RESTATEMENTS AND MATERIALITY

                                Grace Lamont and Steven Skalak*

Restatements Overview

Recently, restatements have become a hot issue of interest and discussion. Several
studies which have been monitoring restatements, including the number and type of
restatements, have concluded, among other things, that the number of restatements has
dramatically increased over the past few years. The US Government Accountability
Office (GAO) report issued on March 5, 2007 reported that the number of restatement
announcements increased from by 67 percent from 2002 to September 2005 and other
private research studies have shown similar increasing trends. The GAO study reported
that for the 39 month period ending September 2005 there were 1,390 restatements. One
other study1 shows that restatements hit an all time record in 2006 with as many as 1,538
restatements made during the year. The same report stated that 146 companies restated
more than once with 25 companies restating multiple times in the same year. Although
the number of restatements reported vary, presumably because of the different
methodologies employed, all demonstrate that the number of restatements are trending in
the same upward direction.

In October 2007, the Public Accounting Oversight Board (PCAOB)'s Office of Research
and Analysis (ORA) presented their working paper entitled "Changes in Market
Responses to Financial Statement Restatement Announcements in the Sarbanes-Oxley
Era." The paper addressed the following issues:

      •    Are market responses to restatement announcements different in the periods
           before and after the enactment of the Sarbanes Oxley Act of 2002 (SOX)?; and

      •    The changes in:

               o Market responses to restatement announcements;
               o Market efficiency and price volatility due to restatements.

The study of 1,711 restatements during the eight year period 1998 to 2005 found that
only 325 caused a statistically significant movement in the price of the reporting entity's
shares. That is only 19 percent. The report states that post-SOX, the negative impact on
companies announcing restatements declined by 71 percent on average (as measured by
the cumulative abnormal return on days 0 and +1) since SOX and that positive market
response to announced restatements is 33 percent less than pre-SOX. In dollar terms, the
reduction represents a net reduction in lost market value of $207 million per restatement
announcement or $74.4 billion in total market value for the two-day announcement event

    Glass Lewis & Co., The Errors of Their Ways, February 27, 2007

* Grace Lamont and Steven Skalak are Partners in the Firm of
window. Additionally, the report suggests less uncertainty on the part of investors
regarding the announcements of restating companies perhaps because investors believe
the disclosed information conveyed by the restated financials is timelier and of higher

In summary, therefore, the foregoing research and studies, taken together, suggest that
despite the burgeoning number of restatements in recent years, market reaction to such
restatements is declining. The growing body of evidence that many restatements are not
especially significant to market investors is leading many to question the cost, expense,
and disruption caused by a restatement exercise and is triggering a reconsideration of the
materiality standards generally used to determine whether or not a restatement is

Not surprisingly, the issue has caught the attention of the SEC. The SEC's Advisory
Committee on Improvements to Financial Reporting (Advisory Committee) which
formed four committees to deal with the issues raised in the Robert Pozen Discussion
paper dated July 2007, released the report of its Subcommittee III dealing with Audit
Process and Compliance to be discussed at the November 2, 2007 meeting of the full
Advisory Committee. The report recognized the significant increase in restatements as
reported by various studies and primarily dealt with the issue of restatements and whether
providing guidance around the subject of materiality of errors would be beneficial. The
report recognizes that the issues, like restatements themselves, are not uniform. The
Subcommittee III's preliminary findings were summarized under three categories
including: Materiality; the Restatement Process; and Other Areas for Consideration.

What are Restatements?

Before addressing the issue of materiality in relation to restatements it is helpful to
understand what restatements are and when they are required to be made.

Statement of Financial Accounting Standards (FAS) 154 Accounting Changes and Error
Corrections, paragraph 2 (j) defines a restatement as:

       "The process of revising previously issued financial statements to reflect the
       correction of an error in those financial statements."

Furthermore, FAS 154 paragraph 2(h) defines an error as:

       “An error in recognition, measurement, presentation, or disclosure in financial
       statements resulting from mathematical mistakes, mistakes in the application of
       GAAP, or oversight or misuse of facts that existed at the time the financial
       statements were prepared.”

Errors also include a change from an accounting principle that is not generally accepted
to one that is generally accepted.

In the event that an error is identified, a restatement is required if the error is considered
material. FAS 154 Paragraph 25, requires that errors in previously issued financial
statements be reported as a prior period adjustment by restating those financial statements
and requires that:

           a. The cumulative effect of the error on periods prior to those presented shall be
              reflected in the carrying amounts of assets and liabilities as of the beginning
              of the first period presented.
           b. An offsetting adjustment, if any, shall be made to the opening balance of
              retained earnings (or other appropriate components of equity or net assets in
              the statement of financial position) for that period.
           c. Financial statements for each individual prior period presented shall be
              adjusted to reflect correction of the period-specific effects of the error. 2

An important aspect of the process of establishing whether an error should be restated or
not, is the determination that the error is material. FASB Concept Statement (CON)
No. 2, Qualitative Characteristics of Accounting Information describes materiality as:

           "The magnitude of an omission or misstatement of accounting information that, in
           the light of surrounding circumstances, makes it probable that judgment of a
           reasonable person relying on the information would have been changed or
           influenced by the omission or misstatement."

In the context of CON No. 2, SEC Staff Accounting Bulletin (SAB) No. 99, Materiality,
provides the Staff's view that registrants and auditors should consider not only
quantitative factors in determining materiality but rather should also consider qualitative
factors, examples of which are listed. The consideration of both quantitative and
qualitative factors can result in errors which may be considered as quantitatively
immaterial being determined as material to the financial statements.

There is no prescriptive or formulaic definition of materiality therefore. Instead, the
materiality determination is left to judgment after considering all relevant circumstances.

Materiality Issues

As a threshold matter there is the question of whether new or revised materiality guidance
is necessary. While it is possible that existing authoritative documents including FAS
154 and SAB 99 could be revised, that option seems far from practical in the short-term.
In addition, the frameworks they set forth - the evaluation of both quantitative and

    FAS 154 went into effect for fiscal years beginning after Dec 15, 2005

qualitative factors, seem to meet the needs of most constituencies using financial
statements. The question thus becomes, are these standards being interpreted in a manner
that is too restrictive when it comes to the restatement question.

Indeed, Mr. Pozen's report raises the very fundamental question of whether SAB 99 is
applied in only one direction - that is are qualitative factors used to make a quantitatively
immaterial matter material. However, a quantitatively material item generally remains so
no matter what the qualitative factors would suggest. The Sub committee comments:

       "The subcommittee believes that materiality guidance should be similar in both
       directions. Specifically, the subcommittee believes that there should be a "sliding
       scale" for evaluating errors. On this scale, the higher the quantitative significance
       of an error, the stronger the qualitative factors must be to result in a judgment that
       the error is not material. Conversely, the lower the quantitative significance of an
       error, the stronger the qualitative factors must be to result in a judgment that the
       error is material."

The suggestion that the qualitative aspects should cut in two directions arises from the
underlying concept that the primary driver of the restatement question ought to be what is
helpful to current investors. By emphasizing the interests of current investors, it may be
possible to avoid some restatements that do not enhance the usefulness of financial
information for their purposes. One such example might be curtailing restatements when
the periods in question are old, say five years or more in the past.

Considering the usefulness of information to the current investors raises several other
relevant questions about materiality judgments. Foremost among them is the question of
whether interim financial statements should receive different treatment and whether
restatements that do not affect operating income, or pre-tax income or other significant
metrics be treated differently.

There are two aspects of restatements that do not significantly alter a key metric. First is
the question of the "reclassification" restatement. This occurs when line items within the
income statement must be corrected, but none of the items move between accounting
periods; they merely move between line items. This situation could be one in which a
quantitative analysis suggests a material misstatement, but if the line items affected are
not key statistics for investor purposes, then the qualitative analysis would suggest
correction when the statement was next presented, but not a restatement. The second
example is the situation in which there are offsetting errors. In a situation where two
errors that are material based on quantitative factors exist, but are fortuitously offsetting
in their impact on income for the period, a legitimate question seems to exist as to
whether a restated financial statement is of any increased usefulness to the current
investors. Clearly, this example may be concerning to the regulatory community because
it suggests that "being lucky, rather than good" in ones financial reporting is an
acceptable basis for avoiding restatements. While somewhat dissatisfying, the SAB 99

framework for evaluating all factors, both quantitative and qualitative, would appear to
provide a sound basis for a conclusion of this type.

The alternative disclosures and critical reporting to deal with the "off-setting" error
circumstance have already been established by Sarbanes-Oxley as a material weakness in
internal control. A material weakness can exist even if the financial statements are not
misstated. Reporting the off-setting error situation as a material weakness but not a
restatement gives financial statement users transparency into the nature of both the
reporting issues as well as the control circumstances, which quite likely were at the root
of the issue to begin with.
Interim financial statements present a more difficult set of considerations. One third of
the Subcommittee’s restatement study included restatements related to interim financials.
According to the Subcommittee:

       “…there is not currently much authoritative guidance on assessing materiality
       with respect to interim periods outside of paragraph 29 of APB 28, Interim
       Financial Reporting, which was issued over 30 years ago in an environment
       where interim reporting was viewed differently than today. Current practice on
       this issue is mixed. Some people view that APB 28 allows all materiality
       judgments to be made based on the impact of an error on the annual period.
       Others believe that errors in the current interim periods should be evaluated solely
       on the basis of the impact of the error on the interim period”

It remains widely accepted that intentionality will tip the scale used to evaluate
quantitative and qualitative factors heavily toward restatement. Thus, the "two-way"
street reading of existing guidance should not be viewed as an apologetic approach
toward financial reporting improprieties. Fraud remains fraud, and as such restatements
will continue to be required in those circumstances where fraud, rather than error,
complexity, or oversight is the root cause of inaccurate financial reporting.

December 5, 2007


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