Fannie Mae's
interim unaudited financial statements for the quarter ended September 30,
2004. Press sources stated that the public accounting firm had refused to
sign off on the statements. As a result, Fannie Mae announced that it
would not be able to file its Form 10-Q for the September 30, 2004, in a
timely fashion. A month later, KPMG alerted Fannie Mae that there existed
strong indicators of material weakness in the company's internal control
of financial reporting. Fannie Mae switched auditors and engaged Deloitte
& Touche LLP on January 28, 2005, to be the company's independent auditor.
Stock Prices
Fannie Mae's stock is traded on the NYSE under the ticker symbol FNM.
Fannie Mae's stock traded at $75 around the time it announced
computational errors in October of 2003 and remained stable during the
days before and after the company's announcement. On September 22,
2004--the day Fannie Mae announced that OFHEO's review found serious
accounting problems and earnings manipulation--the company's share price
dropped 7 percent, from $75.65 per share to $70.69. About a week later, on
September 30, 2004--the day the press announced that an investigation into
the company's accounting practice by DOJ had been confirmed--the company's
share price fell again, to $63.05. By December of 2004, the company's
stock rebounded. The day before Fannie Mae's restatement announcement,
December 15, 2004, the share price was $70.69. On December 16, 2004, the
day the company officially announced it would have to restate, the share
price dropped slightly to $69.30. On June 1, 2006, the company's share
price was $51.44--down 27 percent since December of 2004, when the company
formally announced that it would have to restate four years of earnings
(see fig. 16).
Figure 16: Daily Stock Prices for Fannie Mae, October 1, 2002-February 28,
2006
Fannie Mae has not filed annual or quarterly reports since August 9, 2004,
nor has it filed restated financial statements for 2001 through 2004.
However, the company's stock continues to be listed and traded on the
NYSE. Under its listing standards, the NYSE may initiate suspension and
delisting proceedings when a company, such as Fannie Mae, fails to file
its financial statements in a timely manner. In certain very limited
circumstances, however, NYSE, at its sole discretion, may determine to
allow a company to continue listing if it has not timely filed. At the
time this report was published, Fannie Mae's stock continued to be listed
and traded on the NYSE.
Security Analysts' Recommendations
In September of 2004, after OFHEO made public a report that was highly
critical of accounting methods at Fannie Mae, securities analysts at four
firms downgraded the company's rating. About a year later, in November of
2005, one firm upgraded Fannie Mae's rating, and in January of 2006
another firm downgraded Fannie Mae once again. Ratings for the company in
2006 have followed no particular trend, with one firm upgrading Fannie
Mae's rating in May 2006 and another firm downgrading the company's rating
in June of 2006.
Credit Rating Agency Actions
Two major credit rating agencies, Standard & Poor's and Moody's rate
Fannie Mae. On September 28, 2004, the same month OFEHO's review exposed
Fannie Mae's accounting problems, Moody's revised the ratings outlooks for
Fannie Mae's subordinated debt and preferred stock to negative, and
affirmed senior debt at Aaa with a stable outlook. On December 23, 2004,
approximately a week after the company announced that it would have to
restate, Moody's affirmed Fannie Mae's rating with a stable outlook,
placed their financial strength rating under review, and maintained a
negative rating outlook for their subordinated debt and preferred stock.
On August 11, 2005, Moody's affirmed Fannie Mae's senior debt and
downgraded their financial strength ratings. It continued to review Fannie
Mae's subordinated debt and preferred stock ratings for a possible
downgrade. On December 15, 2005, Moody's confirmed Fannie Mae's
subordinated debt, preferred stock, and senior debt, and affirmed their
financial strength rating.
Standard & Poor's current "risk to the government" rating for Fannie Mae
is AA- and on CreditWatch Negative.^1 The rating has remained on
CreditWatch Negative since September 23, 2004. Moody's current "Bank
Financial Strength Rating" for Fannie Mae is B+ with a stable outlook.
Legal and Regulatory Actions Taken
As a result of the findings of OFHEO's special examination report issued
in September of 2004, and as part of its continuous supervisory program,
OFHEO directed Fannie Mae to take a number of actions. OFHEO's primary
remedial actions include increasing its capital levels, changing its
corporate governance structure, and restating past financial statements.
In an agreement with Fannie Mae's Board of Directors reached in September
2004, OFHEO directed Fannie Mae to maintain an additional 30 percent of
capital above the minimum capital requirement to compensate for the
additional risk and challenges facing the enterprise. In addition to the
capital requirements, OFHEO directed the Board of Directors of Fannie Mae
to make significant changes to its corporate governance structure. Those
changes include, but are not limited to, separating the chairman of the
board and CEO positions, creating a new independent Office of Compliance
and Ethics to conduct internal investigations, and creating a Compliance
Committee of the Board of Directors to monitor and coordinate compliance
with the Fannie Mae's agreements with OFHEO.
To address accounting problems, OFHEO directed Fannie Mae to restate
inappropriate past financial statements, to meet all applicable legal and
regulatory requirements (including having the new financial statements
reaudited by Fannie Mae's new external auditor), and to cease engaging
inappropriate hedge accounting. OFHEO also directed Fannie Mae to
implement an appropriate policy for SFAS 91 and develop and implement a
plan to address the deficiencies in the accounting systems for Fannie
Mae's portfolio.
On December 15, 2004, the chief accountant of SEC announced that the
agency's review of Fannie Mae's historical financial statements found that
the accounting policies of Fannie Mae for both FAS 91 and FAS 133 departed
from GAAP in material respects, and advised Fannie Mae to restate its
financial statements for the years 2001 through 2004. In a follow-up
announcement that occurred on May 23, 2006, SEC and OFHEO informed the
public that Fannie Mae agreed to settle charges relating to the
misstatement of its financial statements from 1998 through 2004, and that
Fannie Mae had entered into a consent decree with OFHEO and consented to
the entry of judgment in our action, which included injunction from
violations of the antifraud, books and records, internal controls
provisions of the federal securities laws and a $400 million civil
penalty. Fannie Mae has agreed, without admitting or denying these
allegations, to a fraud injunction for violations of Section 10(b) of the
Securities Exchange Act of 1934 and Rule 10b-5, and to an injunction for
violations of Section 17(a)(2) and (3) of the Securities Act of 1933. As a
result of the violations described in the Commission's complaint, Fannie
Mae expects to restate its historical financial statements for the years
ended December 31, 2003, and 2002; and for the quarters ended June 30,
2004, and March 31, 2004.
OFHEO's special examination of Fannie Mae's accounting policies is
ongoing, and SEC and the U.S. Attorney's Office for the District of
Columbia also continue to investigate matters related to the misstatement
of the company's financial statements. In addition, a number of lawsuits
have been filed against Fannie Mae and certain current and former officers
and directors of the company relating to the company's restatement. These
lawsuits are currently pending in the U.S. District Court for the District
of Columbia and fall within three primary categories: a consolidated
shareholder class action and related opt-out lawsuits, a consolidated
shareholder derivative lawsuit, and a class action lawsuit based on the
Employee Retirement Income Security Act of 1974 (ERISA).
The consolidated shareholder class action and two related opt-out lawsuits
generally allege that Fannie Mae and certain former officers and directors
made false and misleading statements in violation of the federal
securities laws in connection with certain accounting policies and
practices. In addition, the opt-out lawsuits assert various federal and
state securities law and common law claims against Fannie Mae and certain
current and former officers and directors based upon the same alleged
conduct, and also assert insider trading claims against certain former
officers. The opt-out cases were filed by institutional investors seeking
to proceed independently of the putative class of shareholders in the
consolidated shareholder class action.
The consolidated shareholder derivative lawsuit asserts claims,
purportedly on behalf of Fannie Mae against certain current and former
officers and directors. Generally, the complaint alleges that the
defendants breached their fiduciary duties to Fannie Mae and that the
company was harmed as a result. The company's and the other defendant's
motions to dismiss the consolidated shareholder derivative lawsuit are
pending.
The ERISA-based class action lawsuit alleges that Fannie Mae, and certain
current and former officers and directors, violated ERISA. The plaintiffs
in the ERISA-based lawsuit purport to represent a class of participants in
Fannie Mae's Employee Stock Ownership Plan. Their claims are also based on
alleged breaches of fiduciary duty based on the accounting matters
discussed in OFHEO's interim report. A motion to dismiss that lawsuit is
pending.
Appendix XII
Qwest Communications International, Inc. Case Study
Business Overview
Qwest Communications International, Inc. (Qwest) is a developer and
operator of telecommunications networks and facilities. It provides local,
long distance, wireless, and data services within its 14-state local
service area. It also provides long distance services, broadband, data,
voice, and video communications outside its local service area. The
company has about 41,000 employees and is headquartered in Denver,
Colorado. For the years ending December 31 2004, and 2005, Qwest had total
revenues of $13.8 billion and $13.9 billion, respectively.
Restatement Data
On April 3, 2002, SEC issued an order of investigation of the company that
made formal an informal investigation begun on March 8, 2002. The
investigation included an inquiry into several specifically identified
Qwest accounting practices and transactions. On July 28, 2002, Qwest
announced that, based on analysis to that date, the company had determined
(1) it had incorrectly applied accounting polices with respect to certain
optical capacity asset sale transactions in 1999, 2000, and 2001; (2)
further adjustments were required to account for certain sales of
equipment in 2000 and 2001 that the company had previously determined had
been recorded in error; and (3) that in a limited number of transactions,
it did not properly account for certain expenses incurred for services
from telecommunications providers in 2000 and 2001. The company expected
to restate its financial statements for these periods after it completed
its analysis of its accounting policies and practices.
In a press release on September 22, 2002, Qwest, in restating its 2000 and
2001 financial statements, announced it would reverse $950 million in
revenues and related costs associated with exchanges of optical capacity
assets previously recognized. On October 28, 2002, Qwest announced the
$950 million in revenues being reversed would be spilt into $265 million
and $685 million in 2000 and 2001, respectively. In addition, the company
announced that the $531 million previously recognized on sales of optical
capacity assets for cash ($200 million in 2000 and $331 million in 2001)
should be deferred. Finally, the company was taking a $10.8 billion asset
impairment charge, where approximately $8.1 billion was a write-down of
telephone network, global fiber optic broadband network, and other related
assets, and approximately $2.7 billion was a reduction in the carrying
value of intangible assets related to customer lists and product
technology associated with the company's inter-exchange carrier business.
On February 11, 2003, Qwest announced additional results of its internal
review of the 2001 and 2000 financial statements, and further announced
that its board of directors expanded the review to include an assessment
of internal controls, as well as accounting policies, practices, and
procedures. In connection with this review, the company discovered
additional restatement entries to the 2001 and 2000 financial statements
involving revenue and expense recognition and cost accrual issues for 2001
and 2000, among other things. In a SEC Form 10-K filing on November 8,
2004, Qwest presented its restated financial statements for the years
ending December 31, 2000, and December 31, 2001. Table 11 summarizes the
revenue, net income (or loss), and total asset changes for 2000 and 2001.
Table 11: Selected Financial Data for Qwest, 2000 and 2001
(Dollars in millions; negative values in parentheses)
Affected financial data 2000 2001
Revenue, as reported $16,610 $19,695
Revenue, as restated 14,148 16,524
Net income (loss), as reported (81) (4,023)
Net income, as restated (1,037) (5,603)
Total assets, as reported $73,501 $73,781
Total assets, as restated $72,816 $72,166
Source: SEC filings.
Accounting/Audit Firm
Arthur Andersen LLP (Arthur Andersen) was the company's auditor and wrote
unqualified opinions for the company during the periods that were
eventually restated (2000 and 2001). On May 29, 2002, Qwest's Board of
Directors decided not to re-engage Arthur Andersen as Qwest's independent
auditor for 2002 and instead engaged KPMG LLP. KPMG has continued to be
the independent auditor through the fiscal year ending December 31, 2005.
In 1999, 2000, and 2001, Arthur Andersen signed the audit reports for
Qwest, with unqualified opinions.
Stock Prices
Qwest trades on the NYSE under the ticker symbol Q. Starting in the second
quarter of 2001, Qwest's stock generally trended downward, from a price of
roughly $35. The stock hit a low of near $11 in the middle of the fourth
quarter of 2001. The stock rallied to more than $14 in January of 2002,
then fell below $10, and leveled off near $7 in early April. At the time
of the announcement of a formal SEC investigation into its accounting
practices on April 3, 2002, the stock price fell sharply from $7.63 to hit
a yearly low of $1.11 in August of 2002--a decrease of around 85 percent.
From this bottom the stock price rallied until in hit a yearly high in
2003 of $6.02. From this high, the stock has varied from $2.69 to $7.09
(see fig. 17).
Figure 17: Daily Stock Prices for Qwest, January 2, 2001February 28, 2004
Securities Analysts' Recommendations
Based on historical securities analysts' recommendations that we were able
to identify around the time SEC began it formal investigation, we found
information on five firms that researched the company. In April 2002, when
SEC began its formal investigation into Qwest's accounting practices, five
securities firms had initial ratings on Qwest. Two of the five were buy
ratings--one was a strong buy, one was a long-term buy, and the fifth was
market outperform. On April 19, 2002, all five lowered their ratings. Two
went from buy to hold, one went from strong buy to buy, one went from
long-term buy to long term neutral, and the fifth went from market
outperform to market perform. After July 28, 2002, when Qwest announced
that it would it would restate its earnings for 2000 and 2001, three firms
lowered their ratings between July 29 and August 8, 2002.
Credit Rating Agency Actions
Moody's Investors Service, Inc. (Moody's), Standard and Poor's (S&P), and
Fitch Ratings (Fitch) rated Qwest's long-term debt. During 2002 when the
SEC investigation began, the three agencies lowered Qwest's credit ratings
on multiple occasions. For instance, from December 2001 to December 2002,
Moody's downgraded Qwest's rating from A2 to Ba, S&P downgraded from BBB+
to B-, and Fitch lowered its ratings from A to B. Moody's Ba rating
indicates a security has speculative elements. Similarly, for S&P, any
rating below BBB indicates that the security is speculative in nature.
According to S&P, a B- rating indicates that the issuer currently has the
capacity to meet financial commitments on the obligation but adverse
business, financial, or economic conditions likely would impair its
capacity or willingness to meet financial commitments on the obligations.
Finally, any Fitch rating below BBB is considered speculative in nature,
and a B rating is highly speculative, meaning that significant credit risk
is present.
Legal and Regulatory Actions Taken
On October 21, 2004, Qwest entered a settlement with SEC, concluding a
formal investigation concerning Qwest's accounting and disclosures, among
other subjects, that began in April 2002. In connection with this
settlement, SEC filed a complaint against Qwest in federal district court
in Denver, Colorado. The complaint alleged that between 1999 and 2002
Qwest fraudulently recognized more than $3.8 billion in revenue and
excluded $231 million in expenses as part of a multifaceted fraudulent
scheme to meet optimistic and unsupportable earnings projections. Without
admitting or denying the allegations in the complaint, Qwest consented to
the entry of a judgment by the court.^1
The final judgment, which was entered on November 4, 2004, enjoins Qwest
from future violations of certain provisions of the securities laws and
requires Qwest to pay a civil penalty of $250 million and a $1
disgorgement. This penalty amount is to be distributed to defrauded
investors pursuant to the Fair Funds provision of the Sarbanes Oxley Act
of 2002, which allows SEC to place civil penalties and disgorgements
levied on a company that commits fraud into a fund on behalf of harmed
shareholders. In addition, Qwest is required to maintain a Chief
Compliance Officer, who is to report to a committee of outside directors
and who is responsible for ensuring that the company conducts its business
in compliance with federal securities laws.
On July 9, 2002, the U.S. Attorney's Office for the District of Colorado
informed Qwest of a criminal investigation thought to relate to various
matters that SEC was investigating.
Twelve putative actions filed since July 2001 on behalf of purchasers of
Qwest's publicly traded securities between May 24, 1999, and February 14,
2002, were consolidated into a consolidated securities action pending in
federal district court in Colorado. Named in this action were Qwest, its
former chairman and CEO, former CFOs, other former officers and current
directors, and Arthur Andersen. The consolidated action alleged from May
24, 1999, to February 14, 2002, the putative class period, that
oQwest and certain of the individual defendants made materially false
statements regarding the results of the firm's operations in violation of
Section 10(b) of the Exchange Act,
ocertain of the individual defendants were liable as control persons under
Section 20(a) of the Exchange Act, and during the earlier stated period,
and
ocertain individual defendants sold some of their shares of common stock
in violation of section 20A of the Exchange Act.
The suit also alleges that the financial results during the putative class
period and statements regarding those results were false and misleading
due to the alleged (1) overstatement of revenue, (2) understatement of
costs, (3) manipulation of employee benefits to increase profitability,
and (4) misstatement of certain assets and liabilities. In addition, the
suit alleges that Qwest and certain individual defendants violated Section
11 of the Securities Act and that certain individual defendants were
liable as control persons under Section 15 of the Securities Act by
preparing and disseminating false registration statements. The plaintiffs
are seeking unspecified compensatory damages and other relief. According
to the plaintiffs' lead counsel, the plaintiffs are seeking damages worth
billions of dollars.
On October 22, 2001, a purported derivative lawsuit was filed in the U. S.
District Court for the District of Colorado. The complaint, as amended,
named as defendants certain of Qwest's present and former directors and
certain former officers and named Qwest as a nominal defendant. This
derivative lawsuit, referred to by Qwest as the Federal Derivative
Litigation, was based on the allegations made in the consolidated
securities action. The suit alleges that board members intentionally or
negligently breached their fiduciary duties to the firm by causing or
permitting the firm to commit alleged securities violations, thus causing
the firm to be sued for such violations, subjecting the firm to adverse
publicity, and increasing the cost of raising capital and impairing
earnings. This derivative complaint further alleges that certain directors
sold shares between April 26, 2001, and May 15, 2001, using nonpublic
information about the firm. In connection with the settlement of the
Colorado Derivative Litigation (defined below), the Federal Derivative
Litigation was dismissed with prejudice by agreement.
On March 6, 2002, and November 22, 2002, a purported derivative lawsuit
was filed in the Colorado District Court for the City and County of
Denver, naming as defendants certain of Qwest's current and former
officers and directors and Anschutz Company and naming Qwest a nominal
defendant (referred to as the Colorado Derivative Litigation). This
complaint was based on the allegations made in the consolidated securities
action and alleged that various individual defendants breached their legal
duties to Qwest by engaging in self-dealing, failing to oversee compliance
with laws that prohibit insider trading and self-dealing, and causing or
permitting Qwest to commit alleged securities laws violations--causing
Qwest to be sued for such violations and subjecting Qwest to adverse
publicity and thereby increasing its cost of raising capital and impairing
earnings. The two purported derivative actions were consolidated on
February 17, 2004.
On October 30, 2002, two purported derivative lawsuits, which initially
were filed in the Court of Chancery of the State of Delaware in August
2002, naming certain of Qwest's current and former officers and directors
and naming Qwest as a nominal defendant, were consolidated (referred to as
the Delaware Derivative Litigation). The plaintiffs alleged that the
individual defendants (1) breached their fiduciary duties by allegedly
engaging in illegal insider trading in Qwest's stock; (2) failed to ensure
compliance with federal and state disclosure, anti-fraud and insider
trading laws within Qwest; (3) appropriated corporate opportunities,
wasted corporate assets and self-dealt in connection with investments in
initial public offering securities through Qwest's investment bankers; and
(4) improperly awarded severance payments to Qwest's former Chief
Executive Officer, Joseph P. Nacchio, and Qwest's former Chief Financial
Officer, Robert S. Woodruff. The plaintiffs sought recovery of incentive
compensation allegedly wrongfully paid to certain defendants, all
severance payments made to Nacchio and Woodruff, disgorgement,
contribution and indemnification, repayment of compensation, injunctive
relief, and all costs including legal and accounting fees.
The Denver District Court entered an Order and Final Judgment effective
June 15, 2004, approving the proposed settlement among the parties to the
Colorado Derivative Litigation and the Delaware Derivative Litigation. The
settlement provided that upon dismissal with prejudice of the Delaware
Derivative Litigation and the Federal Derivative Litigation, $25 million
of the $200 million fund from the insurance settlement with certain Qwest
insurance carriers would be designated for the exclusive use of Qwest to
pay losses and Qwest would implement a number of corporate governance
changes. The settlement also provided that the Denver District Court could
enter awards of attorneys' fees and costs (in amounts not to exceed $7.625
million in the aggregate) to derivative plaintiffs' counsel from the $25
million. Pursuant to the settlement, by agreement the Delaware Derivative
Litigation and the Federal Derivative Litigation have been dismissed with
prejudice.
On March 15, 2005, in three separate but related civil actions, SEC
charged Joseph P. Nacchio, former Co-Chairman and CEO of Qwest, and eight
other former Qwest officers and employees, with fraud and other violations
of federal securities laws. The defendants included former CFOs Robert S.
Woodruff and Robin R. Szeliga, former Chief Operating Officer, Afshin
Mohebbi, and former officers George M. Casey, and William L. Eleveth. The
complaints sought injunctions, disgorgement of ill-gotten gains (plus
prejudgment interest), and civil penalties against all of the defendants
and officer/director bars against Nacchio, Woodruff, Mohebbi, Casey,
Eleveth, and Szeliga. Two of the nine defendants consented to the entry of
judgments against them without admitting or denying the allegations
against them. The complaints allege that the defendants violated Section
17(a) of the Securities Act, and Sections 10(b) and 13(b)(5) of the
Exchange Act, and Exchange Act Rules 10-b5 and 13b2-1; complaints also
allege that the defendants aided and abetted Qwest's violations of
Sections 13(a) and 13(b)(2) of the Exchange Act and Exchange Act Rules
12-b-20, 13a-1, 13a-11, 13a-13. SEC complaints allege that Nacchio,
Woodruff, Mohebbi, Casey, and Szeliga violated Exchange Act Rule 13b2-2,
and that Mohebbi and Casey aided and abetted Qwest's violations of Section
10(b) of the Exchange Act and Exchange Act Rule 10b-5. SEC has instituted
numerous other civil and administrative actions against former officers
and employees of Qwest and it subsidiaries, which are not summarized here.
Pursuant to an administrative order dated March 29, 2005, SEC instituted
administrative proceedings against Mark Iwan, a Global Managing Partner
for Arthur Anderson for Qwest. SEC found that he engaged in improper
professional conduct within the meaning of Rule 102(e)(1)(ii) of SEC's
Rules of Practice by engaging in repeated instances of unreasonable
conduct, each resulting in a violation of applicable professional
standards, which indicate a lack of competence to practice before SEC. In
anticipation of the institution of these proceeding, Iwan submitted an
offer of settlement that SEC accepted. SEC also denied him the privilege
of appearing or practicing before SEC as an accountant, but stated that
under certain conditions he might be reinstated to appear or practice
before SEC.
Appendix XIII
Starbucks Corporation Case Study
Business Overview
Starbucks Corporation (Starbucks) sells coffee and tea beverages and
products, along with a variety of complementary food items including a
line of premium ice cream, coffee-related accessories and equipment, and a
line of compact discs. The corporation sells these products primarily
through approximately 6,000 company-operated retail stores, which
accounted for 85 percent of total revenues in fiscal year 2005. Starbucks
also sells coffee and tea products and licenses its trademark through
other channels, such as grocery stores. The company's retail sales mix, by
product type, during fiscal year 2005, was 77 percent beverages, 15
percent food, 4 percent whole bean coffees, and 4 percent coffee-making
equipment and other merchandise. Based in Washington State, Starbucks has
expanded internationally in recent years--primarily in Canada, the United
Kingdom, Australia, and China--and has approximately 115,000 employees
worldwide. For fiscal year 2005, the Company reported total net revenues
of $6.4 billion and net earnings of almost $500 million.
The Company's business is subject to seasonal fluctuations. Significant
portions of the corporation's net revenues and profits are realized during
the first quarter of the fiscal year, which includes the December holiday
season. The timing of the opening of new stores and the supply and price
of coffee beans also has significant impact on the company's revenues and
profits.
Restatement Data
In a February 7, 2005, letter to the American Institute of Certified
Public Accountants, the chief accountant of SEC clarified SEC staff's
interpretation of certain operating lease-related accounting issues and
their application under GAAP. As a result of this clarification,
Starbucks' management and audit committee agreed to evaluate the company's
accounting practices for operating leases. On February 11, 2005, the due
date for filing Form 10-Q, Starbucks filed for a 5-day extension. On
February 16, 2005, Starbucks' management, audit committee, and external
auditor announced that the company's then-current method of accounting for
tenant improvement allowances and rent holidays was not in accordance with
GAAP. Lease terms may allow for a period of free or reduced
rents--typically known as rent holidays. On February 18, 2005, Starbucks
filed a Form 10-K/A for fiscal year 2004, in which the company restated
its consolidated financial statements for fiscal years 2002, 2003, and
2004. Starbucks also announced that the restatements would not affect its
previously reported first quarter (per share) earnings for fiscal year
2005.
Starbucks does not franchise its product. The corporation operates the
majority of its retail stores, typically in rented commercial space that
has been renovated to reflect the personalities of the communities in
which they are located. Starbucks had historically recognized rent holiday
periods on a straight-line basis over the lease term commencing with the
initial occupancy date, or the opening date for company-operated retail
stores, rather than commencing with the date the company takes possession
of the leased space for construction purposes. Starbucks also reviewed the
FASB's Technical Bulletin No. 85-3, "Accounting for Operating Leases with
Scheduled Rent Increases," for additional guidance. According to the
company's Form 10-K/A, because Starbucks generally takes possession of a
leased space 2 months prior to a store opening date in order to transform
it into the Starbucks style, the company should have been recording
additional deferred rent in "accrued occupancy costs" and "other long-term
liabilities" and adjusted "retained earnings" on the consolidated
statements of earnings for fiscal years 2002, 2003, and 2004. According to
the company's Form 10-K/A, these accounting changes resulted in a
reduction to retained earnings of $8.6 million as of the beginning of
fiscal year 2002, and decreases to retained earnings of $1.3 million, $1.5
million, and $1.2 million for fiscal years 2002, 2003, and 2004,
respectively. See table 12.
Table 12: Selected Reported Financial Data for Starbucks, 2002-2004
(Dollars in thousands)
Affected financial data Ending Sept. 29, Ending Sept. 28, Ending Oct. 3,
2002 2003 2004
Cost of sales including $1,350,011 $1,685,928 $2,198,654
occupancy costs, as
reported
Cost of sales including 1,346,972 1,681,434 2,191,440
occupancy costs, as
restated
Depreciation and 205,557 237,807 280,024
amortization expenses, as
reported
Depreciation and 210,702 244,671 289,182
amortization expenses, as
restated
Net earnings, as reported 212,686 268,346 391,775
Net earnings, as restated 211,391 266,848 390,559
Source: SEC filing.
Accounting/Audit Firm
Deloitte and Touche LLP was the independent auditor for Starbucks during
the relevant period.
Stock Prices
Starbucks is traded on the Nasdaq Stock Market under the symbol SBUX.
Since going public in 1992, Starbuck's stock value has climbed steadily as
the corporation expanded nationally and internationally. By 2002,
Starbucks had split its stock four times. On December 29, 2004, the stock
reached a high of $63.87, reflecting a profitable December holiday season.
Starbucks' February 2005 announcement of its intention to restate its
financial statement for fiscal years 2002-2004 did not adversely affect
its stock value. On February 7, 2005, when SEC released its letter,
Starbucks' stock traded at $51.07. On February 11, 2005, when Starbucks
requested a filing extension with SEC, its stock value decreased to
$49.68. With some fluctuations, the stock traded at $49.90 on February 18,
2005, when the company filed an amended Form 10-K that contained the
restated consolidated balance sheets for 2003 and 2004, as well as its
consolidated statements of earnings and cash flows for fiscal years 2002,
2003, and 2004. The Company's stock value remained briefly around $49
until February 25, 2005, when it increased to $51.24, and remained
slightly above that level for the next month. On September 21, 2005, the
company announced a two-for-one stock split (see fig. 18).
Figure 18: Daily Stock Prices for Starbucks, June 1, 2004-April 28, 2006
Securities Analysts' Recommendations
Based on historical securities analysts' recommendations that we were able
to identify, at least 10 research firms covered Starbucks during the
relevant period. All maintained recommendations ranging from hold to buy.
Analysts generally have rated Starbucks favorably. Data from 1998 show
analysts generally recommending buying Starbuck's stock or holding it. On
February 11, 2005, a few days before Starbuck's restatement announcement,
one analyst recommended holding the stock. On February 18, 2005, when
Starbucks filed its Form 10-K/A with the restated financial statements,
another analyst noted that the stock was "in-line," which means the
earnings adhered to the analyst's expectations. Over the next few months,
several analysts upgraded their actions to outperform or buy.
Credit Rating Agency Actions
At the time of the relevant period, Starbucks was not rated by any credit
rating agencies. According to one credit rating agency analyst, Starbucks
was not rated because it did not have any public debt.
Legal and Regulatory Actions Taken
As of July 2006, there has been no civil or regulatory action taken with
regard to Starbucks' restatement announcement.
Appendix XIV
Sterling Bancshares, Inc. Case Study
Business Overview
Sterling Bancshares, Inc. (Sterling Bancshares) provides financial
services for small- to mid-sized businesses and consumers through 40
banking offices in the greater metropolitan areas of Houston, San Antonio,
and Dallas, Texas.^1 It provides a wide range of commercial and consumer
banking services, including demand, savings and time deposits; commercial,
real estate, and consumer loans; merchant credit card services; letters of
credit; and cash and asset management services. In addition, it
facilitates sales of brokerage, mutual fund, alternative financing, and
insurance products through third-party vendors. As of December 31, 2005,
the company had total assets of $3.7 billion with a net income for the
year of $36.2 million and just over 1,000 employees.
Restatement Data
Sterling Bancshares made one restatement announcement on October 21, 2003,
in its announcement of quarterly results for the quarter ended September
30, 2003. Sterling Bancshares announced that upon the sale of its banking
offices in Eagle Pass, Carrizo Springs, Crystal City, and Pearsall (South
Texas offices) on July 15, 2002, and November 5, 2002, it initially
determined that the sale of the offices met the accounting requirements
for presentation as discontinued operations. However, after further
consideration, the company determined that the sale of the South Texas
offices did not meet the requirements for such presentation. The company's
total net income, basic and diluted earnings per share and shareholders
equity for this period was not affected by the restatement.
The company determined that it was necessary to amend its Form 10-Qs for
the quarters ended March 31, 2003, and June 30, 2003, as well as its 2002
Form 10-K, so that the financial results and condition pertaining to these
offices were not separately presented as discontinued operations. The
company's October 2003 earning's release contained the restated financial
information with respect to these prior periods in order to present the
South Texas offices in continuing operations. The amendments to the March
31 and June 30 Forms 10-Q, and the Form 10-K for fiscal year 2002, were
ultimately filed on November 14, 2003--the same date the quarterly report
Form 10-Q for the period ended September 30, 2003, was filed.
The company's consolidated income statement filed with the original Form
10-Q for the quarter ended March 31, 2003, included $9.2 million as income
from continuing operations and $2.0 million as income from discontinued
operations. As a result of including the South Texas offices in continued
operations, the line item for income from discontinued operations was
deleted from the restated income statement, and the amount presented as
income from continuing operations increased by the $2.0 million that had
initially been presented as income from discontinued operations.
Additionally, the $16.2 million and $43.4 million included on the
consolidated balance sheet filed with the original Form 10-Q as assets and
liabilities of discontinued operations, respectively, were deleted, and
such amounts were redistributed to the appropriate line items on the
restated balance sheet.
Sterling Bancshares' consolidated income statement original Form 10-Q for
the quarter ended June 30, 2003, included $6.2 million as income from
continuing operations and $1.585 million as a loss from discontinued
operations. Additionally, it included $98.8 million as assets related to
discontinued operations and $172.7 million as liabilities related to
discontinued operations. On the restated income statement, income from
continuing operations decreased $35 thousand to $6.19 million while the
loss from discontinued operations decreased $35 thousand to $1.550
million. Additionally, the restated assets related to discontinued
operations decreased 43 percent, or $43 million, to $56.1 million.
Liabilities related to discontinued operations decreased 81 percent, or
$140 million, to $32 million.
The company's consolidated income statement filed with the original Form
10-K for the year ended December 31, 2002, included $36.7 million as
income from continuing operations and a loss of $122 thousand from
discontinued operations. Additionally, it included $42.8 million as assets
related to discontinued operations and $140.3 million as liabilities
related to discontinued operations. On the restated income statement,
income from continuing operations decreased $122 thousand, to $36.5
million, while the restated income from discontinued operations increased
$122 thousand. Additionally, the restated assets related to discontinued
operations and liabilities related were eliminated. Table 13 summarizes
the related financials.
Table 13: Selected Financial Data for Sterling Bancshares (Fiscal Year
2002, the First Two Quarters of Fiscal Year 2003)
(Dollars in thousands; negative
values in parentheses)
Affected financial data Fiscal year First quarter Second quarter
2002 2003 2003
Income for continuing operations, $36,673 $9,210 $6,226
as reported
Income for continuing operations, 36,551 11,237 6,191
as restated
Income (loss) for discontinued (122) 2,027 (1,585)
operations, as reported
Income (loss) for discontinued 0 0 (1,550)
operations, as restated
Asset related to discontinued 42,772 16,223 98,831
operations, as reported
Asset related to discontinued 0 0 56,059
operations, as restated
Liabilities related to 140,340 43,402 172,746
discontinued operations, as
reported
Liabilities related to 0 0 32,406
discontinued operations, as
restated
Source: SEC filings.
Independent Auditor
Deloitte & Touche LLP was the company's independent auditor during the
restatement period.
Stock Prices
Sterling Bancshares stock is traded on the Nasdaq under the ticket symbol
SBIB. On October 20, 2003, the date before the restatement announcement,
the stock price closed at $11.42. On the day of the restatement, the stock
price closed at $11.50. The following day, the stock price closed at
$11.12. However, the stock had been decreasing since October 9, when its
price was $12.36. The announcement of the restatement appeared to have
little longer-term impact on the stock price, as it continued to trend
upward over the next 3 months. The trends in Sterling Bancshares' stock
price are shown in figure 19.
Figure 19: Daily Stock Prices for Sterling Bancshares, April 1, 2003-April
30, 2004
Securities Analysts' Recommendations
Based on historical securities analyst rating information we identified,
one analyst downgraded Sterling Bancshares stock from a buy to hold on
October 22, 2003--the day after Sterling Bancshares' restatement.
Credit Rating Agency Actions
No credit rating agency information was available.
Legal and Regulatory Actions Taken
As of July 2006, there has been no legal or regulatory action taken with
regard to Sterling Bancshares' restatement.
Appendix XV
GAO Contact and Staff Acknowledgments
GAO Contact
Orice M. Williams (202) 512-8678, [email protected]
Staff Acknowledgments
In addition to the individuals named above, Daniel Blair and John Reilly,
Jr. (Assistant Directors); Allison Abrams, Marianne Anderson, Heather
Atkins, Angela Barnett, Martha Chow, M'Baye Diagne, Lawrance Evans, Jr.;
Sonya Hockaday, Tiffani Humble, Joe Hunter, Debra Johnson, May Lee,
Kimberly McGatlin, Andrew J. McIntosh, Marc Molino, Andrew Nelson, Charles
Perdue, Robert Pollard, Omyra Ramsingh, Barbara Roesmann, John Saylor,
Christopher Schmitt, Gloria Sutton, Kaya Leigh Taylor, Dave Tarosky,
Richard Vagnoni, and Nicolas Zitelli made key contributions to this
report.
Glossary
Asset write-down/write off
To charge an asset amount to an expense or loss in order to reduce the
value of the asset and, therefore, earnings. Occurs when an asset was
initially overvalued or loses value.
Derivative
A security whose value depends on the performance of underlying,
previously issued securities. Used properly, these instruments can be
useful in reducing financial risk. Examples include options, swaps, and
warrants.
Goodwill
The excess of the purchase price over the fair market value of an asset.
Goodwill arises when the price paid for a company exceeds that suggested
by the value of its assets and liabilities.
Impairment
Generally refers to a reduction in a company's stated capital, however,
impairment can be used in any context, e.g., "asset impairment" or
"goodwill impairment." Impairment is usually the result of poorly
estimated gains or losses.
Option
Contracts that give the holder the option, or right, to buy or sell the
underlying financial security at a specified price--called the "strike" or
"exercise" price--during a certain period of time or on a specific date.
Options on individual stocks are called "stock options."
Round-trip transactions
A method used to inflate transaction volumes or revenue through the
simultaneous purchase and sale of products between colluding companies.
Warrant
A security that gives the holder certain rights under certain conditions,
both determined by the issuer of the warrant. For example, an exchange
pprivilege may allow the holders to exchange one warrant plus $5 in cash
for 100 shares of common stock in a corporation any time after some fixed
date, and before some other designated date.
(250250)
www.gao.gov/cgi-bin/getrpt?GAO-06-678. .
To view the full product, including the scope
and methodology, click on the link above.
For more information, contact Orice M. Williams at (202) 512-5837 or
[email protected].
Highlights of [111]GAO-06-678 , a report to the Ranking Minority Member,
Committee on Banking, Housing, and Urban Affairs, U.S. Senate
July 2006
FINANCIAL RESTATEMENTS
Update of Public Company Trends, Market Impacts, and Regulatory
Enforcement Activities
In 2002, GAO reported that the number of restatement announcements due to
financial reporting fraud and/or accounting errors grew significantly
between January 1997 and June 2002, negatively impacting the restating
companies' market capitalization by billions of dollars. GAO was asked to
update key aspects of its 2002 report (GAO-03-138). This report discusses
(1) the number of, reasons for, and other trends in restatements; (2) the
impact of restatement announcements on the restating companies' stock
prices and what is known about investors' confidence in U.S. capital
markets; and (3) regulatory enforcement actions involving accounting- and
audit-related issues. To address these issues, GAO collected restatement
announcements meeting GAO's criteria, calculated and analyzed the impact
on company stock prices, obtained input from researchers, and analyzed
selected regulatory enforcement actions.
[112]What GAO Recommends
GAO recommends that SEC investigate potential noncompliance with current
Form 8-K filing requirements and make consistent the guidance to
registrants concerning required disclosures regarding certain
restatements. SEC stated that it would examine the instances of potential
non-compliance and carefully consider harmonizing guidance concerning Form
8-Ks.
While the number of public companies announcing financial restatements
from 2002 through September 2005 rose from 3.7 percent to 6.8 percent,
restatement announcements identified grew about 67 percent over this
period. Industry observers noted that increased restatements were an
expected byproduct of the greater focus on the quality of financial
reporting by company management, audit committees, external auditors, and
regulators. GAO also observed the following trends: (1) cost- or
expense-related reasons accounted for 35 percent of the restatements,
including lease accounting issues, followed in frequency by revenue
recognition issues; and (2) most restatements (58 percent) were prompted
by an internal party such as management or internal auditors. In the wake
of increased restatements, SEC standardized disclosure requirements by
requiring companies to file a specific item on the Form 8-K when a
company's previously reported financials should no longer be relied upon.
However, between August 2004-September 2005, about 17 percent of the
companies GAO identified as restating did not appear to file the proper
disclosure when they announced their intention to restate. These companies
continued to announce intentions to restate previous financial statements
results in a variety of other formats.
Although representing about 0.2 percent of the market capitalization of
the major exchanges, which was $17 trillion in 2005, the market
capitalization of companies announcing restatements between July 2002 and
September 2005 decreased over $36 billion when adjusted for market
movements (nearly $18 billion unadjusted) in the days around the initial
restatement announcement. Researchers generally agree that restatements
can negatively affect overall investor confidence, but it is unclear what
effects restatements had on confidence in 2002-2005. Some researchers
noted that investors might have grown less sensitive to the announcements.
Others postulated that investors had more difficulty discerning whether
restatements represented a response to aggressive or abusive accounting
practices, complex accounting standards, remediation of past accounting
deficiencies, or technical adjustments. Although researchers generally
agree that restatements can have a negative effect on investor confidence,
the surveys, indexes, and other proxies for investor confidence that GAO
reviewed did not indicate definitively whether investor confidence
increased or decrease since 2002.
As was the case in the 2002 report, a significant portion of SEC's
enforcement activities involved accounting- and auditing-related issues.
Enforcement cases involving financial fraud- and issuer-reporting issues
ranged from about 23 percent of total actions taken to almost 30 percent
in 2005. Of the actions resolved between March 1, 2002, and September 30,
2005, about 90 percent were brought against public companies or their
directors, officers, and employees, or related parties; the other 10
percent involved accounting firms and individuals involved in the external
audits of these companies.
March 5, 2007
The Honorable Christopher J. Dodd
Chairman
Committee on Banking, Housing, and Urban Affairs
U.S. Senate
Dear Mr. Chairman:
We are reissuing Financial Restatements: Update of Public Company Trends,
Market Impacts, and Regulatory Enforcement Activities (GAO-06-678), July
25, 2006, to reflect revisions in our market impact calculations. In
addition, we are incorporating our August 2006 supplemental report,
Financial Restatement Database (GAO-06-1053R), which updated the
restatement database through June 2006, into this reissued report as
Appendix V. The associated electronic database (GAO-06-1079SP) has also
been reissued. We have recalculated the dollar impact calculations in this
study, which has resulted in a lower calculation of cumulative market
impact for 2002-2005; however, these revisions do not change the report's
findings, conclusions, or recommendations. That is, the impact on stock
prices in the days surrounding a restatement announcement continues to be
much lower than we found in our 2002 report (GAO-03-138).
The revisions to this report are generally concentrated in the second
objective of the report, which discusses the impact of restatement
announcements on the restating company's stock price in the immediate-,
intermediate-, and longer-term. The revisions were prompted because the
shares outstanding for several foreign companies reflected American
Depositary Receipts (ADR) that had not been converted to equivalent
ordinary shares outstanding.^1 As a result, the market capitalization
calculations for these companies used in our impact analysis for a few
companies resulted in the market capitalization calculations being higher
than they should have been.
^1An American Depositary Receipt is a negotiable certificate issued by a
U.S. bank representing a specified number of shares (or one share) in a
foreign stock that is traded on a U.S. exchange. ADRs are denominated in
U.S. dollars, with the underlying security held by a U.S. financial
institution overseas.
This reissued report reflects the appropriate conversions for foreign
companies and amends our market capitalization calculations and impact
analysis. We also conducted an additional comprehensive review of our
database and calculations in the report and are making a number of other
technical revisions.
Sincerely yours,
Orice M. Williams
Director, Financial Markets and Community
Investment
Enclosure
References
Visible links
111. http://www.gao.gov/cgi-bin/getrpt?GAO-06-678
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