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Alex Morris
Alex Morris

GAO Report: Financial Restatements

May 10, 2011 | About:

I have come to a conclusion in the past couple of days: Accounting is an invaluable resource that must be added to the toolkit of the equity investor. Most people will probably go, "Obviously!," yet next time they are reading through a 10-K (if they do that, which many people probably do not) and come across a footnote that leaves them scratching their head, I’m willing to bet that they will move right past it without losing any sleep. I’ll be the first to admit that I’ve done that many times in the past; no more. If you simply skimmed over Enron’s infamous footnote 16, you would have drank the Kool-Aid like many others, and simply looked in awe at 10-fold revenue growth in four years. No more; the intelligent investor cannot settle, and must look to kill their ideas (as Bruce Berkowitz says) before committing precious capital. This means understanding each and every line of the 10-K, or stepping away from the investment.

This has led me to a couple of great books on the topic, one of which is “Detecting Earnings Management” by Gary Giroux. In the book, he often refers to studies by a government agency which operates what has just become my new favorite website: the U.S. Government Accountability Office (www.GAO.gov). The report I am currently reading (it was published in July 2006) and will write about today discusses financial restatements.

In 2006, an astounding (at least to me) 6.8% of public companies announced financial restatements due to financial reporting fraud and/or accounting errors. On top of that, don’t think these are simply small cap no names; companies with more than $1 billion in assets accounted for more than 37% of the total restatements in that year.

In the three year period for 2002-2005, more than one-third of all restatements were related to cost-or-expense issues (largely due to an increase in lease accounting issues). In general, this refers to “a company understating or overstating costs or expenses, improperly classifying expenses, or any other mistakes or improprieties that led to misreported costs”. The next largest category (roughly 20% of total) was due to revenue issues, which result from improper revenue accounting (for example, improperly recognized or questionable/invalid revenues).

In the five years prior to the period, 49% of restatements came because of internal recognition; from 2002-2005, that number increased to 58%, probably due to the concern among executives from changes made due to Sarbanes-Oxley in 2002 which forced executives to take individual responsibility for the accuracy and completeness of financial reports.

Measuring the impact of restatements is difficult to do on a comparable basis. Choosing a short time frame doesn’t show us the affect for long term shareholders, and might understate/overstate the affect of the announcement on the business (whether it points to fraud or possibly just a mistake). A longer time frame is more appropriate, but suffers from the issue of when to start the measurement. Simply starting from the day of the announcement may not account for events that pointed to trouble earlier on, like the CFO leaving unexpectedly; the same can be said for a favorable business development that surfaces in the weeks/months following the restatement. Without reliable data, it is safe to say that on a company specific review, having to restate earnings is not a favorable development, and can point to other issues that may surface further down the road; any restatement should be met with a skeptical review, and the position should be closed at the first sign of income statement management.

One thing that stood out to me is the number of staff members working for the SEC, which numbered around 200 at the time this research was published. Obviously, this is an inadequate number of people to police a wide array of accounting and audit related enforcement needs. Short sellers, who are largely misunderstood and inappropriately stereotyped by the general population, are essentially SEC staff in the markets, keeping management honest. As noted by James Montier in “Intelligent Investing: Tools and Techniques for Intelligent Investment”, companies in battles with short sellers from 1977-2002 in the United States underperformed by nearly 25% in the first twelve months; in the first 36, that number grows to more than 40%. Obviously, there is a big difference between yelling “Fire!” (essentially creating the decline) and what guys like David Einhorn; as Montier notes, “rather than being some malignant force within the markets, in my experience short sellers are closer to accounting police”.

Another of the findings from the report that really struck me as odd was that investor optimism (this is in 2005) was still low following the accounting scandals around the turn of the century, but was not focused on accounting issues. In fact, investors listed energy prices (oil & gas), the situation in Iraq, and the impact of Hurricane Katrina as bigger reasons for a lack of optimism among investors. Certainly, these are issues that can affect a company’s business; but what are you going to do about a hurricane? They have happened before, and will happen again. People are more concerned with things that have a short term (and possibly little/no) effect on their individual investments, yet overlook the accounting practices as if they are non-material. The efficient market guys REALLY got it wrong with that assumption about all market participants being rational…

Here is the link to the report: http://www.gao.gov/new.items/d06678.pdf

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

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