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Sep 05, 2016

Transparency in financial restatements plunges

Companies use reporting loophole to soften impact of negative reporting

A new report finds US companies increasingly using a loophole in financial reporting to make ‘stealth’ financial restatements, according to the American Accounting Association (AAA). The trend is likely to increase as more top executives see their pay linked to the stock price.

‘By avoiding the high-transparency disclosure of restatements, executives can attempt to soften the effect of negative market reaction on company stock, provide more time to manage stock sales to their advantage, reduce the risk of being terminated and minimize damage to their reputations,’ say the authors of the study, Brian Hogan from the University of Pittsburgh and Gregory A Jonas of Case Western Reserve University.

The paper, originally published in the September issue of the AAA’s journal Accounting Horizons, analyzes 1,178 corporate restatements issued between August 2004 and December 2013. These are disclosed in a way other than filing an 8K with the SEC, which is the most transparent way to make a disclosure. Low-transparency disclosures include correcting items in financial statements without taking steps to signal these changes to investors.

The study finds that at companies that issue an 8K for their restatement, the  

CEO’s pay is 45 percent linked to the stock price, and the CFO’s pays is 38 percent linked. At companies making low-disclosure restatements, meanwhile, CEO pay is 46 percent linked and CFO pay 43 percent linked to the share price. 

The data shows that for every 1 percentage-point increase in the stock-based proportion of total CEO pay, an 8K disclosure is 2.26 times less likely to be issued, according to the researchers. A major cause of the problem is the SEC’s loosening of the rules that require an 8K for financial restatements, back in 2004. Since then, executives, lawyers and auditors have been encouraged to use their own judgment to decide whether an 8K is needed for a restatement. 

The authors of the study recommend that investors check companies’ proxy statements and keep an eye on the pay structures of the CEO and CFO.

In an interview with IR Magazine Jonas also said IR team could 'advise investors to consider executive pay structure as governance mechanism when assessing potential disclosure transparency.'

Restatement decline

According to a separate study from Audit Analytics financial restatements dropped in 2015.  However, over 70 percent of the restatements were done in a method other than filing an 8K

The overall number of restatements dropped 12.7 percent in 2015 and their severity was considered low, the report shows. There were 161 disclosures in 2015, issued by 141 companies.

Restatements had been rare but became more common from the 1990s, when the number of filings increased substantially. In 2006 ‒ at the peak ‒ 9.8 percent of all US public company filings were restated. Some analysts claim the surge was due to increased complexity in reporting standards.