The Speculator
Some companies deserve a 'do-over'
Earnings restatements preceded several high-profile collapses in recent years, the reason shareholders often punish these admissions. But we've found that when they do it over, some companies get it right.
By Victor Niederhoffer and Laurel Kenner

If I have a single goal in my career, it’s never to make an earnings restatement.
-- Kris Chellam, chief financial officer, Xilinx

Scene: The Spec Duo at work, barely visible behind flickering computer monitors and stacks of earnings restatements, computer spreadsheets, federal indictments of various corporations and a 262-page General Accounting Office report.

Vic: Laurel, despite all the scandals over earnings misstatements, despite the complete erosion of trust, hundreds of companies out there still insist on taking back their last statements. Just the other day, Parametric Technology (PMTC, news, msgs) restated earnings. On the last day of 2002, Ariba (ARBA, news, msgs) bit the bullet. Xerox (XRX, news, msgs) restated -- again -- the day before Christmas. Right before that, it was Allegheny Energy (AYE, news, msgs), Restoration Hardware (RSTO, news, msgs) and Cole National (CNJ, news, msgs). Each time, the companies put these restatements in the most favorable terms, as if we are all a bunch of jerks.

Laurel: But Vic, stay young-hearted. Shouldn’t you be looking to the future? Aren’t we more interested in what the shares do after the fall? Are the shares ready to rise or plummet? Put some statistics on the table.

More misstatements
If there’s a common thread to all the revelations of accounting errors, corporate fraud, criminal inquiries, phony sales, financial shenanigans and aggressive, irregular or questionable accounting, it’s the restated earnings report. Almost every major financial disaster of the last few years -- Adelphia Communications (ADELQ, news, msgs), Dynegy (DYN, news, msgs), Enron (ENRNQ, news, msgs), Global Crossing (GBLXQ, news, msgs), Lucent Technologies (LU, news, msgs), MicroStrategy (MSTR, news, msgs), Rite Aid (RAD, news, msgs), Sunbeam (now American Household (SOCNQ, news, msgs)), WorldCom Group (WCOEQ, news, msgs) -- has been preceded or precipitated by a restatement.

It’s not just our imagination -- corporate restatements are becoming much more common. According to General Accounting Office estimates, the number of companies restating earnings tripled from just under 1% in 1997 to 3% in 2002, on an annual basis. Over the last six years, 10% of all public companies -- 919 in total -- have restated earnings.

The resulting loss in market capitalization on the day of the announcement and on the day after totals more than $100 billion. But those losses are the tip of the iceberg. Consequences can include shareholder lawsuits and even bankruptcy. A Price Waterhouse study found that 50% of all corporate fraud actions stem from earnings restatements. Often, the company’s shares already have registered huge declines before the announcement, and the restatement triggers declines in companies in similar industries on fears that questionable accounting was widespread. (Restatements resulting in higher earnings are rare as the rhinoceros.)

We report surprising findings below on what actually happens to a company’s performance after it takes its medicine and reports the bad results, or warns that it will be doing so. First, we’ll delve into related situations in other areas of human endeavor, and list some of the entertaining explanations for restatements we found in our research.

Play it again
Childhood games prepare us for most of the activities and contests we will face later in life. Everybody who played games as a child is familiar with the “do over” allowed when something like a passing car or policeman or thrown water bottle affects the point you just lost. You just call out, “Do over,” and if the opponent isn’t big enough to beat you up, you get another chance.

In hardball squash, the sport where Vic was world champion, it was almost impossible to correctly call hard overhead serves in or out. Decisions could be appealed, but only after the play was over. Many players hit the hard serve, played the point out and then, if they lost, appealed the call on the serve. The comparable replay in board games is, “Can I take that move back?” In friendly games, the request is often granted, and the only harm is to your reputation for sportsmanship.

The classic example in the chess world was Milan Matulovic, who made a move after his opponent momentarily left the board, wrote the move down and then, seeing it would lead to disaster, put the piece back and erased the report. Unfortunately for him, many spectators saw his transgression. The play was allowed to stand, but he was known ever after as “J’adoubovic,” a play on the chess parlance for “I adjust.”

“Do overs” are forbidden in most tournaments and, if implemented, would lead to immediate disqualification. In the corporate world, some executives and accounting firms don’t seem to take the situation quite as seriously. The GAO, reviewing the subject for Congress last October, found 919 cases of earnings restatements from 1997 through mid-2002. Multifarious explanations were given as the primary reason; the most frequent culprit was improper revenue recognition (38%), followed by expense-related issues (16%) and “other” (15%), a category encompassing a palette of peccadilloes related to wishful thinking on bad loans. Related-party transactions (3%) included the special-purpose entities made famous by the Enron accounting scandal.

(About 9% were blamed on restructuring, asset and inventory issues, 6% on acquisition and merger charges, 5% each to securities-related and reclassification issues, and 3% to in-progress research and development issues.)

In some cases, the revenue-recognition issues were massive. As part of an April 2002 settlement with the SEC, Xerox reversed $1.9 billion of equipment-lease revenue booked from 1997 through 2000.

But who's next?
The $64,000 question is how to figure out which companies are likely to restate. A paper titled “The Effectiveness of Blue-Ribbon Committee Investigations in Mitigating Financial Restatements: An Empirical Study,” by Lawrence J. Abbott, Susan Parker and Gary Peters, contains a highly suggestive idea. Companies with independent audit committees -- i.e., no executive members -- that meet more than twice a year are the least likely to restate.

Extensions might include classifying companies by price change in the days leading up to announcements, or by reason given. Trader/researcher James Altucher suggested that clues might lie in differences between IRS reported income and GAAP income resulting from depreciation methods. “Almost every funky method of depreciation should and often does raise eyebrows at the SEC. Hopefully, I can get there first.”

Gaylen Larson, a former Financial Accounting Standards Board member in Austin, Texas, says that’s a long shot, because the government allows accelerated depreciation. He advises watching out for companies in cyclical industries that nevertheless report steadily increasing earnings and always meet analyst expectations.

The payoff for finding out which company is about to announce a restatement could be big, as shareholders have little patience for most of the explanations.

• Carreker (CANIE, news, msgs), a consulting and software company, said Dec. 10 it might shift some revenue between quarters because it had been accommodating “the mechanics of delivery from our global operations” by letting end-of-quarter contracts be delivered to the legal department the next day. Carreker shares fell 23% on this explanation, doubling the loss over the previous five days. On Dec. 24, Carreker was delisted from Nasdaq over another timing issue: missing the deadline for filing restated financials.
• Restoration Hardware blamed its third restatement of 2002 on errors discovered in its “effort to upgrade accounting systems and personnel.” The stock dropped 12% that day after losing 13% on the previous day -- even though the errors were in the company’s favor.
• The last restatement of 2002 employed a nuanced distinction. Ariba said Jan. 31 that a $10 million out-of-pocket payment from the chairman to the president hadn’t been recorded as a cost because the payment was viewed as “a personal transaction.” The shares fell 5%.

Then there’s the Arthur Andersen defense, named after the once-respected accounting firm brought down by Enron’s collapse. American HomePatient (AHOM, news, msgs) used this in its Dec. 5 restatement: “Management previously believed that the Company's method of recording these fees was appropriate, and Andersen concurred with management's accounting treatment of the fees.” American HomePatient dropped 14% that day, and lost 8% more when it started trading again 10 days later.

Kudos and eligibility for the Spec Duo’s Do Over Award go to Parametric Technology’s explanation to Bloomberg News of why it restated $20 million in sales: “The mistake was discovered after Parametric installed Oracle (ORCL, news, msgs) software that better calculates when to recognize maintenance contract revenue.”

However, the winner of the Spec Duo Do Over Award is WorldCom by a clear margin. After the company disclosed in June 2002 that it hid $3.9 billion in costs, Chief Executive Officer John Sidgmore said: “It was this company that audited our auditors . . . it was this company that turned itself in.” Because Arthur Andersen was WorldCom’s former auditor, this combined in one stroke the Andersen and holier-than-thou defenses.

Life after restatement
Who ya gonna call when the time comes to put pencil to paper, to examine the performance of companies after they restate? The Spec Duo, of course. We took every company that announced a restatement from March 25, 2002, to the present -- 69 in all -- and compared their performance with that of the S&P 500 ($INX) from the day after the announcement to the end of the year.

Guess what? The restatement companies did much better than the S&P 500. On average, they rose 12% from the day after the restatement to the end of the year, compared to the S&P 500’s drop of 6% (we averaged the index’s performance in each of the 69 relevant periods.) Gainers included BroadVision (BVSN, news, msgs), up 132%; Edison Schools (EDSN, news, msgs), up 206%; Firepond (FIRE, news, msgs), up 565%; Gerber Scientific (GRB, news, msgs), up 117%; Pacific Continental (PCBK, news, msgs), up 324%; Qwest Communications International (Q, news, msgs), up 159%; and WorldCom, up 130%.

A net gain of 18 percentage points against the market might seem pretty good, especially considering that the average holding period was only five months. But before you call your broker -- or decide to hold on to that company that just announced a restatement -- note that the variability in these results was 12 times as great as for the S&P 500 during comparable periods. Furthermore, a handful of stocks selling for less than $1 on the day after the restatement accounted for most of the superior performance. Taking the below-$1 stocks out, the restatement companies fell 4% through year-end versus down 6% for the S&P 500.

Keep in mind, too, that stocks below a buck are high bid-asked, high-commission affairs and certainly vulnerable to bankruptcy and other risks.

Nevertheless, our results show that revisions aren’t all bad. Once they do it over, some of these companies rejoin the living.

Final note
We thank Shi Zhang for data collection and analysis for this column. The list was constructed from data on Bloomberg and Google. Our after-thoughts on these companies are available on our Web site. For those who communicate with us by email at gbuch@bloomberg.net with criticisms, augmentations or congratulations, we have a complete list of all 69 companies, with performance and much more. Also available on our Web site: two beauties on fishing and markets from two vice chairmen of the Old Speculators’ Club, and a stock tip on Texas Genco Holdings from our friend the Jackal, the smartest scavenger we know. We answer all our e-mail, and encourage you to communicate with us so we can learn together and transmit your wisdom to our loyal readers.

At the time of publication, neither Victor Niederhoffer nor Laurel Kenner owned or controlled shares of any of the stocks mentioned in this column.