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November 06, 2002

GAO Report Says Financial Restatements Cost Investors Billions
    by William Baue

The ravaging effects of financial restatements, which have been on the rise since 1997, are documented in a recent General Accounting Office report. -- Financial restatements, such as those made by Waste Management Inc. (ticker: WMI) and Xerox (XRX), not only shake investor confidence but also cost investors billions of dollars in stock value as companies' market prices plummet after the restatements. So says a report prepared by the U.S. General Accounting Office (GAO). The report was prepared at the request of U.S. Senate Committee on Banking, Housing, and Urban Affairs chair Paul Sarbanes (D-MD), who announced the release of the report late last month.

"The results of this probe demonstrate that investors have suffered significant financial harm when the public companies in which they invested misrepresented their financial condition and later restated their financial statements, and this has been a growing problem over the past five years," Senator Sarbanes said.

The report, entitled Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining Challenges, examined financial restatements made due to accounting irregularities between January 1, 1997 and June 30, 2002. Public companies are required by law to announce their financial earnings, and pressure to meet earnings targets often fuels misstatements. The report documented a 145 percent increase in financial restatements over the period studied.

The GAO's Financial Markets and Community Investment department, which conducted the research, identified 919 financial restatements at 845 companies. This number represents a "significant portion" (10 percent) of publicly traded companies, according to the Senate Banking Committee. The restatement trend has also shifted toward larger companies, as the median market capitalization of restating companies increased from $500 million in 1997 to $2 billion in 2002.

Improper revenue recognition and expensing was the most frequently cited reason for restatement, representing 38 percent of the cases. These restatements cost investors 10 percent of their stock value in the short term, from the day before to the day after the restatement, and 18 percent in the intermediate term, from 60 days before to 60 days after the restatement.

The report illustrated the details of financial restatements through 16 case studies of restating companies, including Rite Aid (RAD), Safety-Kleen (SK), and Thomas & Betts (TNB). The report also identified trends and pinpointed responsibility.

"In a number of the restating companies we identified, corporate management, boards of directors, and auditors failed in their roles, as have securities analysts and credit rating agencies that did not identify problems before investors and creditors lost billions of dollars," the report stated.

In assessing possible solutions to the growing problem of financial restatements, the Financial Markets and Community Investment department applauded the New York Stock Exchange (NYSE) and Nasdaq for their recent fortification of listing requirements. Both exchanges have submitted proposals for tougher corporate governance standards to the U.S. Securities and Exchange Commission (SEC), in keeping with mandates of the Sarbanes-Oxley Act of 2002.

"Although Nasdaq's and NYSE's proposed changes to their listing standards are important and positive steps, more could be done to strengthen corporate governance," the report stated. "For example, the proposals do not require a supermajority of independent directors, do not specifically bar a CEO from serving as chairman of the board of directors, could more broadly address interlocking directorships, and do not require that key board committees have their own resources and access to independent advisers as and when they deem necessary."

Governance and Public Policy ArticlesThe SEC is still reviewing the proposed changes in listing standards, and therefore still has the authority to require the adaptation of more stringent measures such as those listed above.

The report also set forth six recommendations for the new Public Company Accounting Oversight Board.

"First, members of the new oversight board must not only meet high qualifications and independence requirements, but also fully embrace the principles articulated in the act and the need for fundamental reform," the recommendations begin.

Interestingly, the Financial Markets and Community Investment department is currently conducting an investigation into the controversial appointment of William Webster as chair of the Board. With the first of the report's recommendations already in question, it remains to be seen whether substantive reforms will be made to reverse the adverse effects of financial restatements.

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