The Pain Point: High Cost of Poor Financial Statement Quality
The costs associated with reissuing financial statements are staggering. Fannie Mae, a government sponsored and regulated lender to the U.S. mortgage market, publicly reported spending over $1 billion as of year-end 2006 to correct and restate its accounts – accounts that were wrong by more than $7 billion even after they were audited by independent external auditors and certified by the company’s CEO and CFO. The reputation costs to Fannie Mae, while difficult to estimate and quantify, dwarf direct costs.

The direct cost of restatement as reported by the thousands of U.S. public companies forced to restate their accounts because of material accounting errors, range from $100,000, to over $100 million for larger companies. Fannie Mae is an outlier in terms of its size and public visibility but, the harsh reality is that accounting restatements, and the massive internal and external costs associated with them (accounting, auditing, legal, public relations, cost of capital increases, stock depreciation, etc.), have become somewhat commonplace. The investing public now “accepts” a staggering error rate of one in 10 (the proportion of U.S. publicly traded companies who restate their financials based on a material error) as a cost of doing business. This certainly does not help investor confidence and it clearly makes the U.S. capital markets less attractive, which impacts the economy and the creation of new jobs.

The U.S. Government Accountability Office (GAO) has studied trends in public company financial restatements, first in 2002 and more recently in its March 2007 update report Financial Restatements: Update of Public Company Trends, Market Impacts, and Regulatory Enforcement Activities. The GAO reported that market capitalization of companies issuing restatements dropped more than $36 billion dollars (adjusted for market movements) in the days following the initial restatement announcement. The total annual direct and indirect costs of repairing and reissuing accounts when problems are discovered are almost certainly in the many billions of dollars each year – money that could have been used to drive business growth and generate real profits.

What is absolutely certain is that the current rate that U.S. listed companies issue unreliable financial statements, is unacceptable and represents a national capital markets problem that must be addressed. Most importantly if efforts to find better solutions to this problem are even marginally successful, the return on investment (ROI) opportunities are attractive. The age-old adages such as “an ounce of prevention is worth a pound of cure” and “measure twice, /cut once” have never been more applicable. The massive effort and spending that have been expended in the first five years of SOX compliance have only scratched the surface of this issue. More and better fact-based research and analysis of root causes must be done to crack this problem. The formation of committees to discuss and explore a problem like this, such as the recently constituted SEC Advisory Committee on Improvements to Financial Reporting are a positive step, but decisions on regulatory driven corrective actions made in the absence of reliable and factual statistical information on the root causes often lack sharp focus on the primary pain points.

Eye-popping errors are regularly exposed in the audited financial statements of U.S. public companies after they are issued. Audit Analytics, a company that tracks public company filings, reported that more than one in every eight large publicly listed companies acknowledged major errors in their audited statements in 2006. Over 1,100 non-accelerated, smaller U.S. companies (companies with under $75 million in market capitalization) issued financial restatements in 2006, a rate of just under one in every 10. Research studies have found that the rate of material errors in financial statements has reached a point where investors now assume - and factor in to their investment decisions - that there is a high probability that the audited, CEO/CFO certified financial statements of U.S. firms contain major errors.

The reliability of the financial statements of public companies is a problem that must not be trivialized, rationalized or swept under the table. It is a problem that requires the collective efforts of management accountants, external auditors, securities regulators, educators and the U.S. government. The problem will be significantly exacerbated as more then 6,000 smaller publicly traded companies are added into the SOX regulatory regime.

A Call to Action – The Need for Comprehensive Fact-Based Research

In the abstract to “Doing Worse by Doing Bad: Evidence from Financial Misrepresentations,” a ground-breaking research study that examines financial statement restatements believed to be rooted in executive-led misconduct, author Jared Harris, Darden School of Business Administration at the University of Virginia, concludes:

The analysis finds strong support that firms ‘do worse doing bad’; that is , financial misrepresentations leads to decreased legitimacy and impaired performance, and this detrimental impact is observable in the ongoing diminished operational profitability of the firm.

A July 31, 2007 press release from the U.S. Securities Exchange Commission announcing the formation of a blue ribbon panel to study the growing problem of restatements, whether caused by sinister intentions or not, concluded:

As financial reporting has become more complex, many investors have expressed concerns that it is often difficult to understand the financial reports of companies in which they invest. Likewise, companies have expressed concerns that it is difficult to ensure compliance with U.S. GAAP and SEC reporting rules when preparing financial reports. In fact, during 2006, almost 10% percent of U.S. public companies had to restate prior financial reports due to the discovery of errors in those reports. Restatements are costly to companies, and undermine the confidence of investors in the financial reporting system.

The IMA Finance GRC Research Practice is studying a critical dimension of unreliable financial reporting: the ongoing problem of auditor and CEO/CFO certified Internal Control over Financial Reporting (ICFR) systems and financial statements that are later found to contain material misstatements. If accounting complexity, management driven fraud, inconsistent regulatory interpretation, confused and/or conflicted accounting standards and other factors are root causes of a material number of major errors in financial statements they should be identified during the risk assessment phase of all ICFR control reviews and the quality of controls should be examined. If this step is happening regularly in all public companies, it has not yet escalated these issues as material control weaknesses in the macro level financial reporting system.

The are two primary purposes of the Finance GRC research

1. Identify the root causes of errors in predicting the effectiveness of ICFR in a post-SOX world (i.e., situations where auditors and management certify both the effectiveness of internal controls and the financial statements, which are subsequently determined to contain material errors).
2. Develop cost-effective recommendations for regulators, accounting standard setters, and the U.S. government to reduce the frequency of materially wrong financial statements and the related need for the issuance of restated financial statements.

This research nicely complements initiatives underway at the SEC, U.S. Department of Treasury, and the AICPA’s Center for Audit Quality. It is the only study we are aware of that aims to shine light on the key question of why literally thousands of CEOs, CFOs and external auditors are unable to reliably predict whether existing control frameworks, both at the company and macro level, are capable of preventing material errors in financial statements issued to the public.

The Value Proposition for the IMA Finance GRC Research Practice

In addition to the IMA-sponsored research study, IMA’s new Finance GRC Research Practice will deliver

• A “resource center” that provides one-stop shopping for practitioners around the world who are interested in building awareness and capability in the financial aspects of governance, risk, and compliance; and
• IMA educational programs with modules focused on FGRC

This new research practice is unique in that it addresses the objective of producing materially fault-free financial statements and notes disclosures primarily from the “inside” perspective of company management and management accountant’s. By focusing on building quality in, inspections performed after the fact (i.e., by external auditors) should find nothing that would give investors any cause for concern.

For U.S. publicly traded companies, including the 6000+ smaller entities that will soon begin compliance with SOX Section 404, the value in reducing the number of financial statement errors includes a lower cost of capital, better error prediction rates on controls effectiveness, fewer restatements and more cost effective SOX implementations that truly catch the big risks.

For individual practitioners, the value proposition includes building awareness and competency to help their employers in the growing area of GRC (which includes ERM) - a competency area that is becoming increasingly relevant and necessary for management accountants, compliance officers, risk managers, business process owners, and so forth.

For organizations outside the U.S. seeking to increase transparency, to build a more robust risk-based framework for planning, compliance and other business applications, and to improve their global capital formation capability, IMA’s Finance GRC Research Practice provides the resources, research, training and educational modules to enable this market growth.