Regulatory and Legal Implications of Stealth Restatements

By Chan, Leon; Hee, Kevin | The CPA Journal, December 2010 | Go to article overview

Regulatory and Legal Implications of Stealth Restatements


Chan, Leon, Hee, Kevin, The CPA Journal


Can Companies Bury the Bad News?

Due to the major accounting scandals of the early 2000s and the resulting increased emphasis on financial information transparency, the issue of restatements and the quality of financial information provided by companies has been in both the public and regulatory spotlight for the past decade. In May 2010, SEC Chairman Mary Schapiro spoke about the importance of financial transparency in today's world:

Over the course of the last 10 years, we have had a number of painful reminders of just how important good information - from accurate accounting by individual businesses to aggregate information on trades and positions - is to investors, to markets and to regulators. . . . And so, a focus of the SEC in the post-crisis world is . . . increasing the ability of investors, their advisors, and ourselves to get the kind of information we need to make rational economic and regulatory decisions. ... Accounting standards must provide transparency for investors, and must not obscure the truth, even if the truth is painful." (May 18, 2010 speech at the CFA Institute 2010 Annual Conference)

While this speech was focused on the financial markets reform bill that was being debated in Congress, the overlying theme of better transparency was evident in the draft of the SECs strategic plan for 2010-2015, which stated that the vision of the SEC is "to promote a market environment that is worthy of the public's trust and characterized by transparency and integrity." In this strategic plan draft, one of the main desired outcomes was the following:

The SEC establishes and maintains a regulatory environment that promotes high quality disclosure, financial reporting, and governance, and that prevents abusive practices by registrants, financial intermediaries, and other market participants.

Statistics show that only in recent years has the number of restatements started declining. With the decline in the frequency of restatements, a new issue regarding how restatements are disclosed has arisen with "stealth" restatements. Stealth restatements are generally defined as restatements that are only disclosed in periodic reports and not in an 8-K or amended periodic report such as a 10-K/A or 10-Q/A. Academic research has shown the following:

* The percentage of restatements being disclosed in a stealthy manner has been increasing in recent years.

* Restatements involving core operating accounts (e.g., sales; cost of sales; selling, general, and administrative expenses; and other operating expenses) have a significantly greater negative stock price impact than noncore operating account (e.g., reclassification, in-process R&D, restructuring costs, other gain/loss restatements).

* Stealth restatements mitigate the negative market value impact of restatements (i.e., the market is initially fooled by corporations hiding violations of accounting rules that lead to restatements).

Therefore, not only does the incentive exist for companies to do their best to reduce the transparency or limit the disclosure prominence of restatements, but it is even greater if the restatement involves a core operating account. There is also evidence (Rebecca Files, working paper, 2009) that less transparent disclosure of restatements has increased the likelihood of an SEC sanction since the Sarbanes-Oxley Act (SOX). The increase in companies attempting to hide restatements has also led to an increase in the consequences for violating accounting and auditing rules.

The question still exists as to whether the legal and regulatory penalties imposed are affected by the types of accounts involved in the restatement. If certain types of restatements (that involve more important operational accounts, such as sales) are more likely to lead to future prosecution by the SEC or a private party, then corporations contemplating reporting a similar restatement in a stealthy manner may be less inclined to do so and might, instead, disclose the restatement in a more transparent manner. …

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