Three Reasons to Expect More Earnings Restatements

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According to a report published by the New York Times, the capital markets have good reason to worry about corporate earnings this year. Companies have at least three good reasons to drag all the skeletons out of the closet and try to wipe the slate clean with an earnings restatement. The three reasons:

  1. Legacy of the 1990s. Lawyers and accountants blame the excesses of the 1990s. They say capital markets rewarded growth stocks handsomely, and companies sought to manage stock prices as a way of maximizing the value of their stock-based compensation plans. Often this meant meeting earnings expectations, and the markets would punish a stock severely for a company's failure to meet analysts' expectations. All these factors combined to create a "pressure cooker" in which companies and executives were rewarded for aggressive accounting and risky business practices, such as acquisitions.
  2. Aftermath of auditor-switching. Many public companies switched auditors this year, either before or after Andersen announced it would cease to audit companies whose securities are registered with the Securities and Exchange Commission (SEC). The companies' successor auditors are doing a more thorough review than usual because they don't want to be burdened with liability for past errors. "It's a phenomenon very similar to what you have when you get a change in administrations," explains Professor Joseph Grundfest, a former SEC Commissioner who teaches at Stanford University. "Everything that's bad is the old administration's fault."
  3. Fear of tough enforcement. Corporate officers and directors are fearful of shareholder lawsuits, SEC investigations and even criminal charges, especially now that the SEC has ordered them to personally certify their companies' financial statements. Most would prefer to come clean quickly, rather than risk being caught in a cover-up. Besides, with a little luck, they too may be able to blame someone else. Melvyn Weiss, an attorney at Milberg Weiss Bershad Hynes & Lerach (a firm that often files lawsuits on behalf of investors) explains, "People at the top of companies are starting to get scared" now that they have seen the potential consequences. "You're going to have a lot of whistle blowers." Another attorney predicts some executives will refuse to sign, leading to more earnings restatements.

But a backlash of sorts is already developing. Joseph Floyd, a director at Huron Consulting, is advising clients to listen carefully to managers and accountants, but also to "push back" and resist if anyone wants to restate earnings without a very good reason. "There are technical rules on when a restatement should occur," he explained. "If a company revises earnings reports only because its managers and directors want to apply a more conservative accounting approach to the past, they may be subject to SEC penalties." ("Recomputing Earnings With Lawbook and Eraser," New York Times, July 2, 2002.)

-Rosemary Schlank

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