Dr. P.V. Viswanath

pviswanath@pace.edu

Selected Information On Restating Financial Results

Ali Gursoy

Q. When does a company need to restate its financial results?

Ans. Restatements in financial statements are made for many reasons. Generally, firms restate financial statements when;

1. A change in accounting principle. (A change from straight-line to declining- balance depreciation)
2. A change in accounting estimate. (A change in the estimated useful life or estimated residual value of depreciable asset.)
3. A change in reporting entity. (Substitution of consolidated statements for individual company financial statements)
4. Error correction.

Ans. There are three approaches in restatement of financial statements.

1. Current approach: This method recognizes in current period earnings the cumulative difference between the total expense or revenue under the old and new accounting principles for all affected prior periods up to the beginning of the current period. (Companies post this amount, if any, to the account titled Cumulative Effect of Change in Accounting Principle)
2. Retroactive Approach: This method restates all prior financial statements presented on a comparative basis to conform to the new principle.
3. Prospective Approach: This method applies revised accounting estimates to current and future periods affected by change. Prior financial statements remain unchanged, and no cumulative effect effect on prior years' income is computed.

Ans. Unfortunately, restatements in financial statements affect stock prices. The goal of financial reporting is to provide useful and comparable data to third parties. (Investors, government,...) Third parties justify the usefulness of any relevant financial data by making time series analysis and cross-sectional analysis. Any changes in past financial data will affect the current perception of investor, because:

• The sustainability, measurement, or manageability of the reported (un-restated) earnings number keep it from reflecting economic value-added of a firm.
• Financial statements of previous years are restated in the current year.
• Financial statement items are classified in different ways across companies.

MicroStrategy tanks on restatement news

VIENNA, Va. (Bloomberg) -  MicroStrategy Inc., an inventory-management software maker, said it is revising revenue and operating results for the past two years because of a change in the way it accounts for software sales. The shares tumbled 62%.

In the case of MicroStrategy, restatements in the past years' earnings affected the current price of the company.  Whatever the current year (2000) earning of MicroStrategy before restatement of financial statements, since the trend of earning has changed significantly after restatement and the market has perceived it as a bad sign for MicroStrategy's future.

Q. What causes a company to restate its earning?

A. These changes sometimes are required by regulating authorities or companies make them voluntarily.

The reasons are:
-To improve matching of expenses and revenues
-To enhance asset valuation
-To provide new information
-To respond to changed economic/market condition
-To comply with new reporting standards

In addition to restatement of financial statements, an investment student should always keep in mind that using financial statements as given by companies may cause misleading judgments about future performance of companies.  Disclosures in some accounts of financial statements are prime candidates for judging the company's future.

1-Discontinued Operations
2-Extraordinary gains and loses
3-Changes in accounting principle
4-Impairment losses
5-Restructuring charges
6-Changes in estimates
7-Gains and losses from peripheral operations.

Before making any analysis (ratio, trend,...) these accounts should be carefully investigated.

Sources:

• Intermediate Accounting, Dyckman/Dukes/Davis, 4th. Edition, Irwin/McGraw-Hill, pp.1262,1263,1264,1265,1275,1277,1286
• Financial Reporting and Statement Analysis, Stickney/Brown, 4th. Edition, Dryden, pp.202,203,204,205,210,211,229
• Financial Statement Analysis, Bernstein/Wild, 6th. Edition, Irwin/McGraw-Hill, pp.69,70,178,179
• Investment Analysis and Portfolio Management, Reilly, 3rd. Edition, Dryden, pp.442,443,444