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Quantitative Measures of the Quality of Financial Reporting

June 7, 2001

Copyright ©2001 by Financial Executives Research Foundation Inc.

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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.

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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.

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Observations – Frequency

Average rate of restatements:

1985 – 2000 = 0.51%

1995 – 2000 = 0.67%

*excluding IPR&D

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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

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Observations – Restatements Spike Starting in 1998

1990 to 1997 Average 49 restatements a year

1998 = 91 restatements1999 = 150 restatements 2000 = 156 restatements

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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

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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

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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

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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

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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

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Total Restatements by Stock Exchange 1977-2000

228

84

715

48

5

NYSE

AMEX

Nasdaq

OTC

Pink Sheets

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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

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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.

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Restatements by Market Value of Restating Company 1995-2000

3655

46

389

105

$5B+

$1B to $4.99B

$500M to $999M

<$500M

N/A

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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

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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

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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

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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

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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

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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

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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

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Market Value Losses 1990-2000

0

5

10

15

20

25

30

35

Top 10

Total

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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

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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.

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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.

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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.

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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.

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Question:Why Did Restatements Increase Significantly

in 1998?

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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

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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.

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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.

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Market Pressures on Management

One consequence of dramatically higher equity returns on behalf of shareholders is higher performance pressure on management teams.

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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.

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Quantitative Measures of the Quality of Financial Reporting

Copyright ©2001 by Financial Executives Research Foundation Inc.