Avoiding Reputation Damage in Financial Restatements

Long Range Planning 39 (2006) 429e456 www.lrpjournal.com

Avoiding Reputation Damagein Financial Restatements

Fred H. M. Gertsen, Cees B. M. van Riel and Guido Berens

The incidence of companies restating their financial results has recently been increasingsteadily each year. This has resulted in the public trust in large companies being eroded,and in some cases, most notably Enron, the restatement has triggered the company’sdownfall. Corporate collapse is not always the result however. Companies can to someextent control the damage that a restatement inflicts on their market value. In thisarticle, we outline which factors can aggravate this damage, and which actions canalleviate it.� 2006 Elsevier Ltd. All rights reserved.

IntroductionAn avalanche of accounting scandals in the past few years has eroded public trust in large compa-nies and the accounting firms which audit them. All these scandals were accompanied by financialrestatements whereby previously approved and adopted financial statements were publicly adjusted.In most cases, these restatements triggered the discovery of substantial internal control and gover-nance problems in the companies, which caused substantial damage to their reputations and marketvalue and occasionally even led to their bankruptcy (e.g. Enron and WorldCom). While the restate-ments themselves were obviously not directly responsible for these devastating consequences, theydid expose underlying control and governance problems. This realisation then created a crisis sit-uation as investors lost confidence in management. As Grant and Visconti make clear elsewhere inthis issue, the incidence of restatements has increased substantially over the past few years. More-over, restatements are no longer confined to the US, as cases such as Parmalat and Aholddemonstrate.

Previous research on restatements have addressed their causes and consequences includingbreakdowns in corporate governance structures, their effects on market value, the role of manage-ment reward systems, the occurrence of management fraud, the restatement categories that are

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most likely to attract litigation (e.g. shareholder lawsuits) and the role of auditor failures, possiblycaused by conflicts of interest (e.g. selling consulting services).1 However, the research so far doesnot provide guidelines on dealing with a restatement once there is a need for it. The goal of ourresearch is to define such guidelines, by providing insight into the managerial behaviours thatcan influence the damage done by a restatement. While some of these insights are consistentwith findings from previous studies, such findings have not before been integrated into an overallmodel.

In our research, we studied a number of recent European and US restatement cases (see Appen-dix A). The results of this research suggest that two dimensions of financial restatements determinetheir severity:

(1)the degree of distortion (i.e. the possible effect of the restatement on the company’s futurefinancial prospects); and

(2)the degree of malicious intent.

However, the ‘‘objective’’ level of distortion and intent matters less than the level as perceivedby the public and other stakeholders. There are a number of issues that can put tremendouspressure on restatement scenarios, increasing the level of distortion and intent the public per-ceives to be present, and thereby damaging a company’s market value. However, there are alsoopportunities to respond to these issues in a way that can limit the damage. These includeforthright communication about the problems, as well as actions to solve them. Table 1 showsthe overall results of our analysis with respect to these five responses. As is clear, companiesthat are successful in taking these actions suffer less damage to their share price than companiesthat are less successful. Our reasoning with respect to the issues and responses in dealing withrestatements is illustrated in Figure 1. In the following sections, we will expound the results ofour study in detail.

Table 1. Overview of Results with Respect to the Five Managerial Responses

Confirming Taking

the

blame

Communicating

openly

Governance

measures

Compliance

with

standards

and rules

Total Market

reaction

Adecco �� + �� Ahold �� + �� +/�Cablevision ++ � �� + � + ++

Computer

Associates

+/� + �� +/� +/� � �

El Paso � � +/� + + + +

Freddie Mac ++ + ++ +++ + +++ +

Goodyear ++ + +++ � � + ++

Interpublic �� Nortel �� Parmalat �� Qwest + ++ �� + + + ��Shell + + �� ++ +++ ++ �Symbol � � +/� � � � ++

Tyco + �� + � + + +++

+++: very high, ++: high, +: above average, +/�: average, �: below average, ��: low, ��: very low

430 Avoiding Reputation Damage in Financial Restatements

Classification of restatements e just black, or shades of grey?Research by Dechow et al. and by Palmrose et al. has shown that the reaction of the stock market toa restatement is caused by two main factors:

(1)the decline in the firm’s future prospects; and(2)the increase in uncertainty about these prospects.

The decline in the firm’s prospects is partially determined by the degree to which the restatementlowers the company’s net income. The perceived pervasiveness of the problem (how many areasare affected) and its persistence (how many years/quarters are restated) also determines the declinein value as pervasive and persistent problems may continue for some time. Furthermore, the nature ofthe restatement is also a relevant factor. Restatements may relate to a number of different accountingissues (see Table 2). Research has shown that restatements involving revenue recognition issues havegreater adverse effects than restatements involving other issues.2 The reason is presumably that

Non-alignment

Paralysis

Comprehension

gap

Discrediting of

management

Tip-of the iceberg

effect

Perceived

distortion

Perceived

intent

Taking governance

measures

Confirming

the problem

Communicating

openly

Acting in

compliance

with norms

Issues Responses

Market value

Communication

Actions

Blame taking

Figure 1. Issues and Responses with Respect to Perceived Intent and Perceived Distortion

Table 2. Major types of accounting issues involved in restatements

Percentage of all financial

restatements, 2000e2004

Revenue recognition 19%

Equity 15%

Reserves, Accruals and Contingencies 15%

Capitalisation/Expense of Assets 9%

Inventory 5%

Source: Adapted from J. J. Floyd and J. J. Szafran, 2004 annual review of financial reporting matters, Huron ConsultingGroup, Boston (2005).

Long Range Planning, vol 39 2006 431

revenue figures are considered especially indicative of a company’s future profit potential. In addi-tion, revenue recognition issues are more likely to attract lawsuits.3 Similarly, revenue recognitionranks high on the agenda of the Securities and Exchange Commission (SEC) because it is the mostfrequent cause of a restatement and underlies many cases of accounting fraud.4 Finally, the risk ofmaterial misstatement of financial statements is generally greater when accounting estimates are in-volved, rather than essentially factual data. Estimates, such as those for goodwill impairment, statingacquisitions at fair value, inventory obsolescence, uncollectible receivables and warranty obligations,are subject to the unpredictability of future events as well as errors arising from data mismanagement.

Besides diminishing the perceived future prospects of a company, restatements tend to create fur-ther uncertainty as they often damage the credibility of management and the company’s reportingsystem, particularly when fraud is involved. If management has tried to mislead its stakeholders,investor confidence in the trustworthiness of information from the management is diminished.Consequently, investors vary more widely in the value they place on the company. As Dechowpoints out, this wider variation in turn leads to a lower value of the company.

While previous studies have looked at the different mechanisms through which restatements af-fect firm value, they do not provide a classification of different types of restatement. On the basis ofprevious findings, we propose two dimensions that categorise a restatement situation according toits severity, namely

(1)the degree of distortion of value-relevant information; and(2)the degree of management intent.

The degree of distortion refers to the decline in the perceived value of the company, as a result of theincome effect of the restatement, and its pervasiveness and persistence (among other things). Intentrefers to the degree to which management has knowingly and purposely distorted its financial figuresand is likely to do so again. It is related to investor uncertainty about the company’s value.

The two dimensions of the severity of restatements are illustrated in Figure 2. These two dimen-sions create four types of restatements, differing in their overall severity. ‘‘White lies’’ rate low onboth intent and distortion, and are therefore relatively harmless. More serious are what we call‘‘grey accounting hocus pocus’’ and ‘‘purple delusion’’. The former implies a high degree of distor-tion performed more or less by accident. This will likely decrease the company’s perceived futureprospects (because it usually decreases the company’s performance), but not the credibility of itsfuture financial reports. On the other hand, ‘‘purple delusion’’ implies a low-level but deliberatedistortion. This will not decrease the company’s future prospects much but will decrease investors’faith in the truthfulness of the company’s future financial reports, leading to uncertainty in the

No MaliciousIntent

MaliciousIntent

ImmaterialDistortion

MaterialDistortion

Grey AccountingHocus Pocus

Purple Delusion

White Lies

Black MagicFraud

Figure 2. Perceived intent and distortion as two dimensions of financial restatements


market over the company’s prospects. Finally, there is ‘‘black magic fraud’’ which involves the de-liberate creation of a high level of distortion. These are the most serious cases because they decreaseboth the company’s future prospects and the credibility of its future financial reports. Because ofthe complexity of accounting issues, what is relevant is not so much the objective level of distortionand intent, but the level of distortion and intent as it is perceived by the market and other stake-holders. In every restatement case, there are factors that can aggravate the perceived level of distor-tion and intent, and also factors that alleviate them. For example, the credibility of a company’scorporate communication could be of vital importance in determining the reaction of the public.We will discuss these factors in the following sections.

Issues in restatement situationsIn our research, we observed issues that can increase either the perceived intent or the perceivedlevel of distortion involved in a restatement, or even a combination of the two. We distinguishamong five such issues, as shown in Figure 3. We will explain them in the following paragraphs.

Discrediting of managementManagers are often discredited following a restatement. Senior management is frequently impli-cated in class action suits and/or SEC actions. Also, in many cases executives are ‘‘suspects’’ ininternal corporate investigations or regulatory investigations. The Justice Department and othercriminal investigators all potentially discredit senior management. Furthermore, remedial actions,often agreed with regulators, lead to immediate executive changes. In that case, the new manage-ment will, based on hindsight, question (or even reject) prior and current assertions. In account-ing, many judgments and estimates need to be made based on a high degree of uncertainty, andtheir accuracy can often only be evaluated afterwards. Hindsight may therefore induce new man-agers to be particularly negative about the judgments made by previous managers. In addition,previously settled issues of accounting judgment (often dating back many years) and estimateswill be revisited. Expansion in the scope of investigation will often lead to minute scrutiny ofmanagement’s previous role in accounting decisions. In such cases, even things that were rightlyconsidered ‘‘immaterial’’ when they occurred can qualify as material after all if there is evidenceto substantiate that intent was there to distort the financial position on purpose. Discrediting canalso spring from relatively minor events. For example, the absence of Shell’s chairman during aninitial conference call about the company’s reserves restatement can be seen as the start of a seriesof publicly debated credibility issues involving Shell’s senior management. This includes thepotential leaking to the press of confidential (internal) e-mails to discredit senior managementinvolved in this case.

No MaliciousIntent

MaliciousIntent


MaterialDistortion

• Discrediting of management• “Tip-of-the-iceberg”effect• Paralysis in communication

• Comprehension gaps

• Non-alignment ofmanagement andgatekeepers

Figure 3. Issues influencing perceived intent and distortion


Management credibility is a precious commodity but it can easily be damaged in a restatementsituation. Damage to management credibility is one reason why investors respond more negativelyto a restatement than would be justified by only looking at its net income effect. This is consistentwith marketing research, which has demonstrated that credibility acts like a halo: low credibilityputs all of a company’s actions in a negative light.5 Therefore, when management is publicly dis-credited, this can strongly influence the market’s perception of intent as well as distortion, therebyaffecting the market value of the company.

Comprehension gapsThe fundamental difference between a restatement originating from an accounting irregularity (per-petrated with clear intent), as opposed to an accounting error (perpetrated accidentally or resultingfrom a genuine misinterpretation) is often not sufficiently appreciated and/or recognised and henceresults in unfair media treatment. The full spectrum of accounting adjustments, ranging from‘‘changes in estimates’’ to ‘‘correction of errors’’ to ‘‘restatements’’, is subject to many complextechnical rules and judgment calls within the accounting domain. There may be a significant com-prehension gap between the actual event and the message that is communicated. Senior executivesoften do not fully comprehend the significant differences in restatement categories and the percep-tions that markets (i.e. analysts) have of the restatement. This may lead to misunderstandings anduncertainty in the market, and therefore to an additional loss of market value. For example, in oneconference call by Nortel, the company stated that the impact of its restatement would not be ‘‘ma-terial’’, but when pressed was unable to give an exact definition of this phrase, leaving analystsguessing.

‘‘Q: Material, how does Nortel define material? Five per cent? Ten per cent? I mean, is therea metric you use in saying you don’t think it will have a material change at this point?

A: Well, I think material was - you know, material in the market place. We’re just trying to makesure people understand that if there’s an adjustment, it would be in an immaterial way.’’

Following this lack of clarity, there was an additional drop in Nortel’s share price.6 If manage-ment is not able to articulate the restatement category together with the required nuance, thenthe dialogue with the market will fail miserably.

Research into the way in which audit committees evaluate the quality of financial reports hasshown that a significant difference exists between financial ‘‘experts’’ and financial ‘‘literates’’. 7

Financial literates are people who can read and understand basic financial statements, while finan-cial experts have professional experience or certification in accounting or finance. Financial literatesare more likely to react to reporting issues that are prominent in the business press or are of a non-recurring nature. Therefore, markets (which are financially literate rather than expert), tend tooverreact to restatements. It requires considerable force of argument and the right accounting rhet-oric to differentiate between good and bad restatement situations. Therefore, the ability of manage-ment to communicate in a timely and proper manner the category and nuance of a restatement isa crucial driver of the degree of distortion and intent perceived by the public.

‘‘Tip-of-the-iceberg’’ effectEmpirical evidence suggests that many financial restatements share a ‘‘tip-of-the-iceberg’’ effect.What is, in many cases, a financially immaterial restatement triggers a complete loss of credibility.In many cases, an expansion in the scope of accounting investigation takes place, resulting in other

Management credibility is a precious commodity to guard, but it

can easily be damaged in a restatement situation


transactions, accounts and balances coming under scrutiny.8 Also, a single restatement quite oftenleads to a questioning of the company’s other accounting and disclosure practices. Then, more ir-regularities and errors come to light, leading to more damage to the company’s market value. Palm-rose et al. have shown that restatements that affect more financial statement accounts trigger morenegative stock market reactions. For example, Ahold’s restatement in 2003 led to an investigation ofnot only its subsidiary US Foodservice, for which accounting fraud had been discovered, but also ofall the company’s North and South American businesses. The news of this expansion in scope trig-gered an additional negative stock price reaction.9 Thereafter, the forensic accounting investigation,commissioned by the Supervisory Board, found some 400 issues that needed to be adjusted in orderto bring Ahold’s accounts back into compliance with Generally Accepted Accounting Principles(GAAP). When looking at the long-term effect of the restatement, we can see that although Aholdrecaptured part of its market value at the end of the restatement period, it did not recover com-pletely (See Table 2). This tip-of-the-iceberg effect can also take place at the level of industryplayers. For example, in the wake of the Ahold case, the vendor allowance accounting practice ofthe entire US food industry was questioned.10 The effect can be attributed to a number of ‘‘demandfor information integrity’’ forces, such as:

� Overly harsh cleansing operations, in which executives throughout the company are sacrificedbefore due and fair investigation has been completed. This may be due to the escalation ofthe investigation to the level of the independent supervisory board, thereby encompassing thepersonal reputations of board members. Remedial actions, therefore, often qualify as reputationrepair actions which have a highly rhetorical character, serving mainly to insist that the board hascontrol over the company. In addition, regulators press companies to take remedial actionswithin a certain timeframe.

� A change of auditor, leading to a radical scrutiny of fine-grained technical accounting and dis-closure issues: ‘‘all (small boned) skeletons out of the closet!’’

� The involvement of forensic accountants, who exercise extreme professional scepticism. They areappointed by the board and essentially take over accounting data discovery and control frommanagement, leaving no stone unturned.

The above ‘‘demand for information integrity’’ forces may result from the power-play that takesplace, most often behind the scenes, in the corporate boardroom. Management needs to be fullyaware of these forces as they tend to lead a life of their own and prove to be most difficult to man-age. They are likely to aggravate the level of perceived distortion and the degree of perceived intentinvolved in a restatement situation.

Paralysis in corporate reaction and communicationIn corporate crisis situations of the magnitude triggered by restatements, fear and lack of experienceintuitively lead to a defensive communications strategy e or worse, to no communication at all.This can be seen in the case of Adecco: after the company announced an internal control ‘‘issue’’in January 2004 (interpreted by the market as a potential restatement), a period of silence and se-crecy followed which left the market guessing. Finally, nine months later, independent counsel con-cluded that there were no material financial issues to be reported. But by then, the damage to publictrust had already been done. Adecco’s stock price had decreased substantially shortly after the initialannouncement and did not quite recover at the time the crisis was dissolved (see Table 2). Ofcourse, silence is understandable. The threat of shareholder lawsuits can serve to gag a companyand/or individual executives who do not wish to risk making even reasonable, good-faith disclo-sures. Further, involvement in (potential) litigation implies a fundamental change in a company’scommunication strategy. As noted above, in many cases, the board appoints forensic investigatorsto take control and as a consequence the command structure of a restatement process shifts awayfrom the chief executive and chief financial officer to the independent board, and ultimately tothe independent auditors, lawyers and forensic investigators. This often leads to what is called‘‘Kaltstellung’’ in German, i.e. a complete operational paralysis and shelving of executives which


will impair morale and normal communication with stakeholders for a considerable period. Paral-ysis in corporate reaction and communication most likely leads to a worsening of both the per-ceived intent and the perceived impact of the restatement.

Non-alignment of management, auditors and other gatekeepersFollowing a restatement, a lack of alignment between management, the auditors and other gate-keepers can often aggravates the situation.11 ‘‘Alignment’’ refers to a common view on how to han-dle the problem. Because of their different professional backgrounds and experience, these differentgroups each employ their own codes (language, vocabulary) and cognitive frames (theories, mentalmaps).12 These codes and frames enable them to define and solve problems, but will also lead todifferent opinions, attitudes, and hence, communication behaviour. This limits their ability to strikeup a dialogue with other disciplines and with external stakeholders. Researchers in strategy haveargued that such a dialogue (i.e., alignment) seems especially important when extreme pressureand unusual circumstances are involved.13 Indeed, most restatement cases create enormous pres-sure on the corporate governance status quo, because such an event can lead to irrevocable lossof reputation, financial disaster and even imprisonment. As a consequence, the ‘‘normal’’ rulesof corporate (and collective) management suddenly change. In such a situation, alignment is par-ticularly important.

Before a restatement is filed, a lack of alignment can be apparent from a lack of information flowfrom management to the board and the auditors. In addition, it may be reflected in a lack of re-sponsiveness of management to recommendations made by the auditors. The result of such non-alignment can be the filing of a report under Section 10A of the Securities Exchange Act. Section10A ‘‘requires reporting to the Securities and Exchange Commission (SEC) when, during thecourse of a financial audit, an auditor detects likely illegal acts that have a material impact onthe financial statements and appropriate remedial action is not being taken by management orthe board of directors’’.14 This implies that the auditors have alerted management to the question-able nature of its accounting practices, but that management took no heed of this warning. Sucha situation signals misalignment between management and auditors because the dialogue betweenthem fails. Ultimately, the auditors then decide that they have to report the matter to the SEC,which eventually may lead to a restatement. According to the US General Accounting Office(GAO), only six Section 10A reports were filed between 1996 and 1999. The GAO concludedthat the most likely reason for this low incidence was that in most cases in which likely illegalacts occurred, management did take appropriate remedial actions when their auditors alertedthem to the problems. Therefore, in the majority of cases a dialogue was possible. However, be-tween 2000 and 2003, the number of Section 10A reports rose to 23.15 Therefore, while such ex-treme cases of non-alignment in which a Section 10A report is necessary are relatively rare, theirnumber has increased considerably in recent years. It seems likely that when the stock market per-ceives such a misalignment between the company and its auditors, it will react more negatively tothe announcement. Non-alignment may signal to investors that internal controls failed and thattop management is involved in the underlying problems. Investors are then more likely to suspectmalicious intent, leading to uncertainty in the market and therefore to a loss of market value. Al-though not focusing specifically on alignment, Palmrose et al. argued that when a restatement isannounced by the auditor, rather than by the company itself, this creates a more negative marketreaction.

After a restatement is announced (possibly following a Section 10A report), problems ofnon-alignment generally only become worse. Following a restatement announcement, new

Fear and lack of experience intuitively lead to a defensive

communications strategy e or worse, to no communication at all


management team members and/or new independent auditors are often appointed. The rela-tionship with previous management and predecessor independent auditors then tends tobecome even more strained. If we add on to this an ongoing SEC investigation, short-sellers,a market reaction and the natural tendency of ‘‘new’’ management to start with a clean slate,the pressure can become very intense. Therefore, the non-alignment of management with gate-keepers creates the risk that the public perception of the company’s intent will spiral out ofcontrol. If managers do not co-operate, this increases the risk that the effect of the four pre-viously mentioned issues gain in power resulting in devastating damage to the firm’s reputationand market value.

ConclusionThe five issues discussed above are not absolute, nor are they necessarily disastrous. However, thefact that all these factors tend to occur in combination may create substantial pressure. Manage-ment, reaffirming its prior accounting and reporting, and independent auditors (whether incum-bent, predecessor, or successor) might be able to withstand such mounting pressure. However,in circumstances where the ‘‘old’’ management has been removed or suspended and auditorshave been replaced, who is responsible for the previously reported financial statements? Who standsfor their validity? Who or what is left to countervail restatement pressure, where appropriate? Insuch cases, independent boards and their audit committees and executives share this heavyresponsibility.

Responses to issues in restatement situationsSo far we have seen that the severity of a restatement case can be categorised according to thedegree of malicious intent perceived by stakeholders, and by the degree of perceived materialdistortion. In addition, there are several problems and pressures that can aggravate a company’s po-sition in terms of either intent or distortion. However, we argue that companies can also influencethe perceived degree of intent and distortion by the way in which they act and communicate toanalysts and other gatekeepers. Based on our analysis, we distinguish among five ways in whichcompanies can limit the damage (see Figure 4). The first three ways of acting deal with commu-nication about the underlying problems, and mainly serve to reduce the amount of perceived dis-tortion (although some of them may also reduce the degree of perceived intent). The other twodeal with actions to solve the underlying problems, and mainly serve to reduce the degree of per-ceived intent.

No MaliciousIntent

MaliciousIntent


MaterialDistortion

•Confirming the Nature of the Problem•Communicating Openly

•Taking the Blame

•Corporate Governance•Acting in Compliance

Figure 4. Responses to alleviate perceived intent and distortion


Confirming the nature of the problemIn the restatement cases we analysed, providing confirmative statements regarding the nature of theproblem and voluntary explanations to analysts or the media noticeably improved the understand-ing of these stakeholders. Confirmatory statements are also likely to reduce the perceived amount ofdistortion, because a lack of understanding may lead to ‘‘wild’’ e negative e speculations. This con-tention is consistent with research in consumer inference making, which has shown that peopletend to lower their evaluation of a product when they have insufficient information about it.16

In nine out of our 14 cases, the degree to which a company clearly defined the nature of the prob-lems was consistent with the favourability of the market reaction. However, our cases also show thatexecutives often answer the analysts’ questions in a rather straightforward manner. Few executivessee questions as an opportunity to explain issues raised in greater detail or use a question as anopening to persuade the markets that correct strategic decisions have been taken (see the paragraphon ‘‘communicating openly’’ below).

Taking the blameWhen executives start blaming each other or third parties, this is likely to lead analysts to questionwhether corporate governance is still in control. Research in corporate communication has sug-gested that when management tries to shift the blame for a crisis away from itself, this can aggravatethe perceived severity of the situation because stakeholders believe that control mechanisms havefailed.17 Therefore, blame-giving can increase the amount of perceived distortion. In addition, re-fusing to take the blame can damage executives’ perceived trustworthiness.18 Such a lack of trust-worthiness can affect the belief that the company has misled the market and will try to do so again.Therefore, unless executives are clearly not to blame for the problems, appointing blame should beavoided; explaining how and why the restatement happened proves to be a better strategy. In oursample, the amount of blame-taking behaviour was consistent with the reaction of the market in sixof the fourteen cases. Nevertheless, apologies are rare in most restatement cases; often a public apol-ogy is avoided because of possible litigation. In five of our cases, no apology whatsoever was made.Shell’s Jeroen van de Veer on a number of occasions admitted to errors made in the past, which wasgreeted positively by the analysts: ‘‘They shouldn’t have happened and all of what we can do as newteam about that, we deal with it, we deal with it as quickly as possible, as fully as possible and asopenly as possible.’’19

Communicating openlyMany investors and market participants use a company’s scope of disclosure as a proxy for the de-gree of seriousness of the accounting issues. Similarly to confirming the general nature of the prob-lem, the more detail offered, the less widespread the problems are assumed to be, leading toa decrease in the perceived level of distortion. Furthermore, upfront disclosure of the damagethat the restatement may cause on business operations and/or financing facilities is a constructivefactor in the dialogue between companies and analysts. An overview of experimental research byHealy and Wahlen suggests that analysts are more likely to ‘‘see through’’ earnings managementpractices when financial statements clearly discuss and provide disclosure of the ‘‘managed’’ items,supporting the notion that voluntary disclosures enhance the information supply chain’s under-standing and hence increase transparency. The papers by Gietzmann and by Mazzola, Ravasi andGabbioneta in this issue also provide evidence for the positive influence of openness when commu-nicating a company’s strategy to investors. Therefore, open communication is likely to reduce the

People tend to lower their evaluation of a product when they have

insufficient information about it


perceived degree of distortion involved in a restatement situation, which in turn should reduce thedamage to market value. In our research, the degree of openness was consistent with the market’sreaction to the restatement in 13 of the 14 cases. While previous restatement research has notlooked at openness in depth, Palmrose et al. did show that if a company gives an estimate of thefinancial effect of the restatement in its initial announcement, the negative effect on its share priceis diminished.

The cases we analysed provide evidence that precise command of accounting language as a qualityof financial leadership has been dismissed in favour of ‘‘governance credos’’ and sound businessperformance litany. For example, in one conference call by Qwest, the chief executive outlined mea-sures that have been taken to improve future business performance, rather than providing detailson the effect of the restatement:

‘‘I don’t think we’re ready to put another number out yet. But if you look at what we announcedlast week in our enterprise space, we consolidated our general business branches with our nationalaccount branches, eliminating a lot of redundant directors and middle management. We did nottake any sales people out. We look across the business at what the opportunities are forconsolidation within the various segments that had not been yet integrated. We also, in our ITspace, have, I think, tremendous opportunity for ongoing continued in that 8 per centproductivity increase range or for better to make a huge, huge difference.’’20

Using such general, reassuring words instead of giving precise figures regarding the impact of therestatement is plausible from a reputation repair point of view. However, any suspicion of account-ing hocus-pocus must be addressed in clear and understandable language.

If there is no suspicion of fraud (i.e. if the degree of malicious intent is low), then executives seemto pay greater attention to communicating openly on the financial reporting issues of the restate-ment. This seems natural given the lower risk of litigation involved. For example, in one conferencecall by Shell, Malcolm Brinded, executive director exploration and production, displayed his de-tailed knowledge of the situation by responding in an open and explanatory fashion, volunteeringdetails and background.21

‘‘Q: Your 2003 reserve replacement ratio is now 63 per cent; am I right in thinking that is a changefrom April the 19th, when it was 60 per cent?

A: That’s correct, Andrea. That’s a small technical change.

Q: A small technical change. Well, what exactly -

A: Well, essentially, the 63 per cent is based on the production in that year of 1,408, I think it is,million barrels divided by the production as at the end of the year - the reserves as at the end of theyear. Just to give you some feel, the 63 per cent is for 2003; the five-year figure - because I think it’simportant to highlight that, because on April 19th I talked about the five-year figure which wehadn’t worked out then of being 50 to 60 per cent - is actually around 66 per cent; and thethree-year reserves replacement figure is around 94 per cent. Those are all on an organic basis.’’

What is remarkable is the relatively low level of attention that most companies devote to explain-ing the accounting background or accounting judgments causing the restatement of incorrect ac-counting information. Chief executives clearly avoid dialogue on technical matters and leavetechnicalities to the chief financial officer. However, various cases show that the markets neverthe-less expect the chief executive to explain the technical details and to show that he or she has com-mand of technical accounting issues. For example, during a conference call with Ahold, one analystposed the following question to the interim CEO: ‘‘. in terms [of] the reconsolidation, or the pro-portional consolidation of the joint ventures, what has driven that decision to do that at thispoint?’’ 22 Answering such a question adequately requires considerable knowledge of accountingprinciples.


With the introduction of the required explicit sign-off by the CEO and CFO of financial state-ments, a clear market signal was given. Numerous restatement cases and subsequent litigation doc-ument the unsuccessful efforts by corporate executives in claiming ‘‘but the auditors agreed!’’ Thisprovides clear evidence that the ultimate responsibility for the true and fair presentation of finan-cials is the domain of both CEO and CFO. They also have to deal with closer scrutiny by regulators.The SEC has the objective of reviewing every listed company at least every three years. As of August2004, comment letters by the SEC and the company’s responses have been made publicly available;therefore, companies have to assume that the financial press will obtain copies. The tactic of theSEC to make comment letters public most likely will be copied by other securities regulators.Regulators want to avoid drawing in responsibility for financial reporting by pushing their com-ments back to management publicly. By making this process of critiquing the application ofGAAP public, the SEC clearly establishes, once again, that the CEO and CFO bear the ultimate re-sponsibility for resolving the problems diagnosed by the regulators. In addition, the CEO and CFOare responsible for ‘‘unadjusted audit differences’’. This technical phrase refers to the auditors’ listof proposed adjustments to the financial statements, which, on an individual basis or taken as anaggregate do not warrant adjustment of those financial statements due to them not being consid-ered material; hence the phrase ‘‘unadjusted differences’’. Nowadays, most audit firms require theCEO or CFO to concur with this decision, by attaching the schedule of unadjusted differences tothe letter of representation. This letter of representation is the instrument auditors use to havemanagement provide representations on aspects of the financial statements on which the auditorswere not able to independently obtain corroborative or satisfactory audit evidence. For example,the completeness of contracts concluded, guarantees issued, minutes of meetings held, off-balancesheet arrangements and full disclosure of litigation and claims find their way into the managementrepresentation letter. Under most Generally Accepted Auditing Standards frameworks, this letter isa normative audit procedure. The inclusion of the summary of unadjusted differences requiresmanagement to be on guard for the following reasons. In subsequent years, and if confrontedwith a restatement, these unadjusted differences will be one of the focal points of forensic inves-tigators or regulators trying to uncover whether accounting decisions were subject of unacceptableaccounting ‘‘bias’’.

In sum, lack of technical accounting knowledge will no longer be considered as an excuse ora ‘‘mitigating’’ factor when judging management’s involvement in financial reporting matters. Infact, to create trust and build financial reputation precise command of accounting language willbe necessary for not only the CFO, but also the CEO, as the latter is the figure head of the companyand carries primary responsibility.

Taking corporate governance measuresIn cases in which there was a suspicion of intent or fraud, CEOs and/or board members of the com-panies we studied made frequent attempts to persuade analysts and the media that appropriate re-medial actions had been taken. In fact, a number of cases illustrate that (often regulatory) remedialactions were taken under time pressure, sacrificing senior members of management for cause, with-out publicly justifying what that cause was precisely! This is substantiated by the fact that in five ofour 14 cases, relatively high scores on governance actions were combined with relatively low scoreson communicating openly about the problem. Still, in eight of the 14 cases, the score on governanceactions was consistent with the overall market reaction. Similarly, previous restatement research hasshown that when a company takes appropriate governance measures (such as increasing the num-ber of outside directors), this leads to an improvement in stock and bond prices.23 The reason ispresumably that proper governance decreases the expectation that the company will act with mali-cious intent again. In addition, Mazzola, Ravasi and Gabbioneta in this issue demonstrate the roleof governance in assuring investors of the credibility of a company’s strategy.

In order to avoid the alignment problems discussed under ‘‘Issues in Restatement Situations’’, itseems important that companies take remedial governance actions in co-operation with both theinternal audit committee and with the external auditors. In the past, the relationship between


executives and the internal audit committees could be characterised as one of ‘‘act and inform’’.With the changes resulting from new governance regulations, boards and therefore audit commit-tees need to actively, rather than passively, involve themselves with management on financial con-trols and reporting matters. The new regulations imply that the board/audit committee’s active roleshould extend to at least the following:

� Management’s antifraud programmes and controls, including management’s identification offraud risks and implementation of antifraud measures;

� Management’s potential to override controls, or other inappropriate management influence;� Mechanisms for employees to report concerns (whistle-blowing procedures);� Receiving and reviewing periodic reports describing the nature, status and eventual disposition

of alleged or suspected fraud and misconduct;� An internal audit plan that addresses fraud risk and a mechanism to ensure that the internal

audit committee can express any concerns about management’s commitment to appropriateinternal controls or to report suspicions or allegations of fraud.24

A good example of the start of such a governance reform programme can be seen at Tyco.25 Itsreforms included separating financial management from operations management, establishingnew positions dealing with corporate governance which report directly to the board and establish-ing clear principles and policies. Such programmes give a positive signal to the market. By the timethe restatement issues were resolved, Tyco’s share price had recovered substantially, and was evensignificantly higher than just before the restatement.26

The external auditors, for their part, are working in a zero-tolerance environment as a result ofthe corporate scandals: a much greater focus is placed on what is material, both from a quantitativeand a qualitative perspective. The rules to deal with, in accounting as well as in auditing, are verycomplex; and the ways for auditors to defend themselves are quite limited. Furthermore, thechanges brought about by the convergence of different accounting frameworks led to the use in ac-counting of more ‘‘fair values’’ resulting in higher inherent subjectivity (more judgment) and con-sequential volatility. Audit firms have learned their lessons from the restatement phenomenon. Inissuing audit opinions on financial statements, risk aversion was a trait of the accounting professionfor many decades. Now, with the introduction of International Financial Reporting Standards(IFRS) and corporate governance changes, audit firms are avoiding any risk with respect to the ap-plication and/or interpretation of GAAP. Audit partners will often use the so-called technical officeof their firm (a department that advises technical accounting matters) to obtain a final ‘‘blessing’’on accounting and/or auditing issues. Auditors strictly apply the rules, leaving no room for man-agement’s interpretations and/or wishes. Management, for its part, increasingly uses its own legaladvisors to check its auditor’s opinions on technical accounting issues. This can jeopardise thetrustful, open and direct communicative relationship between auditors and their clients that pre-viously existed. In most cases the relationship between companies and their auditors will becomemore formal, often sterile and always highly technical. This in turn may lead to polarisation,with each party first and foremost looking after its own interests. In sum, while resolving complexfinancial reporting matters should be a team effort by management, current changes in regulationmay render such a team effort increasingly difficult.

Acting in compliance with standards and rulesThe objective of regulators is to weed out the underlying causes of restatements. In the US, theSarbanes-Oxley legislation, enacted in mid-2002, was the political reaction to corporate and executivemisconduct. Many other countries followed suit with stricter and more comprehensive corporategovernance rules. Most of these frameworks cover such issues as whistle-blower protection, auditcommittee responsibilities and expertise requirements, auditor independence and a ban on the pro-vision of certain consultancy services, and, last but not least, executive responsibility for internalcontrol systems. The latter item in particular has required US-listed entities to invest heavily in(re-)designing, testing and documenting their internal controls. Auditors, as a consequence, have


also upgraded their audit methodology by expanding the scope of their procedures, the compliancestandards they test against and upgrading their internal quality and documentation standards. Tycois an example of a company that clearly stated its adherence to rules and regulations:

‘‘We’ve implemented new conservative standards for financial reporting which, by the way, accountsfor a substantial portion of the charges we are announcing today. We have instituted a new spirit oftransparency with investors and regulators and we’ve instituted changes to the company’s internalculture with new compensation guidelines, and stronger standards of internal disclosure andreporting. With regard to the internal audits, and operating reviews, we’ve acted withdeliberation, but with a sense of urgency.’’27

As we saw earlier, Tyco’s share price successfully recovered after the restatement. It seems likelythat by closely adhering to policies and regulations after being confronted with the necessity fora restatement, companies can regain some of the trust that was lost following the restatement. In-deed, in nine of our 14 cases, the degree of compliance was consistent with the overall reaction ofthe market. The reason is presumably that when a company complies well, the market will be moreconfident that it will not act with malicious intent again.

Two opposing casesWe will now further illustrate the validity of the ‘‘damage containing’’ responses in dealing withfinancial restatements that we have outlined by discussing two of the cases we have analysed, Fred-die Mac and Nortel. Both cases were concerned with the timing of revenue recognition: revenueswere shifted from previous years to future years or vice versa. Of the cases that we analysed, they arealso the ones that attracted by far the most media attention. However, the two companies differwidely in the way they handled the restatement crisis.

Freddie MacThe Federal Home Loan Mortgage Corporation, known as Freddie Mac, is one of the largest par-ticipants in the US secondary mortgage market where financial institutions buy and sell mortgagesin the form of loans and mortgage-related securities. In 2003 for example, Freddie Mac purchasedsome 25 per cent of the US-originated conventional mortgages which totalled $2,800bn. On De-cember 31, 2003 Freddie Mac’s total assets amounted to $800bn, making it one of the largest finan-cial institutions in the world.

On January 22, 2003 Freddie Mac announced that it expected to restate its previously issued (andaudited) financial statements for 2002, 2001 and 2000. The ensuing legal, accounting and forensicinvestigations, regulatory scrutiny, SEC involvement, shareholder litigation, management changesand employee turmoil lasted for 12 months. The appointment of Richard Syron as the new CEOon December 7 more or less ended Freddie Mac’s exercise in modern financial reporting catharsis.

The net cumulative effect of Freddie Mac’s restatement was an increase of $5bn in the company’snet income in the year ended December 2002, which included a net cumulative increase of $4.4bnfor 2000, 2001 and 2002 and $600m for periods prior to 2000. These corrections of past accountingerrors could be considered material to the company’s financial position e in other words, the ac-counting errors were large enough to substantially distort the financial picture of the company. Theinvestigation into the restatement revealed that Freddie Mac had engaged in substantial earningsmanagement practices, deliberately delaying the accounting recognition of earnings in order toachieve a steadier, smoother growth curve.28

When a company complies well, the market will be more confident

that it will not act with malicious intent again


The Freddie Mac case scores relatively high on the recommended actions that we have described,as judged from our analysis of the archival data pertaining to the case (see Table 1). The initial re-statement underestimated the ultimate accounting effects of the restatement and mentioned thecomplexities of hedge accounting as the major cause for the restatement. However, once manage-ment intent with respect to the smoothing of income became apparent, remedial actions were takenimmediately with full disclosure of details. The newly-appointed management adopted a full andfair disclosure strategy, providing open and confirmative details of the complexities of hedge ac-counting for Freddie Mac’s portfolio of derivatives. Mastering the accounting rhetoric and volun-teering accounting explanations were key characteristics of management’s communication strategy.Remedial and governance actions were taken swiftly and discussed comprehensively in press releasesand conference calls. Compliance with standards and corporate reporting regulations was made anexplicit strategic (and tactical) goal. Ultimate reporting by independent counsel provided many de-tails of the accounting issues which needed to be resolved and of the remedial actions taken.

Before the restatement, a lack of alignment was evident. For example, one analyst concluded:

‘‘[Independent counsel] Baker Botts found that information given to the board was often ‘tightlyscripted and controlled’. Various accounting issues were often presented in such a way to make itseem that the company was in compliance with GAAP. Furthermore, the investigation foundthat CEO Brendsel and vice-chairman David Glenn had not addressed the need for ‘promptcorrective action’ when the board and audit committee had concerns over accounting policy inthe fall of 2001 and the spring of 2002.’’29

However, comments made by the company in a conference call after the restatement was resolvedsuggested that it realised the detrimental effects of such a situation:

‘‘. along with management practices that are described in the report and found their way into theTreblay Report will be a principle that management needs to be sure that information gets up to theboard, that raises the questions that delivers to the board the opportunity to deliberate on difficultquestions. To challenge or to probe the wisdom of general strategies, that is a mistake formanagement to keep those bottled up and to micro-manage the transmission of that informationto the board.’’30

The behaviour of Freddie Mac is also reflected in media reports surrounding the restatement. Alarge part of the reports described the accounting issues under consideration, reflecting the fact thatFreddie Mac was open on what these issues were (see Figure 5, and Appendix A for details). FreddieMac’s shares dropped about 7 per cent immediately after the restatement but steadily increased inthe subsequent 12 months, ending above the original price by the time of the restatement’s reso-lution. It seems therefore that the company was able to limit the damage caused by the restatement.

NortelNortel is a global communication technology provider specialising in the business-to-business mar-ket. In 2003, its revenues totalled $9.81bn. On October 23, 2003, Nortel announced that it had dis-covered some revenue recognition issues that would lead to a reduction in previously reportedrevenue, part of which would need to be deferred. The revenue adjustments were estimated to resultin a net decrease in revenues for 2001, 2002 and 2003. Nortel’s audit committee undertook an inde-pendent review assisted by an independent law firm. Judging from our analysis of the company’sconference calls and press releases, as well as reports by analysts and the media, Nortel scored rela-tively low on the positive behaviours that we have identified in dealing with this situation (see alsoTable 1). Over and over again the outcome of this investigation needed to be postponed. Only lim-ited information was disclosed on the scope and depth of the accounting problems. The companymerely stated that the impact of the restatement would not be ‘‘material’’, without clearly explainingwhat this meant (see the section on comprehension gaps above). Six months after the initial


restatement, a number of management changes were announced, including president and chief ex-ecutive, chief financial officer and controller. However, these actions were taken without publicisingthe underlying reasons. The uncertainty continued another almost nine months. Analysts then be-came suspicious and interpreted Nortel’s changes in certain reporting practices as a negative sign.For example, one analyst’s report stated:31 ‘‘Our concern is that investors and analysts will find itdifficult to regain confidence in Nortel if the company does not provide the level of granularitythe investment community needs to check its results against comparable and standalone compa-nies..’’, and ‘‘While Nortel has talked the talk on disclosure, we are very concerned that it maynot walk the walk - specifically on its business segment reporting.’’. Clearly, this analyst was con-cerned about the effectiveness of Nortel’s changes because the information the company providedwas not sufficiently detailed and substantiated. Such concerns were also apparent in the financialpress.32 Most reports describe Nortel’s measures to hold executives accountable and the ongoing in-ternal and external investigation, but devote relatively little attention to the accounting issues (seeFigure 5).

Finally, on January 12, 2005, some 15 months after its initial announcement, Nortel provideddetails of its accounting restatements and simultaneously announced substantial leadershipchanges.33 New key positions had been established, including chief marketing officer, chief strategyofficer, president of federal systems, president of charity and president of professional services. Inaddition, the position of chief information officer had been given more strategic importance. Thecompany had also appointed additional directors. Finally, Nortel commissioned Accenture to leada comprehensive assessment of, and assist with, the transformation of its financial processes, orga-nisation structure and the underlying systems and tools. Nortel expected this project to be com-pleted within 18 to 24 months.

0

5

10

15

20

25

30

35

40

45

Delays

Accou

nting

scan

dal

Externa

l inve

stiga

tion

Accou

nting

irreg

ulariti

es/fra

ud

Share

value

loss

Execu

tive a

ccou

ntabil

ity

Intern

al inv

estig

ation

Lawsu

its

Sarban

es-O

xley

Audito

rs

Other m

ajor s

cand

als

No

. o

f p

ress citatio

ns

Freddie Mac

Nortel

Figure 5. Content of media reports for Freddie Mac and Nortel

Analysts became suspicious and interpreted Nortel’s changes in

certain reporting practices as a negative sign


Nortel’s shares fell about 19 per cent on the day of the restatement and were even lower by thetime the restatement was resolved, although investors did react positively to the rigorous changes atthe end of the restatement episode. Nortel did not quite succeed in restoring investor confidenceafter the announcement of the restatement.34

When comparing these two cases of Nortel and Freddie Mac, the relationship between the pos-itive managerial actions that we have identified and the relative movement in the share price pro-vides support for the notion that an open, confirmative and explanatory communication strategyhelps the recovery of the share price after a restatement. While both companies suffered an initialdecrease in their share prices around the day they issued their restatement, Freddie Mac recoveredfrom this decrease to a much higher degree than Nortel. Because the initial market reaction wassimilar for the two companies, it seems likely that this difference in recovery can be attributedto the differing ways in which the companies handled the crisis.

Making up the balance: dos and don’ts of responding to restatement pressuresRestatements of financial statements can trigger serious damage to public trust in large companies.However, recent high-profile scandals may have obscured the fact that the consequences of a restate-ment are not necessarily disastrous and that companies can to some degree limit the amount ofdamage. Previous research on restatements has focused on the causes and consequences of restate-ments. Relatively little work has been done on the way companies are and should be managing re-statements. In this article we have argued that there are several issues that may increase the damagea restatement inflicts on the public trust. These issues involve obstacles to ‘‘proper’’ communicationand actions, such as the difficulty of communicating clearly, if at all, about the causes of the restate-ment and the loss of management credibility after the announcement. These factors can aggravatethe level of distortion in the financial statement that the public perceives, as well as the degree towhich the public believes that actions were taken with malicious intent. They may then lead toa substantial reduction in public trust, accompanied by a decline in the company’s market value.Therefore, it is important for managers to recognise these issues and to act upon them usinga proper communication strategy and appropriate remedial actions. Doing so will limit the levelof distortion and intent perceived by the public. For example, the cases that we have analysed sug-gest that communicating openly, taking the blame and complying with rules and regulation canlimit the amount of damage done by the restatement.

However, while many of the companies we studied implemented corporate governance changesand adherence to new rules and regulations, only a few really communicated clearly and openlyabout the restatement. Most managers tend to focus on getting their business ‘‘back on track’’,rather than explaining exactly what the causes of the restatement were in the first place. However,a proper understanding by the market of what exactly was the problem and how it was fixed is vitalfor restoring trust in the company.

Given this finding, why do managers focus so little attention on offering explanations? One rea-son may be that the job demands that a restatement situation places on managers may be too highfor most executives to handle. For many executives, extremely detailed insight into financial mattersmay be beyond their expertise. In addition, a restatement situation may put intense pressure onexecutives to perform. As recent research suggests, such pressure may interfere with executives’information processing and decision-making capabilities.35 This in turn can lead to inadequateinformation-providing behaviour by managers. Furthermore, recent research in managerial deci-sion-making by Bazerman and his colleagues has suggested that managers may not only be‘‘bounded’’ by limits on their cognitive capacities, but also by systematic biases. For example, becausepeople want to think of themselves as capable, moral and deserving, they sometimes do not see theethical doubtfulness of their own behaviour.36 In a restatement situation, some managers may trulybelieve they have not done anything wrong and act accordingly by not complying, or doing so in-adequately, with stakeholder requests for information. Finally, executives might be so focused onsome aspects of a situation that they completely overlook other aspects. Bazerman et al. term thisphenomenon ‘‘bounded awareness’’.37 For example, managers’ focus on the future of the company,


rather than its past, might not only make them reluctant to talk about what happened, but in somecases even completely oblivious to stakeholder demands for information. Investigating the roleof executive job demands and other ‘‘bounding’’ factors in the degree to which managers succeedin communicating adequately about a restatement may be a worthwhile avenue for futureresearch.

Taking the blame for the problems underlying the restatement was also very rarely seen amongthe cases we studied. This seems natural given the fact that taking the blame for misdeeds leavesone more vulnerable to litigation. However, as Kellerman and other researchers have argued, inmany cases blame-taking is essential in restoring trust. When managers avoid blame for some-thing that is clearly their responsibility, this is likely to erode public trust even further. On theother hand, recent studies by Kim and his colleagues have suggested that while blame-takingcan restore trust in the case of ‘‘honest’’ mistakes (which we have termed ‘‘white lies’’ and‘‘grey accounting hocus pocus’’), this does not necessarily hold for ethical lapses.38 That is,when malicious intent is clearly present (in what we termed ‘‘purple delusion’’ and ‘‘black magicfraud’’), admitting blame might do little to restore trust and could even damage it further. This isbecause when judging integrity, people attach particular importance to negative behaviours. Thatis, we generally consider one highly unethical act (such as fraud) as sufficient grounds to regarda person (or company) as unethical, no matter how ethical the person’s other acts are. Whileblame-taking might be perceived as a morally right behaviour in itself, it might not be enoughto counter the influence of the preceding unethical behaviour. However, when a company facinga restatement can also convince stakeholders that it will do everything necessary to avoid repeat-ing its mistakes (e.g. by replacing executives and taking appropriate corporate governance mea-sures), it seems likely that an apology that acknowledges responsibility will enhance trustrather than decrease it. Such a forgiving reaction by stakeholders also makes sense from a utilitar-ian perspective. Research in game theory has demonstrated that long-term success in a prisoner’sdilemma type of situation is determined largely by the degree to which a player can forgive oc-casional unco-operative (defecting) behaviour from the opponent.39 For example, in Axelrod’s re-search the most successful strategy was ‘‘tit for tat’’, a strategy in which a player mirrors all of theopponent’s actions - defecting when the opponent defects, but co-operating again as soon as theopponent co-operates. Refusing all further co-operation after one ‘‘malicious’’ (unco-operative)act is likely to be detrimental for both parties. Finally, blame-taking could also be the best strategyfrom a legal perspective. While it is true that admitting responsibility could be used against a com-pany or person as evidence for guilt in a court case, it could also positively influence the outcomeof the case.40

Because of the complexity of each of the restatement situations, we have been unable so far todraw firm conclusions about a causal link between company actions and the impact of a restate-ment. While our conclusions are consistent with previous literature, the conditions surroundingthe different restatements that we studied differ in many more ways than can be accounted forby the issues and managerial responses that we described. For example, the restatements took placein different industries, different countries and in different periods. All of these factors may have hadan influence on the damage triggered by the restatement. Therefore, further research is needed toinvestigate the degree to which the different actions a company undertakes following a restatementcan truly be helpful in limiting damage. In spite of this limitation, our study is one of the first todiscuss the set of issues and managerial responses surrounding financial restatements, providingguidelines for dealing with this complex problem.

Appendix A. MethodologyWe developed our classification of restatement situations as well as issues and responses in deal-ing with them through a grounded theory approach. Grounded theory refers to ‘‘the discovery oftheory from data’’ and involves a continuous interaction between a research model and thedata.41 This means that the categories and relationships distinguished in the research model


are generated from initial data, and further data are subsequently interpreted in light of the re-search model, but may also lead to adjustment of the model. Our main research material con-sisted of archival data about 14 European and US restatement cases between January 2002 andDecember 2004, listed in Table 3. These data consist of some 500 press releases, conferencecall transcripts and analysts’ reports containing about 5,000 restatement-related quotations. Wechose the beginning of 2002 as the starting point because at this time the SEC regulation on‘‘Fair Disclosure’’ (FD) became effective. This means that, from this date, company conferencecalls with analysts and representatives of the media have entered the public domain. In additionto analysing the documents, we interviewed nine experts in the field, analysed media reports andstudied literature on the market response to restatements. This provided a validation of the con-clusions drawn from analysing the documents. Specifically, we interviewed a senior risk manage-ment partner and four other senior executives at a major accounting firm, a directors’ andofficers’ (D&O) insurance executive at a major insurance company, a managing director at amajor business information service provider and two professors of accountancy at two leadingEuropean business schools.

Consistent with Glaser and Strauss’s notion of theoretical sampling, we selected restatement casesto achieve a maximum level of variability. For example, after we had identified the level of ‘‘distor-tion’’ and ‘‘intent’’ as two relevant dimensions in our model, we selected further cases on the basisof their variation in these two dimensions. In addition, because of the differences between account-ing principles in the US and Europe, we selected cases from both regions.

We conducted a content analysis of the archival data, designing a coding scheme which aimed toidentify which types of action protect companies from the damage triggered by financial statementrestatements. The coding analysis was conducted with the help of AtlasTi content analysis software.This software allows for grouping/categorising of documents, codes and (descriptive) memos invarious levels. This suited our research objectives well as we wanted to employ three levels of cod-ing: abstract (positive/negative actions), intermediate (broad categories of actions below positive/negative) and concrete (more detailed codes describing specific behaviours underneath each inter-mediate-level code). This coding scheme was applied to the archival data by four independentcoders. The categories that we used are shown in Table 4. The codes related to ‘‘openness’’ and‘‘governance’’ were by far the most frequently occurring (45 per cent and 32 per cent of all codesrespectively), with codes related to confirming, blame taking/giving, and conformity occurring rel-atively infrequently (5 per cent, 5 per cent and 11 per cent respectively). Therefore, the results re-garding openness and governance might be more reliable as they generally are based on a largernumber of quotations.

To generate the overview of companies’ behaviour with respect to the managerial responses thatwe have identified (provided in Table 1), we used a number of heuristics. For every case, we tabledthe number of occurrences of every type of behaviour over time, from the time of the announce-ment of the restatement to the time the issue was resolved, i.e., when the actual restated results werefiled. We did this both for the positive actions and for the corresponding negative behaviours. Forbehaviours associated with confirming the problem and openness, we looked especially at the earlyperiod. Our reasoning was that these behaviours are only useful to the market if they occur early.For example, Freddie Mac and Cablevision largely ‘‘defused’’ the issues by confirmative communi-cation at the beginning of the crisis. If a company only communicates about the details of its re-statement after months of investigations and governance changes, this does not help to restoretrust. For behaviours with respect to governance, we looked at behaviours throughout the period,although here too we considered early action as better than subsequent measures. Finally, for ac-tions with respect to blame-taking and acting in compliance with rules and standards, we lookedat the entire period without favouring early actions over subsequent measures. In fact, compliancewith standards and rules is mainly relevant at the end of the restatement episode, i.e. when it is re-solved. We provide examples of graphs of the occurrence of some types of positive company behav-iour in Figures 6 and 7. Figure 6 shows Freddie Mac’s scores on communicating openly and takinggovernance measures. Figure 7 shows a similar graph for the Nortel case.


t issue Start of case Length of

case (days)

No. of documents

(quotations)

analysed

trol issue January 12, 2004 239 16 (188)

venue, purchase

nd various

ments

February 24, 2003 549 58 (788)

eleration June 18, 2003 258 22 (138)

ing October 8, 2003 350 27 (237)

February 17, 2004 188 23 (201)

ccounting/smoothing January 22, 2003 574 41 (963)

unting October 21, 2003 381 17 (120)

y expenses August 5, 2002 226 16 (210)

ing October 23, 2003 446 41 (366)

sheet

nd Special

icles

November 11, 2003 188 12 (206)

counting March 11, 2002 619 45 (443)

ccounting January 9, 2004 228 26 (531)

Expense Recognition August 13, 2002 820 29 (381)

t fraud/various June 3, 2002 610 34 (403)

44

8AvoidingReputatio

nDamagein

Financia

lResta

tements

Table 3. Summary of restatement cases analysed

Company Region of origin Industry category Restatemen

Adecco Europe Human Resources Services Internal con

Ahold Europe Wholesale and Retail Trade Fictitious re

accounting a

other restate

Cablevision North America Media and Entertainment Expense acc

Computer Associates North America ICT Revenue tim

El Paso North America Oil and Gas Reserves

Freddie Mac North America Financial institutions Swaptions a

Goodyear North America Tyre Manufacturing Various acco

Interpublic North America Communication Consulting Services Intercompan

Nortel North America Communication Technology Revenue tim

Parmalat Europe Food Off-balance

accounting a

Purpose Veh

Qwest North America Telecommunication Purchase ac

Shell Europe Oil and Gas Oil-reserve A

Symbol North America ICT Revenue and

Tyco North America Manufacturing Managemen

restatements

To provide an estimate of the effect of a restatement on the market value of a company, we cal-culated for each case the percentage change in the adjusted share price during:

(1)the three days surrounding the restatement announcement; and(2)the period between the day before the announcement and the day the restatement was resolved.

This method, similar to the one used by Palmrose and Scholz, provided us with an estimate of howsevere the initial market reaction to the restatement was, and to what degree the company managed

Table 4. Codes for categories of behaviours used in the content analysis

Positive Negative

Confirming

� Confirming accounting misinterpretation

� Confirming accounting error

� Confirming accounting irregularity/ fraud

� Confirming ‘‘numbers’ game’’

� Other

Denying

� Denying accounting misinterpretation

� Denying accounting error

� Denying accounting irregularity/ fraud

� Denying ‘‘numbers’ game’’

� Spinning

� Other

Open

� Precise statement of effect of the restatement

on financial position

� Precise statement of business effect of the restatement

� Precise statement of restatement period

� Provides explanation of causes

� Responds with explanation

� Data collection process explained

� Other

Closed

� Non-precise statement of effect of the

restatement on financial position

� Non-precise statement of business effect

of the restatement

� Non- precise or revised statement of

restatement period

� No reference to cause of restatement

� Incomplete or selective response

� Tedious process/ process not explained

� Other

Blame-taking

� Apology

� Assertion of no intent

� Taking the blame for control deficiencies

� Taking the blame for operational irregularities

� Other

Blame-giving

� Blaming the CEO

� Blaming the CFO

� Blaming internal control deficiencies

� Blaming operational irregularities

� Other

Appropriate governance measures

� Governance/ remedial actions taken

� Forensic investigation explained

� Conclusive evidence of no fraud

� Reassurance on business

� Board expertise assertion/credentials

� Other

No appropriate governance measures

� Vague on corrective measures

� Resisting investigation

� Conclusive evidence of fraud/ irregularities

� Uncertainty regarding company survival

� Uncertainty regarding completeness of

information

� Other

Acting in compliance with norms

(Sarbanes-Oxley as standard)

� Code of conduct upgrade

� Accounting policies improvement

� Accounting operations/ systems improve

� Regulator settlement

� Litigation settled

� Audit firm has helped; explicit

� Other

Not acting in compliance with norms

(Sarbanes-Oxley as standard)

� Audit firm qualifies accounts

� No accounting policy change

� No system improvements

� Regulators continue investigation

� Justice department involved

� Litigation against audit firm

� Other


to recover. We rated companies based on the degree to which they recovered, attributing a higherrank to companies that recovered from a more serious negative market reaction in share price justafter the restatement announcement. When the adjusted share price at the end of the episode waseven lower than just after the announcement, we rated this as ‘‘��’’; when the price was about the

1,000,800,600,400,200,00

40,00

30,00

20,00

10,00

0,00

Open

Governance measures

Total positive codes

Fit line for Open

Fit line for Governance measures

Fit line for Total positive codes

Figure 6. Sample graph of content codes for the Freddie Mac case

1,000,800,600,400,200,00

40,00

30,00

20,00

10,00

0,00

Open

Governance measures

Total positive codes

Fit line for Open

Fit line for Governance measures

Fit line for Total positive codes

Figure 7. Sample graph of content codes for the Nortel case


same as just after the announcement, we rated it as ‘‘�’’; when it had gone up but did not quitereach the level it had just before the announcement, as ‘‘+/�’’; when it had about reached the orig-inal level, as ‘‘+’’; and when it exceeded the original level, as ‘‘++’’.

Finally, we also analysed media reports. This analysis was based on worldwide major newsand business publications in the English language. Search keywords and strings for companiesand market issues were constructed and searches were conducted through Factiva withthe number of quotes mentioning each content category for each company tabled (seeFigure 5).

Freddie Mac and Nortel were selected for a more detailed comparison because:

(1)they involved the same restatement issue (revenue timing);(2)they received the most media attention of all cases (with 206 and 256 articles in our media

analysis for Freddie Mac and Nortel, respectively); and(3)they differed substantially in the way they responded to the crisis.

Although Freddie Mac’s restatement involved adjusting the results for previous years upwards,while for Nortel this was the reverse, we believe that this does not undermine the comparabilityof the cases. In both cases a revision upwards in one period was compensated by a revisiondownwards in another period (either past or future), thus leaving net revenues over the longerterm unaffected. Second, the fact that fraud was involved is likely to weigh much more heavilyon the market than whether the revision was upward or downward. This can also be seen fromthe fact that in both cases the company’s stock price decreased immediately after theannouncement.

Appendix B. Glossary of accounting terms42

Term Definition

Audit committee An audit committee is an operating committee of a publicly-held company. Committee

members are normally drawn from members of the company’s board of directors. An

audit committee usually has a number of independent or outside directors.

Responsibilities of the audit committee typically include:

� Overseeing the financial reporting process

� Monitoring the choice of accounting policies and principles

� Monitoring the internal control process

� Overseeing hiring and performance of the external auditors

The US Securities and Exchange Commission (SEC) first recommended that

publicly-held companies establish audit committees in 1972. The stock exchanges quickly

followed by either requiring or recommending that companies establish audit committees.

Over the years, various initiatives to strengthen and increase the responsibilities of

audit committees have been made. In 2002, the Sarbanes-Oxley Act increased audit

committees’

responsibilities and authority, and raised membership requirements and committee

composition to include more independent directors. In response, the SEC and the

stock exchanges proposed new regulations and rules to strengthen audit committees.43

Auditor A person or firm appointed to carry out an audit of an organisation.

Class action A legal action in which a person sues as a representative of a class of persons who share

a common claim.

(continued on next page)


Appendix B. (continued)

Term Definition

Consolidation The process of adjusting and combining financial information from the individual

financial statements of a parent undertaking and its subsidiaries to prepare

consolidated financial statements. These statements should present financial

information for the group as a single economic entity. For example, if one subsidiary

has sold a fixed asset to another subsidiary in the group for a profit, this transaction

should be eliminated in both the consolidated profit and loss account and the

consolidated balance sheet.

Earnings

management

‘‘Earnings management occurs when managers use judgment in financial reporting and

in structuring transactions to alter financial reports to either mislead some stakeholders

about the underlying economic performance of the company, or to influence

contractual outcomes that depend on reported accounting numbers’’ (Healy & Wahlen)

Fair value Under GAAP, the fair value of an asset is the amount at which that asset could be

bought or sold in a current transaction between willing parties, other than in a

liquidation. On the other side of the balance sheet, the fair value of a liability is the

amount at which that liability could be incurred or settled in a current transaction

between willing parties, other than in a liquidation. The concept is essential in

acquisition accounting and is covered in International Financial Reporting Standard 3,

‘Business Combinations; Fair Value in Acquisition Accounting’. If available, a quoted

market price in an active market is the best evidence of fair value and should be used

as the basis for the measurement. If a quoted market price is not available, preparers

should make an estimate of fair value using the best information available in the

circumstances. In many circumstances, quoted market prices are unavailable. As a

result, difficulties occur when making estimates of fair value. (US GAAP)

Financial statements The annual statements summarising a company’s activities over the last year. They

consist of the profit and loss account, balance sheet, statement of total recognised gains

and losses, and, if required, the cash-flow statement, together with supporting notes.

Forensic accounting Accounting that involves litigation. In such circumstances accountants may be called

on to provide expert investigations and evidence.

Fundamental error Errors or irregularities that destroy the fair presentation of the financial statements

of the relevant periods or render those financial statements completely unreliable.

These errors in the fair presentation of a company’s financial statements can be

adjusted in a number of ways:

� The company adjusts (restates) the previously issued and approved financial

statements e which could imply adjusting accounts of one or more years back; this

is the ‘retrospective’ method applied under U.S. GAAP for many years (restatement

method),

� The company applies a cumulative adjustment of prior period results, reported in

current income (the cumulative effect method)

� The company adjusts the opening balance sheet, including shareholders’ equity, if

required and applies the appropriate accounting throughout the current year (the

prospective method). (US GAAP)

Gatekeepers ‘‘Reputational intermediaries who provide verification and certification services to

investors’’. (Coffee, ‘‘Understanding Enron’’)

General Accounting

Office (GAO)

The investigation and audit department of the US Congress.

Generally Accepted

Accounting Principles

(GAAP)

In the US, the rules, accounting standards and accounting concepts followed by

accountants in measuring, recording, and reporting transactions. There is also a

requirement to state whether financial statements conform with GAAP. In the UK the

concept is more loosely used but is normally taken to mean accounting standards and

the requirements of company legislation and the stock exchange.


Appendix B. (continued)

Term Definition

Goodwill The difference between the value of the separable net assets of a business and the total

value of the business. Purchased goodwill is the difference between the fair value of the

price paid for a business and the aggregate of the fair values of its separable net assets.

It may be written off to reserves or recognised as an intangible fixed asset in the balance

sheet and written off by amortisation to the profit and loss account over its useful

economic life. Internally generated goodwill should not be recognised in the financial

statements of an organisation. In the UK, the treatment of goodwill is governed by

Statement of Standard Accounting Practice 22, ‘Accounting for Goodwill’. In IFRS 3,

Business Combinations, goodwill is addressed.

Governance The manner in which organisations, particularly limited companies, are managed and

the nature of accountability of the managers to the owners. This topic has been of

increased importance since the publication of the Cadbury Report (1992), which sets

out guidance in a Code of Practice. There is a stock-exchange requirement for listed

companies to state their compliance with this code; a number of companies now

provide information on corporate governance in their annual report and accounts.

Immaterial Denoting any item or transaction that is not significant in the context of the whole of

which it forms a part.

Inventory In the US, the equivalent of the UK stock, i.e. the products or supplies of an

organisation on hand or in transit at any time. For a manufacturing company the

types of inventory are raw materials, work in progress and finished goods. An inventory

count usually takes place at the end of the financial year to confirm that the actual

quantities support the figures given in the books. The differences between the inventories

at the beginning and the end of a period are used in the calculation of cost of sales for

the profit and loss account and the end inventory is shown on the balance sheet as a

circulating asset.

Receivables Claims held against customers and others for money, goods or services. These will

appear on the balance sheet of a company.

Revenue recognition The process of recording revenue in the accounts of an organisation in the appropriate

financial period. Revenue could be recognised at various points; for example, when an

order is placed, on delivery of the goods or on receipt of payment. It is essential to

recognise revenue correctly to be able to calculate the appropriate amount of profit for

a financial period. Normally, revenue is recognised when the buyer assumes the

significant risks and rewards of ownership and the amount of revenue must be capable

of reliable measurement. However, the complexity of some business transactions may

make it difficult to determine in which financial period revenue should be recognised.

Securities and

Exchange

Commission (SEC)

In the US, the federal government agency monitoring and controlling corporate financial

reporting, auditing practices and trading activity. The SEC follows, to a very large extent,

the accounting and auditing pronouncements of bodies organised by the public

accounting profession, such as the Financial Accounting Standards Board and the

Auditing Standards Board.

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11. Gatekeepers are ‘‘reputational intermediaries who provide verification and certification services to inves-tors’’ e J. C. Coffee, Understanding Enron: ‘‘It’s about the gatekeepers, stupid’’, Business Lawyer57(August), 1403e1420, (2002) Besides auditors, examples of gatekeepers are analysts, lawyers and invest-ment bankers. The phrase ‘‘reputational intermediaries’’ refers to the assumption that gatekeepers are un-likely to assist companies in committing fraud, because the potential damage to their reputations willoutweigh the fees they may receive.

12. C. K. Prahalad and R. A. Bettis, The dominant logic: a new linkage between diversity and performance,Strategic Management Journal 7, 485e501 (1986); R. A. Bettis and C. K. Prahalad, The dominant logic:retrospective and extension, Strategic Management Journal 16, 5e14 (1995).

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15. Gramling, op. cit.; J. M. Franzel, Securities Exchange Act: review of reporting under section 10A, GeneralAccounting Office (GAO), Washington, DC, (2003) Available at:http://www.gao.gov/new.items/d03982r.pdf (2003).

16. E.g., J.-S. Lim and J. Kim, Impact of consumers’ confidence in judgements about missing information onproduct evaluations, Journal of Business Research 25(3), 215e229 (1992).


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18. B. Kellerman, When should a leader apologize and when not?, Harvard Business Review 84(4), 72e81(2006).

19. Royal Dutch Petroleum Co (Shell) Conference Call ‘‘Recategorisation of proved hydrocarbon reserves’’,Fair Disclosure Wire, March 18, 2004.

20. Q1 2003 Qwest Communications Earnings Conference Call, Fair Disclosure Wire, May 29, 2003.21. Royal Dutch Petroleum Co (Shell) Conference Call ‘‘Advance Advice to Annual Report Publication’’, Fair

Disclosure Wire May 24, 2004; see also A. Felsted and C. Harris, Shell restates reserves of oil and gas forthe fourth time this year, Financial Times (May 25 2004).

22. Q4 2002 Royal Ahold Earnings Conference Call, Fair Disclosure Wire, February 24, 2003.23. D. B. Farber, Restoring trust after fraud: does corporate governance matter? Accounting Review 80(2),

539e561 (2005); R. C. Anderson, S. A. Mansi and D. M. Reeb, Board characteristics, accounting reportintegrity, and the cost of debt, Journal of Accounting and Economics 37, 315e342 (2004).

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(2004); OFHEO, Report of the special examination of Freddie Mac, Office of Federal Housing EnterpriseOversight, Washington, DC, (2003) Available at:http://www.ofheo.gov/News.asp?FormMode¼Search&;NewsType¼1&ID¼168 (2003).

29. FRE, Internal Investigation Reveals Widespread Accounting, Control, and Disclosure Weaknesses; Trou-bling Excerpts Below, Prudential analyst report, July 23, (2003) Thomson One Analytics.See also Yurdayand Duffie, op. cit. OFHEO, op. cit.

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42. Unless indicated otherwise, the source of all definitions isin R. Hussey (ed.), A Dictionary of Accounting,Oxford University Press, (1999) available at:http://www.oxfordreference.com (1999).

43. Wikepedia, available at: http://en.wikipedia.org/wiki.

BiographiesFred H. M. Gertsen has been a partner with PricewaterhouseCoopers in the Netherlands for 18 years specialising in

assurance services to the Financial Services industry. He is Register accountant at the Dutch Institute and received

a Master’s of Professional Accounting from the University of Miami. His current research towards a PhD at

Erasmus University, Rotterdam concentrates on senior executives’ behaviour in connection with Financial State-

ment Restatements. He has lectured on topics such as Treasury and Risk Management, Banking, Hedge Funds and

complex financial instruments. [email protected]

Cees B. M. van Riel is Professor of Corporate Communication at the Rotterdam School of Management, Erasmus

University. He has published his research, which deals with organisational identity, reputation management and

corporate branding, in several international books, as well as in major academic journals such as the Academy of

Management Journal, Journal of Marketing and Journal of Management Studies. [email protected]

Guido Berens is Assistant Professor of Corporate Communication at the Rotterdam School of Management, Eras-

mus University. His research interests include corporate branding, corporate social responsibility and reputation

management. His research has been published in the Journal of Marketing and the Corporate Reputation Review, and

as chapters in several international books. [email protected]


http://www.oxfordreference.com/

http://en.wikipedia.org/wiki

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Avoiding Reputation Damage in Financial Restatements

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