Financial Restatements: Update of Public Company Trends, Market Impacts, and Regulatory Enforcement Activities
Published: 2006-07-24T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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.
section_title: What GAO Found
paragraphs: 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 38 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 21 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 0.4 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 $63 billion when adjusted for market movements ($43 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.

section_title: Letter
paragraphs: 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.
subsections: section_title: Highlights
paragraphs: 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.
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.
subsections: section_title: Background
paragraphs: 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. (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.
section_title: The Number of Restatements Has Continued to Grow and New Trends Have Emerged
paragraphs: 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.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.
subsections: section_title: The Number of Restatement Announcements Grew since 2002, as Did the Number of Listed Companies Restating
paragraphs: 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. 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.
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.
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. 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. 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.
section_title: The Percentage of Large Companies Restating Has Continued to Grow
paragraphs: 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. For example, between  2002 and September 2005, the number of NYSE-listed companies  announcing restatements had increased 64 percent from 114 to 187.  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.
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. 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.
section_title: Restatement Announcements Most Frequently Were Made for Cost- or Expense-Related Reasons
paragraphs: 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.
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. 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.)
section_title: Internal Parties Prompted the Majority of Restatements Announced from 2002 through 2005
paragraphs: 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.
section_title: While SEC Revised Its Forms to Make Disclosures of Certain Restatements More Uniform, Many Companies Continue to File in Other Formats
paragraphs: 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. 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. 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. 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.
section_title: Market Capitalization of Restating Companies Decreased by Billions in the Days Surrounding Restatement Announcements, but Was Less Severe Than in Our Prior Report
paragraphs: 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. 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.
subsections: section_title: On Average, Stock Prices Fell over the Days Surrounding the Initial Restatement Announcement
paragraphs: 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.
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. Later in this report, we examine losses over longer periods,  as well as the effects of restatements on overall market confidence.
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). 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.
section_title: 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
paragraphs: 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. 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.
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.
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).
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.
section_title: Restatement Announcements Continued to Have Some Longer-Term Impact on the Market Capitalization of Restating Companies
paragraphs: 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). This suggests that  the reaction was more negative than expected given the movement in the  overall market.
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. 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.
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.
section_title: Certain Restatements Appear to Affect Investor Confidence but Trends in Restatements Complicate Analysis
paragraphs: 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.
subsections: section_title: Researchers Have Suggested Numerous Reasons for Why Investors May Have Reacted Both Positively and Negatively to Restatements since 2002
paragraphs: 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. 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.
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.
section_title: UBS/Gallup Index of Investor Confidence Reveals Investor Confidence Remains Low but Accounting Issues Appear to Be of Less Concern
paragraphs: 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. 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.
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.
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.
The results of UBS surveys were consistent with the findings of the  Securities Industry Association’s (SIA) annual investor surveys. 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.
section_title: Yale Indexes Shows Mixed Results for Changes in Stock Market Confidence since 2002
paragraphs: 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. 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. 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. 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. 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.
section_title: Accounting- and Auditing-Related Enforcement Actions Have Continued to Grow
paragraphs: 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.
subsections: section_title: Financial Fraud and Issuer Reporting Issues Accounted for a Significant Number of SEC’s Actions
paragraphs: 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.
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).
section_title: SEC’s Enforcement Resources Have Grown
paragraphs: 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.
section_title: Accounting- and Auditing- Related Actions Included a Variety of Entities and Individuals
paragraphs: 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. 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. 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:  the need to deter the particular type of offense,  the extent of the injury to innocent parties,  whether complicity in the violation is widespread throughout the   the level of intent on the part of perpetrators,  the degree of difficulty in detecting the particular type of offense,  the presence or lack of remedial steps by the corporation, and  the extent of cooperation with the Commission and other law  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. 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.
section_title: Newly Created PCAOB Also Took Variety of Enforcement Actions
paragraphs: 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.
section_title: Conclusions
paragraphs: 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.
section_title: Recommendations
paragraphs: 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.
section_title: Agency Comments and Our Evaluation
paragraphs: 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 williamso@gao.gov. 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.