vol. XV no. 3

				The accounting scandals that rocked corporate America to its core over the summer brought to the surface a topic that the Securities and Exchange Commission (SEC) and savvy investors have been concerned about for some time increased levels of earnings restatements. Until the mid-1980s, it was unusual for financial restatements to top half a dozen in any given year. But according to a study by Arthur Andersen, the number of public companies that have corrected or restated earnings since 1998 has soared to 233. This high frequency of restatements coupled with the revelations of fraud and questionable accounting methods by corporate giants such as Enron, WorldCom and Xerox Corporation sparked skepticism among investors and caused the market to bottom out during one of the most volatile weeks in Wall Street history. "The issue here is the loss of credibility," said James Owers, a finance professor at the Robinson College of Business. Owers, who has been researching the causes and financial consequences of accounting restatements for the past 10 years, notes that restatements are not a recalibration of investors' expectations but rather a change in results previously announced by companies to be the "real numbers." But why has the increase in restatements become a concern? According to Owers, the answer is that it raises doubt and "in this case, has been a major contributor to the malaise in the stock market." However, he notes that not all earnings restatements are created equal. In his most recent study, "The Informational Content and Valuation Ramifications of Earnings Restatements," published in the International Business & Economics Research Journal, Owers (along with co-authors Ronald Rogers, University of South Carolina, and Chen-Miao Lin, Robinson College of Business) investigates the valuation consequences of restatements from 1994 to 1997. The study organizes restatements into nine different categories: accounting issues (errors/irregularities/method changes); SEC initiated; acknowledged fraud; earnings/loss arrangement; restructuring/spinoff; legal settlement; merger/joint venture; stock split/dividend; and undetermined causes. Based on the study, Owers found that the market actually responded positively to restatements that reflected and provided the accounting calibration of previously announced settlements of legal issues. "The market can be forgiving," explained Owers. "Investors understand the need, at times, for earnings to be recalibrated." However, when earnings are adjusted as a result of accounting issues, investors are quick to react. The study shows that in circumstances where accounting issues were the cause of restatement, especially when accompanied by the resignation of a CEO, shares of affected firms fell 37 percent on average over a two-week period. A History Lesson The recent scandals that have jolted investor confidence and caused the market to plummet demonstrate that history indeed repeats itself. Unfair practices of the 1920s were revealed in the chaos of the market crash in 1929 and subsequent developments in the 1930s. Ultimately, the formation of the SEC in 1934 helped the healing process and restored confidence. But, according to Owers, that system of regulatory processes that served the country well for 60 years may have developed unacceptable flaws in recent years. During the euphoria of the late 1990s, companies appeared to be very adroit at turning profits. "As earnings grew, investors became overly optimistic," said Owers. "Once earnings growth decreased - which was inevitable - investors were disappointed. They realized that companies could not maintain their superhero status." Additionally, the quality and accuracy of financial reporting during this time came under question, and the number of companies forced to restate earnings grew. This increase, said Owers, sparked investors to question "the caliber of management - ranging from 'can they add?' to 'are they up to mischief?' or worse - as well as the efficacy of the auditing profession." This debate also prompted questions about whether the accounting profession is an effective self-regulating body - which Owers says is understandable in light of the Enron and Arthur Andersen fiasco. The Age of Skepticism This loss of credibility is a cumulative process with spill-over effects. For example, the day after WorldCom announced it would restate earnings to the tune of $3.8 billion and trading for the company was temporarily suspended, other companies with questionable accounting issues, such as Tyco, experienced notable drops in their stock prices. This reaction from investors was a clear message that the level of skepticism regarding the quality of earnings had increased. As the "accounting games" at Enron, WorldCom and other companies were exposed, investors demanded that something be done. According to Owers, the government needed to take definitive and aggressive action in order to minimize any additional damage. "If the government wants to fix what ails the country, then some people at the top are going to need to hang a few of their friends." On June 28, the CEOs and CFOs of more than 900 publicly traded companies were ordered by the SEC to swear to the accuracy of their corporate financial statements. In addition, on July 30, President Bush signed bipartisan legislation on corporate accountability. The act tightens regulations on financial reporting and makes it harder for companies to deceive investors. It also imposes restrictions on accounting firms that provide consulting services for corporations whose books they audit; creates new rules for financial analysts; and establishes an independent board with subpoena power to oversee the accounting industry. But perhaps the most significant aspect of the legislation is the addition of criminal penalties and prison terms for corporate fraud. "In theory, this action by the government is a critical step in calming the fears of investors; however, it's the practice that will dictate its success," said Owers. "If investors conclude that the accounting data and enforcement of standards isn't sufficient, then they will rationally withdraw from the financial markets. The effect of such a development would be debilitating for a system of commerce that has, overall, served us well." Top |

Copyright © 2003 Robinson College of Business/Georgia State University.