The Institutional Risk Analyst: Just What Do Restatements Indicate?

As 2006 begins, we again ponder the practical issues raised by Sarbanes-Oxley. If you are the Congress or SEC, how do you measure the effectiveness of rules focused on the adequacy of internal controls? How can the Congress assess whether public policy makers at the SEC and other agencies need to pursue more remedies or if the time to ponder instituting a degree of relief has arrived?�

All public policy and certainly something as dramatic as Sarbanes-Oxley causes shock to a complex system of private enterprises. The data suggests a response steeped in panic and unfortunately costly in terms of compliance, an image enhanced by a media image of corporate misdeeds.

Public policy efficacy needs to look at the majority of companies to gauge its worth, but the financial media has a bad habit of sensationalizing the bad actors. Supported by the data, we start with the hypothesis that most companies and their leaders turn out to be good economic citizens that�welcome the chance to improve. We must ask two questions about this hypothesis.

One, following SOX, did companies respond by exhibiting behaviors consistent with the intent of the law? That is, did they clean up sloppy disclosure and take a hard look at systems and controls?

Two, is there any indication that the quality of corporate governance for public companies is improving in the aggregate in the wake of all of this activity and expenditure?

Using IRA's Corporate Monitor we look at the most dreadful consequence of them all, filing a material restatement that changes net income.

Instances of Corporate Financial Restatements
Resulting in Material Changes to Net Income

Year	Material Restatements�
2001	439�
2002	597�
2003	780�
2004	741
2005	154�

Source: IRA Corporate Monitor

Grant for a moment that most material restatements are clerical in nature. Notice the increase in material restatements as the worry over SOX cast its cloud over the country. In 2003 and 2004, a shock wave of cleansing can clearly be seen reacting to the law.

And in 2005, just under one business cycle later, the bookkeeping is so tight that material corrections number is far below the pre-SOX clerical error rate. Why?� Is SOX working perhaps too well?� We're not sure, but the data suggests that Corporate America may be so scared it is in danger of over spending and over controlling itself.

To test this question we turn our attention to the equity markets. Like all stones thrown upon the water, at some point the shock wave diminishes and becomes lost in the greater scheme of things. Equity markets have that interesting property of attempting to feed on the arbitrage against public policy. And when that arbitrage ceases to exist the markets move on. Let's look at four restatements that were big in absolute dollar amount that resulted in lower net income for the filer:

On June 20, 2005, News Corporation (NYSE:NWS) corrected its net income for the June 2003 period by some $393 million and for June 2004 by another $74 million. The restatement in the 2003 period equaled 32% of the originally stated income, and the stock has drifted lower in the months since. Maybe the man who said investing in any media company is insane was right.

In December 2004, Rental and leasing services company Amerco (NASDAQ:UHAL) restated its March 2001 and 2002 periods to the tune of $50 million each and driving the company deep into the red for both periods. In percentage terms vs. the originally filed income number, this was one of the most significant downward restatements of the past 18 months. The stock almost touched $20 on the news, but closed last week at $72.05. Go figure.

In January 2005, Westpac Banking Corp (NYSE:WBK) revised its September 2004 income of $1.87 billion down some $29 million or an earthshaking 1.5%. Stock was in the $80s at the time; in the $90s now.

In September 2004, Walgreens (NYSE:WAG) restated its August 2004 income from $1.36 billion to $1.35 billion, a difference of $10.4 million or 0.7% of the original income. The stock drifted lower immediately thereafter, almost touching $35, but closed last week at $44.26.

Question is, does all of this restatement activity increase the clarity of public company financial reporting? Are companies which restate "bad" or counted among the righteous?� A byproduct of SOX "cleaning house" certainly looks to have bought some companies speculative premium as investors grapple with the expectations of a stock's potential based on non-financial factors juxtaposed against the what the books say.

We hear from a number of quarters that the sheer volume of restatements in 2002-2004�has so clouded the corporate behavioral picture as to�render the mere fact of a restatement unremarkable. But that era seems to be ending. As material restatements dwindle in number, will the positive and negative consequences�magnify?

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