How Problematic is a Financial Restatement?

“On August 12, 2014, the Board of Directors and the Audit Committee of the Board of Directors of Ocwen Financial Corporation, after consultation with Deloitte & Touche LLP, the Company’s independent registered public accounting firm, determined that the Company’s financial statements for the fiscal year ended December 31, 2013 and the quarter ended March 31, 2014 can no longer be relied upon as being in compliance with generally accepted accounting principles.”  (8/12/2014, Securities and Exchange Commission, Ocwen Financial Form 8-k)

As the auditor for Ocwen, it is the responsibility of Deloitte to identify material misstatements.  As required by Auditing Standard No.12, “The objective of the auditor is to identify and appropriately assess the risks of material misstatement, thereby providing a basis for designing and implementing responses to the risks of material misstatement.”

At this point it is unclear whether the Ocwen material misstatement is due to an error in the application of accounting guidelines; or due to fraud.  The top accounting reasons for financial restatements include  – debt and securities issues; expense recording; reserves and accrual estimates; executive compensation; revenue recognition; and, inventory.  While the most probable fraud committed is the management of earnings to mislead investors.  But neither option is very positive for a company to admit.

Regardless of the accounting reason, a financial restatement shakes the confidence of investors, credit institutions and potentially customers/clients.  Regulatory scrutiny may increase and your ability to grow constrained.  As the actual impact to earnings is directly related to the issue, an average cost to restate cannot easily be projected.

In this situation, in response to the announcement – The Ocwen share price fell 4.5% the day of the announcement, to $25.16; Block & Leviton LLP announced that it was investigating the company and certain officers and directors to determine if anyone profited from the alleged accounting errors; The Rosen Law Firm announced the filing of a “Securities Class Action” against Ocwen Financial Corporation; The SEC subpoenaed records from Ocwen regarding its dealings with sister companies; and, S&P lowered its outlook on Ocwen Financial to negative.

Unfortunately, this situation with Ocwen is not uncommon.    According to research performed by the Center for Audit Quality, from 2003 through 2012, 10,479 entities required restatements, i.e. SEC 8-K filings.  For this 10 year period, restatement counts ranged from a high of 1,784 in 2006 to a low of 711 in 2009; averaging 1,048 per year.

So what can a company due to avoid this situation – Seek guidance from an Accounting professional on the proper application of GAAP, for your situation; Remove the opportunity for fraud to be committedMaintain a strong Internal Control environment including a Segregation of Duty Analysis; Implement conservative policies and procedures and reduce the manual intervention which causes errors; and, Ensure an ethical environment, but maintain a Whistleblower program.

As the SEC continues with the implementation of the JOBS Act, one can only wonder about the frequency of material misstatements, requiring financial restatements with small and medium-sized non-public entities.

SEC Press Release – January 20, 2016 – “The Securities and Exchange Commission today announced that Ocwen Financial Corp. has agreed to settle charges that it misstated financial results by using a flawed, undisclosed methodology to value complex mortgage assets.  Ocwen agreed to pay a $2 million penalty after an SEC investigation found that the company inaccurately disclosed to investors that it independently valued these assets at fair value under U.S. Generally Accepted Accounting Principles (GAAP).”

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

Audit Transparency – Rating the Raters

On May 1, 2012, the Public Company Accounting Oversight Board (PCAOB) announced changes to its website (www.pcaobus.org) where site visitors can now review certain public information provided by audit firms, which includes registration, annual and special reporting, disciplinary proceedings and inspection reports.

The PCAOB was created in 2002 as a result of the Sarbanes-Oxley Act.  As required by the act, auditors of US public companies are subject to external and independent oversight, by the PCAOB.  The SEC maintains authority over the PCAOB, with respect to rules, standards and budgets.

As of April 25, 2012, there were 2,378 registered firms (foreign and domestic), as well as 42 pending applications.  As of May 7, 2012, information for 1,627 inspection reports was provided, including 118 “QC criticisms now public.”  A quick review of the Big 4 Audit firms showed –

Firm Entity Reports QC Criticisms
Deloitte & Touche 18 1
Ernst & Young 30 0
PriceWaterhouse 32 0
KPMG 35 0

This type of information can only benefit companies/issuers that are looking for a new auditor for their private or public concern.

Please let me know how useful this information was to you, by Commenting.

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

The Evolution of the Audit Process

By this time, your annual audit is either complete or winding down.  You have documented the auditor’s requests and considered how you could make the process easier next year.  You may have had your exit discussion and are in the process of considering how and when to implement any suggested process improvements.  In year’s past, that was it, until you received your engagement letter next November/December.

But this year may be different.  One change being discussed may alter the process, in the next twelve months –

In August 2011, the Public Company Accounting Oversight Board (http://pcaobus.org) released for comment PCAOB Release No. 2011-006, which proposed an audit FIRM rotation.  PCAOB questions how objective an auditing firm could be if the audit firm and the client have had a long-standing relationship.

As of March 24, 636 letters were received, i.e. some for the proposal and some against.  The comment period will stay open until April 22, 2012.

This proposal represents a more stringent requirement than the one imposed by the Sarbanes-Oxley Act (2002).  As a way to ensure independence and objectivity of audit firms, Sarbox requires senior managing audit PARTNER rotation every five years.

The primary objection, for those that oppose the PCAOB proposal, are that as you shorten the time of engagement, you lose the expected efficiencies and cost savings associated with a long-standing relationship.

According to a study entitled “Audit Partner Rotation: An Analysis of Benefits and Costs” audit partners reported that it required two-to-three years before client familiarity was established.  Based on this research, audit clients only receive the benefits of an established audit relationship for two years, prior to a partner rotation.  At this early stage, Firm Rotation research is spotty.

Even though these actions technically are imposed only on public companies, it would be prudent for a CFO to take note.  Quickly when business methods are adopted and accepted by key stakeholders, they have a way of becoming a “Best Practice,” i.e. a business requirement that is expected, but not legally based.

What is your experience?

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.