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1
Quantitative Measures of the Quality of Financial Reporting
June 7, 2001
Copyright ©2001 by Financial Executives Research Foundation Inc.
2
Overview
Objective:– Identify quantifiable metrics that can track the
absolute and relative quality of financial reporting over time.
Metrics identified:– Number of announced financial reporting
restatements.– Market value losses from restatements as a percent
of total market value of equity securities.
3
Methodology
Searched Lexis-Nexis and Dow Jones Interactive for all mentions of “restatements” from 1977 to 2000.
Included irregularities or errors reported voluntarily by the companies, forced by company auditors, or enforced by the SEC.
Excluded instances of accounting methodology changes, stock splits, dividends, inflation accounting and discontinued operations.
Data compilation performed by Min Wu, Ph.D candidate at NYU Stern School of Business.
4
Observations – Frequency
Average rate of restatements:
1985 – 2000 = 0.51%
1995 – 2000 = 0.67%
*excluding IPR&D
5
Restatements by Year 1990-2000
33 48 51 3261 50 58 59
91150 156
9
571
0
50
100
150
200
250
IPR&D
All others
6
Observations – Restatements Spike Starting in 1998
1990 to 1997 Average 49 restatements a year
1998 = 91 restatements1999 = 150 restatements 2000 = 156 restatements
7
Restatements by Reason
37
360
305
30
94
39
67
24
5569
Unknown
Revenue
Cost
Rev & Cost
Loan Loss
Acquisition
IP R&D
Reclassification
Bookkeeping error
Others
8
Restatements by Year and Reason
0%
20%
40%
60%
80%
100%
1990 1992 1994 1996 1998 2000
Unknown
Revenue
Revenue/Cost
Cost
Loan Loss
Acquisition
IP R&D
Reclassification
Bookkeeping Error
Others
9
Revenue Restatements – Examples
Sales contingencies not disclosed to accounting or management
Sales booked before delivery completed Significant rights of return existed Software revenue recognized before
underlying services were performed False sales agreements and documentation “Bill and hold” sales not deferred
10
Cost Restatements – Examples
Inventory valuation – overhead absorption, obsolescence, valuation
Bad debt allowances inadequate Costs capitalized / deferred improperly Compensation arrangements not recorded Income taxes Start-up costs
11
SEC Enforced Restatements by Year
615 14 10 8 4 3 4
17
75
21
01020304050607080
1990 1992 1994 1996 1998 2000*IPR&D accounted for 48 enforced restatements in 1999
12
Total Restatements by Stock Exchange 1977-2000
228
84
715
48
5
NYSE
AMEX
Nasdaq
OTC
Pink Sheets
13
Restatements by Stock Exchange 1990-2000
0
50
100
150
200
250
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Pink Sheets
OTC
Nasdaq
AMEX
NYSE
14
Restatements by Market Value of Restating Company 1977-2000
38 8663
752
141
$5B+
$1B to $4.99B
$500M to $999M
<$500M
N/A
Note: Market values were calculated using the share price prior to the restatement.
15
Restatements by Market Value of Restating Company 1995-2000
3655
46
389
105
$5B+
$1B to $4.99B
$500M to $999M
<$500M
N/A
16
Observations–Market Value Losses
1995 - 2000 average = $13.1 billion / year
1995 - 2000 total = $78.3 billion
Losses averaged 0.09% of total equity market value
17
Number of Losses >$100K by Year
23 25 2817
35 3143 38
69
116
66
0
20
40
60
80
100
120
1990 1992 1994 1996 1998 2000
18
Top Ten Market Value Losses 2000
Company 3 Day Value Loss SEC
Enforced?
Reason
Microstrategy $11.9 Billion No Revenue recognition
Lucent 10.9 Billion No Revenue recognition
Legato Systems 2.0 Billion No Revenue recognition
Raytheon Co. 1.9 Billion Yes Revenue recognition
First Tennessee 701 Million Yes Revenue recognition
The Limited Inc. 672 Million No Revenue recognition
Alpharma Inc. 457 Million No Revenue recognition
Rent-Way Inc. 449 Million No Cost/expense
Profit Recovery 438 Million No Revenue recognition
Avon Products 297 Million Yes Software write-off
19
Top Ten Market Value Losses 1999
Company 3 Day Value Loss SEC Enforced?
Reason
McKesson $8.8 Billion No Revenue Recognition
Yahoo Inc. 4.6 Billion Yes In-Process R&D
Texas Instrument 1.6 Billion Yes Cost
BMC Software 1.3 Billion No In-Process R&D
Lycos, Inc. 813 Million Yes In-Process R&D
Williams Cos. 642 Million No Cost
Zions Bancorp 620 Million Yes Acquisition-related
Baker Hughes 617 Million No Cost/expense
Xilinx Inc. 589 Million No Revenue recognition
J.C. Penney 445 Million Yes Acquisition-related
20
Top Ten Market Value Losses 1998
Company 3 Day Value Loss SEC Enforced?
Reason
Cendant $11.4 Billion No Revenue and acquisition
Boston Scientific 1.7 Billion No Revenue recognition
Vesta Insurance 460 Million Yes Accounting irregularities
Philip Services 425 Million No Copper trading fraud
Green Tree 417 Million No Revenue recognition
McDonald's 301 Million No Cost
Envoy Corp. 275 Million Yes In-Process R&D
SmarTalk 253 Million No Revenue recognition
SunTrust Banks 235 Million No Loan-loss provision
Telxon Corp. 225 Million No Revenue recognition
21
Total Market Value NYSE, AMEX & NASD Companies
(in $ trillions)
3.234.35 4.76 5.47 5.34
7.318.95
11.41
13.61
17.6416.09
02468
1012141618
1990 1992 1994 1996 1998 2000
22
Market Value Losses 1990-2000 (in $ billions)
0.68 0.4 1.5 0.24 1.19 1.142.89
1.24
17.67
24.2
31.2
0
5
10
15
20
25
30
35
1990 1992 1994 1996 1998 2000
23
Market Value Losses 1990-2000
0
5
10
15
20
25
30
35
Top 10
Total
24
Percentage of Total Restatement Losses to Total Value of Public Companies
0
0.2
0.4
0.6
0.8
1
1990 1992 1994 1996 1998 2000
25
Observations
Losses are most severe when companies make revenue recognition restatements.
Although the number of IPR&D cases has increased, market reaction has generally been mild.
26
1999 In-Process R&D Restatements
SEC initiative and rule change in 1999 caused 57 of 207 restatements
Overall, there has been little market value impact from these restatements; however, IPR&D was the stated reason for three of the top ten shareholder losses – Yahoo $4.6B, BMC Software $1.3B and Lycos $813MM.
27
Conclusions – Quantitative Measures of Financial Reporting
Both quantitative measures indicate a high overall level in assessing financial reporting quality.
Market value losses are sharply focused. From 1998 to 2000, total losses from 397
restatements, excluding IPR&D, equaled $64.9 billion. The top eight cases accounted for $50.2 billion, or
77%, of those losses, indicating enforcement has greater effect than added regulations.
28
Conclusions
Market value losses following financial reporting problems are very small, relative to the entire market.
Consistent with other studies, revenue accounting is the largest source of problems. Additional education initiatives on revenue accounting are needed.
These quantitative measures indicate a systemic and environmental change has taken place over the last three years.
The rate of restatements remains very small.
29
Question:Why Did Restatements Increase Significantly
in 1998?
30
Key Events
July 1997 – Asian Financial Crisis Oct. 1997 – AICPA SOP 97-2 on Software Recognition
Issues issued April 1998 – Cendant announces reporting problems Aug. 1998 – First IPR&D restatement (Envoy Corp.) Sept 1998 – Arthur Levitt Earnings Management speech Aug. 1999 – SAB 99 Introduced Dec. 1999 – SAB 101 Introduced
31
SEC Changes since 1998
The SEC drove the increased number of restatements through a change in enforcement and review policies.
SEC staff seeking to force issuer restatements. Previously immaterial items or items that would be
fixed prospectively are now required to be restated. Companies registration statements are being held up
on accounting issues, and they concede small restatements to get clearance.
32
SEC Changes since 1998
The “Jawboning” begun after the Arthur Levitt Earnings Management initiative of October 1998 led companies to restate past results, rather than correcting on a “go forward” basis.
1998 Timeline– Waste Management restates Jan. 29– Cendant restates April 16– Sunbeam restates June 30– Levitt speech Sept. 28– 33 of 100 restatements for year follow Levitt speech.
33
Market Pressures on Management
One consequence of dramatically higher equity returns on behalf of shareholders is higher performance pressure on management teams.
34
Market Pressures on Management
While this challenge is largely embraced and has been good for the competitive position of U.S. companies, it comes with a cost.
The $4.7 trillion market value increase (97-00) that resulted from that performance culture should be evaluated with consideration of the $74.3 billion (1.6%) of market value losses that followed financial reporting problems.
35
Quantitative Measures of the Quality of Financial Reporting
Copyright ©2001 by Financial Executives Research Foundation Inc.