Undoing the past: implications of earnings restatements; The number of earnings statement restatements has risen sharply, and a Financial Executives Research Foundation (FERF) study sheds light on some of the consequences to companies and their executives.

• Author: Bryan, Stephen
• Position: Earnings restatements

Earnings restatements are in the news again, and it's no surprise that restated earnings often result in a serious blow to a company's stock price. On Jan. 4, 2005, Krispy Kreme Doughnuts Inc. said it would restate its financial statements for its 2004 fiscal year ended Feb. 1, 2004. That quickly hit the wires, and its stock price fell $1.83 that day, or about 15 percent. The restatement, the company said, was due to errors in how it accounted for the repurchase of franchises. It explained that such a restatement could reduce its earnings by seven to eight cents a share--more than the company had previously forecast--which could cause it to default on its credit agreement.

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Earnings restatements can also have dire consequences for the CFO and the outside auditors. On Dec. 15, 2004, Donald T. Nicolaisen, the chief accountant for the U.S. Securities and Exchange Commission (SEC) asked the Federal National Mortgage Association (Fannie Mae) to revise its financial statements to eliminate the use of hedge accounting. On December 21, Fannie Mae's Board of Directors announced the resignation of Vice Chairman and CFO J. Timothy Howard. On Jan. 4, 2005, Fannie Mae announced that its audit committee had approved the engagement of Deloitte & Touche LLP as it independent auditor to perform an audit of 2004 and a re-audit of prior-period financial statements, which will be restated.

These announcements came against a backdrop of increasingly frequent restatements. Huron Consulting Group recently announced that amended SEC filings for financial restatements rose to a record 414 in 2004, up 28 percent from 323 the previous year. The year 2003 had marked the first time that that restatement filings had leveled off, after an upward trend over the past five years, but they jumped up again in 2004. (See chart)

Jeff Szafran, managing director of Huron Consulting, suggests specific reasons for this increase in the number of restatements in 2004. "[It] was the first year of an unprecedented level of regulatory and audit scrutiny, driven primarily by The Sarbanes-Oxley Act of 2002," he says. Also, during 2004, Szafran points to other conditions:

* Public companies spent significant amounts of time and money to comply with the requirements of Sarbanes-Oxley Section 404, and may have found some accounting mistakes in the process.

* The Public Company Accounting Oversight Board (PCAOB) began reviewing the audit practices of the major accounting...