Businesses may reissue their financial statements for several reasons. Management might have misinterpreted the accounting standards, requiring the company’s external accountant to adjust the numbers. Or they simply may have made mistakes and need to correct them. But a financial restatement also can be a sign of incompetence — or even fraud. Lenders should examine financial restatements closely to accurately evaluate their borrowers’ situations.
When Alice took over her mother’s public relations company, her lender quickly discovered that Alice’s accounting skills hadn’t kept pace with her consulting abilities. The company engaged in various types of related-party transactions, including seller financing and a leasing arrangement with the previous owner. Alice also seemed unsure when to capitalize or expense supplies and equipment.
After two years of sloppy, delayed financial reporting, Alice’s lender recommended hiring an accountant for financial reporting and tax expertise. Shortly thereafter, the lender received an unwelcome surprise: The company needed to reissue its financial statements for the past three years.
Ultimately, the restatements revealed that Alice had overstated profits by more than $2 million over the last three years. When confronted with the news, she confessed that she’d been intentionally padding profits, because she didn’t want to disappoint her mother.
The lender called the company’s $3 million line of credit. So Alice was forced to confess her mismanagement to her mother, who eventually left retirement to turn around the business.
Consider the reasons
Not all restatements result from misleading or unethical management. Often owners and managers just aren’t on top of today’s increasingly complex accounting rules — and honest mistakes or misinterpretations cause a restatement.
Restatements typically occur when the company’s financial statements are subjected to a higher level of scrutiny. For example, restatements may occur when a borrower converts from compiled financial statements to audited financial statements or decides to file for an initial public offering. They also may be needed when the borrower brings in additional internal (or external) accounting expertise, such as a new controller or audit firm.
The restatement process can be time consuming and costly. Regular communication with interested parties — including lenders and shareholders — can help overcome the negative stigma associated with restatements. Management also needs to reassure employees, customers and suppliers that the company is in sound financial shape to ensure their continued support.
Look at the risk
Recognition errors are one of the most common causes of financial restatements, according to a report from proxy research firm Glass, Lewis & Co. Borrowers typically make these mistakes when accounting for leases or reporting compensation expense from backdated stock options.
Income statement and balance sheet misclassifications also cause a large number of restatements. For instance, a borrower may need to shift cash flows between investing, financing and operating on the statement of cash flows. Other leading causes of restatements are:
- Equity transaction errors, such as improper accounting for business combinations and convertible securities,
- Valuation errors related to common stock issuances, and
- Preferred stock errors and the complex rules related to acquisitions, investments, revenue recognition and tax accounting.
You can minimize your dependence on bad numbers by requiring independent audits for private borrowers. You also may request cost-effective internal control testing procedures for prospective and high-risk borrowers, such as those that engage in hedge accounting, issue stock options, use special purpose or variable interest entities, or consolidate financial statements with related parties.
Restatements aren’t always bad news. It’s important to consider the possible reasons for financial restatement in order to properly evaluate and determine whether the restatements are potentially fraudulent. Of course, if you find that a borrower is engaging in unethical practices, it may be necessary to cut ties with that company. On the other hand, showing understanding for a borrower that is simply correcting a mistake can lead to an excellent long-term relationship.