plumlee & yohn_2010_an analysis of the underlying causes of attributed to restatements

8/10/2019 Plumlee & Yohn_2010_An Analysis of the Underlying Causes of Attributed to Restatements

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An Analysis of the Underlying CausesAttributed to Restatements

Marlene Plumlee and Teri Lombardi Yohn

SYNOPSIS: The dramatic increase in the number of restatements led over the pastyears has been attributed to numerous causes, including the complexity of the account-ing standards, internal control reviews, changes in materiality thresholds, the overlyconservative nature of auditors, earnings management, increased transaction complex-ity, and the second-guessing of management judgments by a variety of interested par-ties. However, empirical evidence on the underlying causes of restatements has beenlacking. This study provides such evidence by directly addressing these questions: 1To what causes do companies attribute restatements? 2 To what characteristics of theaccounting standards do companies attribute restatements? Relying on the restatingcompanies disclosures about restatements, we nd that companies most often at-tribute restatements to basic internal company errors unrelated to any specic charac-teristic of the accounting standards. We also nd that, for those restatements attributedto some characteristic of the accounting standards, the primary contributing factor is thelack of clarity in applying the standards and/or the proliferation of the literature becausethe original standard lacked clarity. These ndings should interest standard setters andregulators addressing the proliferation of restatements and academics using restate-ments as proxies for constructs of interest in research.

Keywords: restatement; restatement causes; accounting standards; accounting com-plexity .

Data Availability: The data are available from public sources.

JEL Classications: K22; M41; M43; M49 .

INTRODUCTION

A ccounting restatements have been led at record levels in the past few years: Glass Lewis& Co. 2006 documents that 1,538 restatements were led in 2006, more than three timesthe 475 restatements led in 2003. Although the rapid increase in the number of restate-ments led in the United States is apparent, a signicant debate remains regarding the underlying

Marlene Plumlee is an Associate Professor at The University of Utah, and Teri Lombardi Yohn is an Associate Professor at Indiana University.

The authors have greatly beneted from discussions with SEC staff, especially Scott Taub, and senior auditing staff fromBig 4 and other audit rms, in designing and implementing the research design in this study. We appreciate the helpfulcomments of workshop participants at the University of CaliforniaBerkeley and the University of Michigans HarveyKapnick Accounting Conference. Marlene Plumlee and Teri Lombardi Yohn acknowledge the generous support of theDavid Eccles Faculty Fellowship and the PricewaterhouseCoopers Fellowship, respectively.

Accounting Horizons American Accounting AssociationVol. 24, No. 1 DOI: 10.2308/acch.2010.24.1.412010 pp. 4164

Submitted: December 2008 Accepted: September 2009

Published Online: March 2010Corresponding author: Marlene Plumlee

Email: [email protected]


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cause of this increase. Various groups have posited plausible reasons for restatements, includingaccounting complexity, second-guessing of management judgment, proliferation of accountingrules and implementation guidance, application of the Sarbanes-Oxley Act of 2002 SOX Section404 requirements, transaction complexity, and earnings management. The various constituentshave also suggested specic measures that could be taken to reduce restatements based on thecauses suggested. However, measures proposed to curtail restatements based on one suggestedcause may contradict measures proposed based on another suggested cause. This conict high-lights the necessity for rst understanding the underlying cause of restatements before implement-ing measures to curtail them. To date, as the Advisory Committee on Improvements to FinancialReporting SEC 2008 noted, denitive evidence on the drivers of restatements is lacking.

In this study, we analyze disclosures surrounding restatements led from 2003 to 2006 toprovide empirical evidence of the restating companies explanations of the underlying cause of restatements. Relying on these disclosures, we classify each restatement as having been attributedto one of the following four causes: 1 an internal company error; 2 intentional manipulation;3 transaction complexity; or 4 some characteristic of the accounting standards. For restate-

ments attributed to some characteristic of the accounting standards, we also consider whether thecompanies disclosures suggest that the restatement is most consistent with either 1 a lack of clarity in the standard and/or the proliferations of the accounting literature because of the lack of clarity in the original standard; 2 the use of judgment in applying the standard; or 3 themisapplication of detailed and complex rules. While restating companies may have strategicincentives regarding how they disclose restatements, we argue that these disclosures are informa-tive and that classifying the restatements based on an analysis of those disclosures improves ourunderstanding of the underlying causes of restatements and of the attributes of accounting stan-dards that might contribute to them.

For a subset of our sample, we calculate the net income effect of the restatement to betterunderstand whether materiality levels related to restatements have become more conservative overtime and to compare with prior research. Finally, we examine whether a companys reporting of amaterial internal control weakness relates to the underlying cause of the restatement identied.

We document that the majority of restatements 57 percent led from 2003 to 2006 are

attributed to internal company errors, inconsistent with the conventional wisdom that the com-plexity of the accounting standards drives most restatements. The second most commonly attrib-uted cause of restatements led during the four-year period is some characteristic of the account-ing standards 37 percent . Of those restatements, 58 percent are related to a lack of clarity in thestandard, and 37 percent are related to the use of judgment in applying the standard. Overall, wedocument that the mean net income effect of restatements is negative 0.013 , although a sig-nicant number of restatements have no net income effect 26 percent . The proportion of restate-ments for which the absolute net income effect is greater than 5 percent of total assets decreasedover the four-year period, consistent with a change in the quantitative materiality threshold acrosstime. Finally, we nd that only 66 percent of the restatements attributed to manipulation and 44percent attributed to internal errors are from companies that report material internal control weak-nesses. This suggests deciencies in the implementation of SOX internal control weakness attes-tation and reporting requirements.

Our results provide insights to regulators and standard setters regarding the causes to whichcompanies attribute restatements, which might aid in designing and implementing initiatives toreduce the number of restatements. In addition, our nding that companies frequently attributerestatements to an internal company error is consistent with SOX reviews working as expected andsuggests the number of restatements will decline as improved controls are established. The nd-ings regarding restatements attributed to judgment in the standards are especially important toconsider as the United States moves toward convergence with International Financial Reporting

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Accounting Horizons March 2010American Accounting Association


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Standards, which are often considered more principles-based and reliant on judgment. Finally, thending of inconsistencies between restatement lings attributed to basic internal company errorsand manipulation and reported material internal control weaknesses suggests a need to addressissues related to improving the attestation of internal controls and the reporting of material weak-nesses.

Our results are also useful to academic research that employs restatements. Researchers maybenet by identifying a subset of restatements based on the attributed underlying cause that mostclosely relates to the construct of interest to ensure that the restatement sample is appropriate forthe research question. Prior academic research that examines restatements either does not distin-guish between different types of restatements or merely sorts restatements into unintentional errorsor intentional manipulations i.e., Hennes et al. 2008 ; Palmrose et al. 2004 . This study considersa broader range of causes and factors related to restatements, distinguishing between those attrib-uted to unintentional internal books and records deciencies, misapplications of accounting stan-dards because of their specic characteristics, transaction complexity, and intentional errors. Thestudy also identies the characteristics of accounting standards that companies attribute to restate-ments. This classication provides important insights relative to prior research that primarilyfocuses on whether the restatement can be classied as intentional or unintentional.

The remainder of this study is organized as follows. First, we provide background informationabout restatements and their suggested causes as motivation for our study. We then detail our datacollection and classication process and provide descriptive statistics regarding restatement causesand contributing factors. In the next section we report the empirical ndings related to the netincome effect and the reporting of material internal control weaknesses. We end with a summaryof the ndings and some general conclusions.

BACKGROUND AND MOTIVATIONClearly, the number of restatements led within the United States between 2003 and 2006

increased, but the cause of this increase continues to be debated. The U.S. Chamber of Commerce,

the Securities and Exchange Commission SEC , and the Financial Accounting Standards BoardFASB have each identied accounting complexity as a formidable problem; some argue that thiscomplexity is a primary driver of restatements Ciesielski and Weirich 2006 . In response to thisconcern, the SEC formed the Advisory Committee on Improving Financial Reporting ACIFRwhose aim is to reduce the complexity of nancial reporting. The ACIFR has outlined plans tomove toward more principles-based standards. They and many others argue that rules-based stan-dards, with their array of confusing bright lines and exceptions, lead to accounting restatements,and suggest that moving to principles-based standards will decrease complexity and help reducethe number of restatements. However, others contend that restatements are driven by auditors andregulators unforeseeable reinterpretations of management judgments Pozen 2007 . They arguethat the move toward more principles-based standards, with an increased reliance on management judgment, has increased the number of restatements as auditors and regulators second-guess those

judgments.Another reason stated for the increased number of restatements is the sheer volume of ac-counting standards. Dzinkowski 2007 and others suggest that companies struggle to nd theparagraphs that apply to the transaction of interest as they sift through the thousands of pages of accounting standards. In addition, they argue that the SEC and FASB periodically change theinterpretation of the standards and that the changes are episodically announced through speeches,Staff Accounting Bulletins, and other outlets without any advanced notice or public comment

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Pozen 2007 , 2 .1 In response to these concerns, the FASB has codied the accounting standardsto allow for logical and expeditious access to the rules related to a specic topic and has workedto limit the guidance issued for standards.

Still others attribute the recent increase in restatements to the implementation of SOX Section404 internal control reviews, which has uncovered past errors, as expected. In contrast, some claimthat the creation of the Public Company Accounting Oversight Board PCAOB has caused audi-tors to act too conservatively, requiring restatements for technical corrections with dubious ma-teriality Pozen 2007 . They argue that auditors went from an anything goes perspective in thelate 1990s to an extremely conservative perspective after the collapse of Arthur Andersen Taub2005 . To address this issue, the FASB, SEC, and PCAOB encourage a communicative relation-ship between auditors and companies managers.

Increasingly complex business transactions without a corresponding change in nancial re-porting have also been mentioned as a reason for increased restatements Dzinkowski 2007 .Finally, some argue that the increase is because of the rise in earnings management and compa-nies focus on meeting or beating earnings benchmarks. This, in turn, causes companies to mis-apply generally accepted accounting principles to meet earnings targets that eventually have to be

restated once the earnings management is uncovered.Ultimately, numerous explanations are proposed for restatements and their dramatic increasein recent years; various parties e.g., FASB, SEC, and PCAOB have taken steps to address theconcerns based on these explanations. It is important, however, to distinguish among the proposedalternative explanations for accounting restatements using empirical evidence on the drivers of restatements to properly address the problem. Such evidence assists regulators and standard settersin focusing their efforts on initiatives that are more likely to curb the incidence of restatements.

Empirical evidence on restatement causes will benet academics as well, who have madeimplicit or explicit assumptions about the causes of restatements. Restatements have been used toproxy for earnings management Efendi et al. 2007 ; Lee et al. 2006; Desai, Krishnamurthy, andVenkataraman 2006 ; Desai, Hogan, and Wilkins 2006 , for accruals quality Doyle et al. 2007 , forinternal company errors from inexperienced nancial executives Aier et al. 2005 , and for poorcorporate governance Srinivasan 2005 . However, if restatements are not the appropriate proxyfor the underlying construct of interest, interpretations of the ndings from these studies may bemisleading. Evidence on restatement causes will therefore facilitate the use of restatements as aproxy for the appropriate construct in academic research.

Prior research highlights the importance of distinguishing between restatements that are in-tentional or unintentional. For example, Palmrose et al. 2004 and Hennes et al. 2008 sortrestatements into intentional and unintentional misstatements and document that the market reac-tion to restatements is signicantly greater for restatements classied as intentional relative tothose classied as unintentional. Hennes et al. 2008 also nd that sorting restatements into thesetwo groups increases the power of tests that rely on restatements as an indicator of deliberatemisreporting.

As the objective of our study differs from that of prior work, we contribute signicantly to theliterature and note many differences in the sample and the analysis. First, we examine a muchlarger sample of restatements and include restatements that are not announced via 8-K reports,whereas Hennes et al. 2008 and Palmrose et al. 2004 examine only publicly announced re-statements. Our sample includes 3,744 restatements from 2002 through 2006; Hennes et al. 2008

1 Examples include the lease accounting letter the SEC sent to the American Institute of Certied Public AccountantsAICPA stating the regulators stand on the accounting for leases and the investigation of Fannie Mae in which the

SECs stand on hedge accounting was made clear.

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examine a sample of 630 restatements from approximately the same period. Plumlee and Yohn2009 document that only approximately 67 percent of restatements were reported via an 8-K

report during 2002 through 2006, suggesting that relying on 8-K reports to identify restatementswill result in a much smaller sample of restatements with potentially very different characteristics.Second, Hennes et al. 2008 exclude restatements with no income effect almost one-fourth of oursample and eliminate observations where the investigation their indicator of intentional misstate-ment did not lead to a restatement. Finally, Hennes et al. 2008 employ only two categoriesunintentional errors and intentional irregularities , whereas we consider a broader group of cat-

egories. We consider manipulation as only one of the causes to which companies may attribute arestatement and are also interested in how the standards and the characteristics of the standardsrelate to the incidence of restatements.

DATA AND DESCRIPTIVE STATISTICSOur analysis includes restatements led in 2003, 2004, 2005, and 2006, compiled by Glass

Lewis & Co. The Glass Lewis & Co. data set includes restatements led to correct accountingerrors as dened by Accounting Principles Board Opinion No. 20; therefore, restatements are notincluded if they are because of a change in accounting principle, a change in estimate, the adoptionof a new stand ard, a change in the discussions of results, a minor wording change, or a typo-graphical error. 2

The original Glass Lewis & Co. data set includes 4,070 restatement lings. For each restate-ment, we analyzed the corporate disclosures and outside news sources surrounding the restatementto ascertain the underlying restatement cause. 3 If no information regarding a cause was avail-able, the restatement was excluded from the sample. When necessary, we gathered additionalinformation from other company lings and the accounting literature to classify the restatement.Each co-author independently analyzed each restatemen t, identied differences in classications,and reconciled them to arrive at the nal classications. 4 We consulted extensively with the staff in the Ofce of the Chief Accountant at the SEC and with senior audit managers at Big 4accounting rms for assistance in identifying the restatement cause and contributing factorclassications. Our nal sample includes 3,744 restatements led from 2003 through 2006.

We also employ what Glass Lewis & Co. labels the restatement type the accounting issueto which the restatement relates in our analysis. Glass Lewis & Co. identies a minimum of onerestatement type for each restatement ling; for 70 percent of the restatement lings a singlerestatement type is identied. When more than one restatement type is identied, we include onlythe primary type in our analysis.

2 This denition of an error includes a mathematical mistake, a mistake in applying generally accepted accountingprinciples, an oversight or misuse of facts that existed at the time the nancial statements were prepared, or a changefrom a nonaccepted accounting method to a generally accepted accounting principle.

3 We use company disclosures to ascertain the cause of the restatement primarily because the footnote disclosure is oftenthe only place the information about the restatement is available. The SEC audits and reviews footnote disclosures, andprior research suggests that companies are forthcoming about disclosing bad news Skinner 1994 , which lends cred-ibility to these disclosures. However, we do not make predictions about the strategic disclosure choices made by a

company or posit reasons for specic disclosure choices, leaving this to future research e.g., Plumlee and Yohn 2009 .We argue that classication from the restating companys perspective is interesting and informative in its own right.

4 Although the process of determining the four classication categories and the classication process itself is designed tobe objective, an inherently subjective part of the process exists. To mitigate this subjectivity, we 1 consulted withprofessionals, including senior audit managers and the staff at the SEC, to determine the four categories and contributingfactors; 2 established the categories and factors based on discussion with the professionals, analysis of over 100random disclosures, and reading of the prior literature related to restatements; and 3 employed two coders whoindependently categorized each disclosure. For about 2 percent of the restatements, the classications between the twocoders differed, requiring reconciliation.




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Restatement CausesFor each restatement ling, we classify the underlying cause to which the company attributes

the restatement into one of four categories: an internal company error INTERNAL ERROR , anintentional manipulation MANIPULATION , transaction complexity COMPLEXITY , or somecharacteristic of the accounting standards STANDARD . A restatement is classied as beingcaused by INTERNAL ERROR if the disclosures suggest that the error was because of a books orrecords deciency or a simple misapplication of an accounting standard, and the company dis-closures include no discussion that suggests these errors were intentional or because of any notablecharacteristic of the accounting standard or the transaction. A restatement is classied as beingcaused by MANIPULATION if the disclosures suggest that earnings manipulation was involved, if there is an SEC enforcement action or shareholder class action lawsuit related to the restatement,or if any news articles suggest that the restatement was associated with earnings manipulation.Essentially, if at the time of the restatement some public suggestion indicates that the error wasintentional, it is classied as such. A restatement is classied as being caused by COMPLEXITY if the disclosures suggest that the transaction itself created difculties in the accounting that causedthe error. Finally, a restatement is classied as being caused by a STANDARD if the disclosures

suggest that the error was caused by a misapplication of an accounting standard and some factorrelated to the accounting standard contributed to the restatement.Table 1 provides descriptive statistics on the cause classications. Panel A includes the num-

ber of restatemen ts on an annual basis along with the proportion of those restatements by eachrestatement cause. 5 We document that, overall, 57 percent of the restatements are attributed to an INTERNAL ERROR; most of restatements are attributed to books and records deciencies andsimple misapplications of generally accepted accounting principles. In addition, more than half of the restatements in each of the four years examined are attributed to this cause. STANDARD is thesecond most commonly attributed cause. In each year and across the sample as a whole, disclo-sures suggest that r estatements are attributed to MANIPULATION and COMPLEXITY less than 8percent of the time. 6

Panel B of Table 1 begins with the number of restatements by restatement cause and thendetails the percentage of restatements by cause and type. Restatements attributed to INTERNAL

ERROR are signicantly more likely to be associated with Expense, Inventory, Liability/ Contingency, Misclassication, or Tax issues, while restatements attributed to MANIPULATION are signicantly more likely to be associated with Reserve/Allowance or Revenue Recognitionissues. Restatements attributed to COMPLEXITY are signicantly more likely to be related toEquity, OCI , or Acquisition/Investment issues; restatements attributed to STANDARD are signi-cantly more likely to be Equity, OCI , or Capital Asset issues. Across the sample period as a whole,restatements are most frequently related to Expense 21 percent , Equity 19 percent , Misclassi-

5 We use a Fisher Exact Test because it provides a nonparametric test of whether the frequencies of two independentsamples differ signicantly across two mutually exclusive classes. In this case, we examine whether the frequency of restatements in not in the specied row category differs signicantly across restatements in not in the speciedcolumn category. Therefore, the Fisher Exact Test provides a test for each 2 2 contingency table.

6 We document fewer intentional or MANIPULATION- caused restatements than prior research. For example, Palmrose

et al. 2004 and Hennes et al. 2008 classify approximately 21 percent and 25 percent of their restatement sample asbeing intentional, respectively. We attribute these differences to the samples examined. Palmrose et al. 2004 examinerestatements during a period when restatements were less prevalent and when revenue recognition misstatementsrepresented a greater proportion of the restatements. Hennes et al. 2008 examine a much smaller sample of restate-ments that were announced via 8-K reports, eliminate restatements with no net income effect, and eliminate restatementsin which an investigation did not lead to a restatement. Consistent with our nding of fewer restatements classied as MANIPULATION than in prior research, we document that a large proportion of the restatements in our sample have nonet income effect and that the market reaction to restatements during our sample period is frequently not different fromzero.

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TABLE 1

Restatement Causes

Panel A: Restatement Causeby Year2003 2004 2005 20

# of Restatements 465 588 1,186 1,5% of Restatements

INTERNAL ERROR 56 62 52

MANIPULATION 4 4 3 COMPLEXITY 3 3 3

STANDARD 37 31 42

Panel B: Restatement Causeby Restatement Type

INTERNAL ERROR MANIPULATION COMPLEXITY STA# of Restatements 2,132 98 120 % of Restatements

Expense 24 23 12

Equity 11 2 28

Inventory 3 4 0

Liability/Contingency 4 1 3 Misclassication 20 2 8

OCI 3 0 9

Reserve/Allowance 1 9 1 Revenue Recognition 11 53 6

Tax 8 0 0

Acquisition/Investment 7 0 23

Capital Assets 4 1 6

Other 5 4 6

A c c o u n t i n gH or i z o n s

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, , and , , and reect that the percentage for the cause for the particular year/cause category is signicantly greater less than thecategories at the 1 percent, 5 percent, and 10 percent signicance levels, respectively, using a Fishers Exact Test.Restatement Cause is classied as an:

INTERNAL ERROR if the disclosures indicate that the restatement was caused by a company error; MANIPULATION if the disclosures indicate that the restatement was caused by an intentional manipulation;COMPLEXITY if the disclosures indicate that the restatement was caused by the complexity of the transaction; andSTANDARD if the disclosures indicate that the restatement was caused by some characteristics of the accounting standards.

Restatement Type refers to the restatement classication by Glass Lewis & Co. based on the accounting issue to which the restatement relates.


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cation 16 percent , and Revenue Recognition 10 percent . In additional untabulated results, wend an increase decrease across the four-year period in the percentage of restatements related toEquity, OCI , and Acquisition/Investment Expense, Reserves/Allowances, and Revenue Recogni-tion .

STANDARD RestatementContributing FactorsFor each restatement classied as STANDARD , we also identify a contributing factor based

on the restatement disclosures. Specically, we identify one of three possible contributing factors:1 lack of clarity in the standard and/or the proliferation of the literature because the original

standard lacks clarity CLARITY ; 2 the use of judgment in applying the standard JUDGMENT ;or 3 complications in applying detailed rules RULES .

In Table 2 we analyze the contributing factors related to the standards for the restatementsattributed to STANDARD 37 percent of our sample and 1,394 restatements . Within this set of restatements, CLARITY is the most common contributing factor, identied for 58 percent of therestatements. JUDGMENT is a contributing factor for 37 percent of the restatements, and RULES is a contributing factor for only 5 percent of the restatements. For the restatement sample as awhole

based on untabulated results , CLARITY

is a contributing factor for 21 percent of therestatements; JUDGMENT is a contributing factor for 14 percent of the restatements; and RULES is a contributing factor for just under 2 percent of the restatements.

We document that companies consider JUDGMENT to be a contributing factor for signi-cantly fewer restatements and CLARITY to be a contributing factor for signicantly more restate-ments in 2005 and 2006 relative to the earlier years. 7 The increased incidence of restatementsattributed to RULES during 2005 can be directly traced to lease restatements as a result of theletter sent by the SEC to the AICPA, stating the regulators stand on the accounting for leases in2005. The decrease in restatements attributed to JUDGMENT across the sample period maysuggest that auditors and regulators have been more tolerant with respect to management judgmentover time, although it may also reect a change in managers use of judgment. The increase inrestatements attributed to CLARITY provides support for the notion that accounting complexity viaa lack of clarity in the standards or the proliferation of implementation guidance may have

increased over time.We also examine the relation between the contributing factor and the restatement type. Wend that restatements where judgment is considered a contributing factor are signicantly morelikely to be related to Inventory, Reserve/Allowance, Revenue Recognition, Tax, Acquisition/ Investment, and Capital Assets than other restatement types. CLARITY is more likely to be asso-ciated with Expense, Equity, and Liability/Contingency issues.

INCOME EFFECTS AND INTERNAL CONTROL WEAKNESSESNet Income Effect of Restatements

To address the stated concerns that companies have become more conservative in their deci-sions to restate, we examine changes in a materiality threshold based on the restatement netincome effect using hand-collected data from the restated lings. The net income effect EFFECT

is the difference between the restated net income and the originally reported net income, scaled bythe companys total assets prior to the restatement ling. We also calculate the absolute value of the net income effect scaled by total assets ABEFFECT .

7 Given the relatively short sample period four years we are not able to provide tests of the statistical signicance of thetime trends. Thus, although we discuss the trends in general terms throughout the paper, our inferences should beinterpreted with caution.




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TABLE 2

Restatements Caused by STANDARD

Panel A: Contributing Factorby Year2003 2004 2005 20

# of Restatements 168 183 514 52% of Restatements

JUDGMENT 60 54 30 3CLARITY 35 41 63 6 RULES 5 5 7

Panel B: Contributing Factorby Restatement Type

JUDGMENT CLARITY RULES

# of Restatements 516 808 70% of Restatements

Expense 5 26 12Equity 13 46 3

Inventory 3 0 0 Liability/Contingency 2 10 6

Misclassication 13 11 5

OCI 2 5 45

Reserve/Allowance 3 0 2 Revenue Recognition 16 4 3

Tax 16 0 0

Acquisition/Investment 10 4 5 Capital Assets 17 1 3 Other 2 1 17


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, , and , , and reect that the percentage for the cause for the particular year/factor category is signicantly greater less than thecategories at the 1 percent, 5 percent, and 10 percent signicance levels, respectively, using a Fishers Exact Test.All the restatements included in this analysis are classied as:

STANDARD the disclosures indicate that the restatement was caused by some characteristics of the accounting standards .Contributing factors are classied as: JUDGMENT if the disclosures indicate the use of judgment in applying the standard was a contributing factor;CLARITY if the disclosures indicate a lack of clarity and/or the proliferation of the literature was a contributing factor; and RULES if the disclosures indicate that difculty in applying cumbersome rules was a contributing factor.

See Table 1 for variable denitions.


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The results of our analysis are reported in Table 3. Panel A reports EFFECT by year for the1,306 restatement lings for which we have available data. 8 Overall, we document a signicantlynegative mean net income effect. However, this effect is driven by the rst year of our sampleperiod 2003 . Median values are never signicantly different from zero. Consistent with thisresult, we nd that ABEFFECT is signicantly greater in 2003 0.037 than in the other three yearsof our sample. We also document that the proportion of restatements with a net income effect thatexceeds 5 percent of total assets FIVE is signicantly higher in 2003 than in the other sampleyears; 17 percent of restatements led in 2003 resulted in an income effect that exceeded 5 percentof total assets. In contrast, only 10 percent of the restatements led in 2006 resulted in an incomeeffect that exceeded 5 percent of total assets. As a comparison with our nding of a meanrestatement income effect of 0.013, Palmrose et al. 2004 report a mean net income effect of

0.024 using restatements reported from 1995 to 1999. This is consistent with restatements ledin the more recent periods being less consequential, as the popular press suggests. These ndingsprovide limited support for the notion that quantitative materiality thresholds for restatements mayhave fallen over time. The materiality threshold may have decreased because of factors such asincreased auditor conservatism or the use of the iron curtain as well as the rollover method of determining materiality as required by Staff Accounting Bulletin SAB No. 108 in 2006. SeeKeune and Johnstone 2009 for an analysis of the impact of this SAB. Overall, we document that20 percent of the restatements result in an increase in net income POS ; 26 percent have no netincome effect ZERO ; and 54 percent of the restatements result in a decrease in net income NEG .9

In Panel B we report the net income effect by restatement cause. If misapplications of ac-counting standards and internal errors are unintentional, we expect restatements attributed toSTANDARDS , INTERNAL ERROR , and COMPLEXITY to be equally likely to have positive andnegative effects on income. On the other hand, if companies tend to manipulate earnings upward,then we expect restatements attributed to MANIPULATION to be more likely to have a negativeincome effect. Consistent with expectations, MANIPULATION restatements are signicantly morelikely to decrease net income and signicantly less likely to have no effect on net income. INTERNAL ERROR restatements are signicantly more likely to have no income effect and sig-

nicantly less likely to have a negative effect on net income than restatements with other causes.In contrast, STANDARD and COMPLEXITY restatements are signicantly more likely to have anegative income effect and signicantly less likely to have a no-income effect. This nding maysuggest that companies that attribute the restatement to STANDARDS COMPLEXITY exploit theambiguity within or the judgment allowed in the accounting standards the complexity of thetransaction to their benet. An analysis of the specic factor related to the standard that contrib-uted to the restatement reported in Panel B provides insight into this issue. The proportion of restatements that result in material adjustments FIVE suggest that INTERNAL ERROR andSTANDARD restatements are signicantly more likely to result in material income effects.

Panel C reports the net income effect by contributing factor for the 501 restatements attributedto STANDARD for which we have income data. We expect that if auditors and regulators allow fordiscretion in the use of judgment then restatements attributed to JUDGMENT will have largerincome statement effects. Consistent with this, we nd that restatements where JUDGMENT is a

contributing factor are signicantly more likely to have an income effect greater than 5 percent of

8 Data were collected for restatement lings for the subset of rms for which CRSP and Compustat data are available.Because of the high cost of hand-collecting data, we limit our analysis to this subset of rms. These rms may differfrom the sample as a whole, so our results should be interpreted with some caution.

9 In untabulated analyses, we nd no signicant difference in the frequency of POS and NEG effects between restate-ments that result in a material adjustment FIVE and those that do not.

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TABLE 3

Net Income Effect

Panel A: Net Income Effectby Year2003 2004 2005 2006

# of Restatements 152 231 536 387 EFFECT Mean 0.026 *** 0.011 0.006 0.020

Median 0.001 0.000 0.001 0.000 ABEFFECT Mean 0.037 0.021 0.016 0.029

Median 0.003 0.002 0.003 0.003

2003 2004 2005 2006

% of RestatementsFIVE 17 9 7 10 POS 17 19 20 21 ZERO 28 32 20 29

NEG 55 49 60 50

Panel B: Net Income Effectby Cause FIVE POS ZERO NE

# of Restatements 113 237 303 67% of Restatements

INTERNAL ERROR 36 51 67 4 MANIPULATION 4 3 1

COMPLEXITY 4 3 1

STANDARD 56 43 31 4


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Panel C: Net Income Effect STANDARD Cause by Contributing Factor FIVE POS ZERO NEG

# of Restatements 61 101 94 306

% of Restatements JUDGMENT 48 32 50 3CLARITY 43 57 48 6 RULES 9 13 2

*** Indicates that the value is statistically different from zero at a 0.05 level. , , and , , and reect that the percentage for the net income effect/cause/contributing factor for the particular year/net income effecless than the percentage for the other year/net income effect categories at the 1 percent, 5 percent, and 10 percent signicance levels, respective

Variable Denitions: EFFECT (ABEFFECT) difference absolute value of the difference between the restated net income and the originally reported net income

assets prior to the restatement ling;FIVE 1 if the net income effect exceeds 5 percent of total assets; and

POS (ZERO, NEG) the sign of the net income effect is zero zero, zero .

See Tables 1 and 2 for additional variable denitions.


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total assets than are other restatements. In addition, if managers exploit the use of judgment or thelack of clarity in the standards to manage earnings upward, then we expect JUDGMENT- andCLARITY- related restatements to result in more negative restatements. We nd no evidence con-sistent with this expectation for the use of JUDGMENT , but we do nd evidence consistent forCLARITY . Restatements with JUDGMENT CLARITY as a contributing factor are signicantlymore less likely to have no effect on net income and signicantly less more likely to have anegative income effect. These results are consistent with auditors and regulators being moretolerant of misstatements associated with standards requiring management judgment than for othererrors. In addition, the evidence is inconsistent with managers using the judgment allowed withrespect to the standards to manage earnings upward but is consistent with managers using the lack of clarity in the standard to do so.

Reporting of Material Internal Control WeaknessesOur nal analysis, reported in Table 4, explores the relation between reported material internal

control weakness and restatements. Although many believe that the ling of a restatement istantamount to a material internal control weakness within the company, a large proportion of

companies that le restatements do not indicate a material weakness. In Panel A, we documentthat only 46 percent of companies that le restatements indicate a material weakness. This pro-portion increases across time56 47 percent of restatement lers in 2005 2006 report materialweaknesses, whereas only 20 41 percent do so in 2003 2004 . This is consistent with morecompanies uncovering errors as they apply the provisions of the SOX internal controls require-ments.

Panel B reports the proportion of restating companies that report WEAKNESS by restatementcause. We expect companies with restatements attributed to INTERNAL ERRORS and MANIPU- LATION to be more likely to report material internal control weaknesses than companies withrestatements attributed to STANDARDS and COMPLEXITY . We argue that errors related to acharacteristic of the related accounting standard or to the complexity of the transaction are lesslikely to reect a deciency in a companys internal controls than errors related to books andrecords deciencies, simple misapplications of accounting principles, or intentional manipulation.However, we nd that companies are signicantly more likely to report a WEAKNESS if therestatement is because of COMPLEXITY or MANIPULATION and signicantly less likely toreport a WEAKNESS if the restatement is because of INTERNAL ERROR . The result for MANIPU- LATION is as expected, such that companies with fraudulent reporting are likely to have severeinternal control deciencies. The COMPLEXITY result could be driven by the type of companiesthat engage in more complex transactions. Smaller and higher growth companies that engage inmore complex transactions are perhaps more likely to have internal control weaknesses. The resultfor INTERNAL ERROR is a bit counterintuitive. By denition, a restatement caused by a books orrecords deciency or a simple misapplication of the accounting principles INTERNAL ERRORwould be more likely to have an internal control weakness. Our results are inconsistent withintuition, although they provide support for concerns expressed in Turner and Weirich 2006 thatmany restatements are issued by companies that report no deciencies in internal controls. 10 TheInstitute of Management Accountants 2008 argues that this discrepancy might be because of alack of standards for internal control attestation. Our results are consistent with the concernssurrounding the inadequate reporting of material internal control weaknesses; internal control

10 Our results suggest that the reporting of an internal control weakness is statistically more likely for restatementsattributed to COMPLEXITY or MANIPULATION . However, given the small proportion of our restatements attributed tothese two causes 6 percent , this result should be interpreted with some caution.




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TABLE 4

Material Weaknesses in Internal Controls

Panel A: Reported Material Weaknessesby Year2003 2004 2005 20

# of Restatements 465 588 1,186 1,50% of Restatements 20 41 56

Panel B: Reported Material WeaknessesRestatement Cause INTERNAL

ERROR MANIPULATION COMPLEXITY STAN

# of Restatements 2,132 98 120 % of Restatements 44 66 54

Panel C: Reported Material Weaknesses by FactorCLARITY JUDGMENT RULES

# of Restatements 806 511 66 % of Restatements 48 42 62

, , and , , and reect that the percentage for the cause for the particular year/auditor type/company size/cause category is signicantly for the other year/auditor type/company size/cause categories at the 1 percent, 5 percent, and 10 percent signicance levels, respectively, using a FSee Tables 1 and 2 for variable denitions.


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attestations either fail to uncover or companies are not reporting material weaknesses related tomisstatements attributed to basic internal company errors.

Panel C reports the proportion of restating companies that report WEAKNESS , sorted by thecontributing factor for restatements attributed to STANDARD . Because this analysis is limited torestatements attributed to STANDARD , our sample size is reduced. In this case, we document thatcompanies with restatements related to RULES or CLARITY JUDGMENT are signicantly moreless likely to report a WEAKNESS than other companies. This result is intuitive, given that the

questioning of judgment is less likely to reect an internal control weakness than the misapplica-tion of specic rules within a standard.

CONCLUSIONSAlthough various individuals and groups have posited numerous explanations for both the

number and increase in restatements over the past years, empirical evidence on the underlyingcauses of restatements has been lacking. This study analyzes the causes to which companiesattribute restatements and the characteristics of the accounting standards that relate to restate-ments. We analyze company disclosures related to each restatement and identify the explanation of the underlying causes, as suggested by the restating company. We also examine the relationbetween the restatement cause and the effect of each restatement on net income and the reportingof internal control weakness.

We document that internal company error is the primary cause to which company disclosuresattribute restatements, although a signicant portion of restatements are attributed to accountingstandards. Restatements attributed to a characteristic of the accounting standards are most oftenassociated with a lack of clarity in applying the standards and/or the proliferation of the literaturebecause the original standard lacked clarity. Judgment-related restatements are less common anddeclined over the sample period. We nd some evidence that the proportion of restatements withsigned net income effects that exceed 5 percent of total assets, a commonly used materialitythreshold, decreased over the four-year period. Finally, we nd an increase in the reporting of material internal control weaknesses by restating companies over the sample period, althoughmany companies with restatements attributed to basic company errors fail to report materialinternal control weaknesses.

Overall, the results are inconsistent with claims that the underlying complexity of the account-ing is the primary driver of restatements. Rather, the majority of restatements are attributed tobasic books and record deciencies within the company and to simple misapplications of generallyaccepted accounting standards. When the restatements are attributed to accounting standards, thelack of clarity in applying the standard and/or the proliferation of the literature which manyconsider a signicant source of accounting complexity is the primary underlying factor.

Our results provide information useful to the FASB and the SEC as they seek to implementmeasures to reduce the number of restatements. The results suggest that improved internal nan-cial reporting controls from the application of SOX provisions may reduce the number of restate-ments. Our results also provide useful insights for the SEC as it moves forward in responding tothe proposals included in the ACIFR report, providing them with empirical evidence on the

sources of avoidable complexity. It may be that the FASBs codication project and the SECsefforts to limit detailed implementation guidance will reduce the number of restatements attributedto this issue, as long as these efforts do not also reduce the clarity of the standards. The results alsosuggest that a move to more principles-based standards may increase the number of judgment-related restatements which have declined over time , perhaps suggesting that auditors and regu-lators will continue to become more tolerant of management judgments. Our results also suggestthat regulators may need to address the issue of internal control weakness attestation and reporting




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because many restatements attributed to books and records deciencies and simple misapplica-tions of accounting standards are not associated with companies that report material internalcontrol weaknesses.

Finally, our results should interest academic researchers who use restatements to proxy forearnings management and other corporate events. While using restatements as a proxy for variousconstructs, researchers should consider that all restatements are not alike; it is important thatresearchers understand the underlying causes of restatements that they include in their sampleswhen considering whether restatements serve as an appropriate proxy.

As a nal note, we emphasize that we rely on company disclosures about restatements for ourclassications and that companies may have strategic incentives regarding these disclosures. Wehighlight that the disclosures reviewed were extremely terse, provided few details about therestatement, and may have presented inaccurate or incomplete explanations regarding the under-lying cause of the restatement. Our reliance and investors likely reliance on restatement disclo-sures underscores the potential need for the SEC to more closely review the disclosures about andthe related explanations provided for restatements. As regulators focus attention on strategies tocurtail the number of restatements, they should perhaps also pay heed to restatement disclosurerequirements.

APPENDIXEXAMPLES OF RESTATEMENT DISCLOSURES AND CLASSIFICATIONS

CauseInternal Error

Example 1: From Ableauctions.com, Inc. 8-K with a Filing Date of March 30, 2006 Item 4.02(a). Non-Reliance on Previously Issued Financial Statements . On March 25,

2006, the Registrants Chief Executive Ofcer and the Audit Committee of the Board of Directorsconcluded that the nancial statements covering the scal year ended December 31, 2004 shouldno longer be relied upon because of certain errors in the nancial statements.

During the year ended December 31, 2004, the Registrant recorded marketable securities atcost. During the preparation of its nancial statements for the year ended December 31, 2005, the

Registrant determined that the marketable securities should have been recorded at fair value. Theeffect of the necessary restatement is to increase the carrying value of marketable securities by$269,474 and to increase investment income by $269,474 for the fourth quarter of 2004.

Additionally, during the preparation of its nancial statements for the year ended December31, 2005, the Registrant determined that certain accounts receivable at December 31, 2004, whichhad been outstanding for over one year, should have been offset by an allowance for doubtfulaccounts. The Registrant is restating its 2004 nancial statements to reect a provision for baddebt related to these accounts. The effect of this restatement is to decrease the carrying value of accounts receivable by $200,524, increase bad debts expense by $192,531, and decrease accumu-lated other comprehensive income by $7,991.

Example 2: From E-Com Ventures, Inc. 10-K with a Filing Date of April 28, 2006 Subsequent to the issuance of the Companys consolidated nancial statements for scal year

2004, the Company determined that it had incorrectly excluded the after-tax effects of temporarydifferences in the amount of approximately $3.0 million related to capital lease obligations of property and equipment and $2.4 million of Puerto Rican net operating loss carryforwards in thecomputation of its deferred income tax accounts. The error understated the related components of deferred tax assets, with an offsetting understated valuation allowance, as of January 29, 2005, of approximately $5.4 million. Since the Company had recorded a full valuation allowance related toits deferred tax assets as of January 29, 2005 and prior to scal year 2003, the error had no impact

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on the net deferred tax assets reected in the balance sheet as of January 29, 2005 or on theprovision for income taxes in the accompanying consolidated statements of operations for theyears ended January 29, 2005 and January 31, 2004. However, the below disclosures give effect tothe correction of the error from disclosures previously reported.

CauseManipulation

From America Service Group Inc. 8-K with a Filing Date of March 16, 2006 Restatement of Financial Statements . On March 15, 2006, the Company announced that the

Audit Committee had reached certain conclusions with respect to ndings of the investigation thatwould result in a restatement of the Companys consolidated nancial results for scal years 2001through 2004 and the rst and second quarters of scal year 2005. The restatement reducespreviously reported net income for these periods by $2.1 million, in the aggregate, and reducespreviously reported retained earnings as of January 1, 2001 by $347,000.

Consistent with the conclusions reached by the Audit Committee, the Company has includedin this ling the restated audited consolidated nancial statements for the years ended December31, 2003 and 2004, and restated selected nancial data for the years ended December 31, 2001 and2002 and certain of its unaudited condensed consolidated nancial information for the rst andsecond quarters of 2005.

Refer to Item 7, Managements Discussion and Analysis of Financial Condition and Resultsof Operations and Note 3 in the consolidated nancial statements for further discussion of therestatement-related adjustments and schedules reconciling the various restatement-related adjust-ments. Refer to Item 1A, Risk Factors, for further discussion of potential legal and other mattersthat could have a material adverse effect on the Companys nancial condition and results of operations.

The Company did not amend its previously led Annual Reports on Form 10-K or QuarterlyReports on Form 10-Q for the restatement. Accordingly, the nancial statements and other infor-mation contained in such reports should no longer be relied upon.

Restatement of Financial Statements . On October 24, 2005, the Company announced thatthe Audit Committee of its Board of Directors had initiated an internal investigation into certain

matters related to its subsidiary, SPP. The Audit Committee retained outside counsel who, in turn,engaged independent accountants with signicant forensic experience to assist in the investigation.The Company voluntarily reported the issues being investigated to the staff of the SEC and, sincethat time, the Company has cooperated with the SEC in an informal inquiry it is conducting, aswell as with the ofce of the United States Attorney for the Middle District of Tennessee, andintends to cooperate fully with all government inquiries. Although the investigation focused on anumber of items, the investigation was primarily conducted to determine whether SPP providedpricing of pharmaceuticals in accordance with applicable contract terms and whether some of theaccruals and reserves maintained by SPP were established and utilized in accordance with gener-ally accepted accounting principles.

On March 15, 2006, the Company announced that the Audit Committee had concluded itsinvestigation and reached certain conclusions with respect to ndings of the investigation thatwould result in a restatement of the Companys consolidated nancial results for scal years 2001

through 2004 and the rst and second quarters of scal year 2005. The restatement reducespreviously reported net income for these periods by $2.1 million, in the aggregate, and reducespreviously reported retained earnings as of January 1, 2001 by $347,000.

Pricing Adjustment . In certain instances, SPP did not charge its customers including PHSin accordance with applicable contracts. The Audit Committees investigation involved testing theamounts SPP charged for pharmaceuticals against SPPs purchase invoice cost or the applicablethird-party reference price. The Audit Committees investigation also estimated rebates received




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by SPP from manufacturers for the purchase of certain pharmaceuticals, savings that SPP realizedin purchasing certain pharmaceuticals from alternative sources buy-in savings , and the dollaramounts of returns to SPP of pharmaceutical products. The Company, in consultation with specialpharmaceutical counsel, determined the requirements of each of PHSs or SPPs contracts withrespect to the pricing of pharmaceuticals sold as well as any contractually required sharing of rebates, savings and credits for returns described above. Applying that information to the results of the testing, the Company then concluded that, in certain instances, SPP charged customers morethan SPPs purchase invoice cost or the applicable third-party reference price. The Companyfurther concluded that SPP failed to properly credit customers with discounts, rebates or buy-insavings and, in certain instances, failed to provide customers with contractually required credit forthe return of pharmaceutical products. As a result, the Company intends to provide aggregaterefunds to affected customers of approximately $3.7 million through June 2005, plus $0.6 millionof interest calculated using the applicable federal rate which ranged from 4 percent to 9 percentduring the period covered by the investigation. The Company also concluded that SPP chargedsome customers less than should have been charged under applicable contracts relative to SPPspurchase invoice cost or the applicable third-party reference price. Such amounts total approxi-mately $5.9 million from September 2000 to June 2005; however, because collectability of suchamounts is uncertain, these amounts have not been recognized as revenue.

Accruals and Reserves . The Company determined that accruals and reserves maintained bySPP were not established and utilized in accordance with generally accepted accounting principlesas key members of SPPs senior management inappropriately established and used certain reservesduring various periods over the last ve years to more closely match SPPs reported earnings to itsbudgeted results. The effect of the adjustments related to this matter necessitated by the internalinvestigation has been determined by the Company to be an increase in previously reported pre-taxincome of approximately $355,000, in the aggregate, since January 1, 2001.

Other . The Audit Committees investigation identied certain other issues, relating to accru-als for rebates and inventory valuation, which resulted in changes to the Companys previouslyreported nancial results. To correct the identied issues, the Company determined that adjust-ments representing an increase in previously reported pre-tax income of $146,000, in the aggre-

gate, since January 1, 2001 was needed.Income Tax Adjustments . Income tax adjustments were recorded to correct the Companysincome tax expense for the impact of the restatement adjustments discussed above.

CauseComplexity

From Paradigm Oil and Gas, Inc. 10-KSB with a Filing Date of May 24, 2006 During January 2005, the Company paid Win Energy Corporation $298,631 less a $50,000

deposit paid in December 2004 to acquire a 10 percent interest in the Todd Creek Property seealso Note 6 a . The $50,000 deposit was paid through the advancement of the funds by ashareholder as the Company had no other funds at that time with which to acquire the interest inthe Todd Creek Property. At December 31, 2004, with no funds available to complete the acqui-sition and with no apparent ability to derive a benet from the acquisition, a decision was made for

the Company to write off the $50,000 advance. Although the amount should have been capitalizedpursuant to SFAS No. 19 it was written off as it appeared that there were no opportunities to raisethe capital required to make the acquisition. Subsequent to year-end, the Company was, in fact,able to complete a private placement of securities and was able to complete the acquisition of theTodd Creek interest.

(a) Participation Proposal Agreements . On January 25, 2005, the Company closed twoparticipation proposal agreements with Win Energy Corporation hereafter, Win , an unrelated

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Calgary, Albertabased private corporation. The Company acquired an interest in two explorationprojects in Alberta, Canada for the total payments of $506,014.

Todd Creek Property . During January 2005, the Company paid Win $298,631 less a$50,000 deposit paid in December 2004 to acquire a 10 percent interest in the Todd Creek Property 10-34-5-29W4 located in Alberta, Canada. On June 18, 2005, the Company received apayment of $147,258 from Win for the sale of 50 percent of the Companys 10 percent interest inthe Todd Creek Property. The Todd Creek Property currently has no proven reserves.

Hillsprings Property . During January 2005, the Company paid Win $207,383 to acquire a 5percent interest in the Hillsprings Property 10-34-5-29W4 located in Alberta, Canada at a cost of $207,383. The Company held an option to acquire an additional 5 percent interest by paying anadditional $207,383 to Win, but the option expired on July 1, 2005 unexercised. The HillspringsProperty currently has no proven reserves.

(b) Farm-out and Option Agreement with Related Party .Sawn Lake PropertyOn February 14, 2005 the Company entered into a farmout and Option Agreement with a private

Alberta corporation and a related party for consideration of $152,423. The Company will farm-into a 5 percent interest in a test well, and a similar interest in an additional option well in the SawnLake area located in Alberta, Canada. The Company will earn 100 percent of the farmouts interestan undivided 10 percent interest in the drilling spacing unit before payout, reverting to 50

percent of the farmouts interest an undivided 5 percent interest after payout. In order to earn itsinterest in the initial test well, total costs of the test well, estimated to be $173,200, up to the pointof commercial oil sales are to be borne 100 percent by the Company in order to earn its undividedinterest.

Other The Company has an option to acquire an interest in a similar well located in Alberta, Canada. Inorder to acquire an interest, the Company must pay the total costs of a test well up to the point of

obtaining commercial oil sales. The Company has made no payments and has taken no furtheraction on the agreement as of the date of this report.

CauseStandard

Example 1: Contributing Factor JudgmentFrom Allegro Biodiesel Corp. 8-K with a Filing Date of December 27, 2006 . In connection

with the acquisition of Vanguard Synfuels LLC the Acquisition , on September 20, 2006, theRegistrant issued i certain stock options; ii certain warrants for the purchase of the RegistrantsCommon Stock; iii Series J Convertible Preferred Stock described below ; and iv Series KConvertible Preferred Stock, all as described in the Registrants Form 8-K dated September 20,2006 hereafter, the September 2006 Convertible Securities .

For purposes of accounting for the issuance of the September 2006 Convertible Securities, the

Registrant estimated the fair value of the Common Stock underlying the September 2006 Con-vertible Securities as $0.7587 per share, rather than the closing price of $3.10 per share on the




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OTC Bulletin Board on September 18, 2006, which was the last date on which the Common Stock was traded on the OTC Bulletin Board prior to the issuance of the September 2006 ConvertibleSecurities. The Registrants use of the $0.7587 per share valuation was previously disclosed in thefootnotes to the Registrants unaudited, pro forma combined nancial statements dated June 20,2006, which were included in the Registrants Form 8-K led with the Securities and ExchangeCommission SEC on September 26, 2009 and our previously led Form 10-QSB for the three-month period ended September 30, 2006, led on November 14, 2006. In reaching this conclusion,the Board of Directors of the Registrant determined that the trading price of the Common Stock did not accurately reect the fair market value of the Common Stock. The Board relied on anumber of factors in making its determination, including the fact that, as of September 18, 2006,the date of the last trade prior to the Acquisition, the Registrants liabilities exceeded its assets; theRegistrant had no ongoing business and was a shell company, as dened under the rules andregulations of the SEC; trading in the Registrants Common Stock was extremely limited andsporadic in nature; and the Registrant had obtained a third-party valuation in August 2006 thatstated that the value of the equity of the Registrant as a shell company was $0.42 on a fully-diluted basis.

To nance the Acquisition, the Registrant issued $28,500,000 of shares of its Series J Con-vertible Preferred Stock hereafter, the Series J Preferred with a conversion price of $0.7587 pershare of underlying Common Stock. The Series J Preferred was the senior equity security of theRegistrant, with a liquidation preference over the Common Stock, as well as other preferentialrights, including an 8 percent preferential dividend.

Based on the above factors, the valuation of the Series J Preferred, and other factors, andgiven the lack of certainty involving the valuation of the Common Stock of the Registrant, theBoard determined to set the value of the Common Stock underlying the September 2006 Convert-ible Securities as $0.7587, the same valuation as the shares of Common Stock underlying theSeries J Preferred.

Subsequent to ling its Form 10-Q for the quarter ended September 30, 2006, the Registrantdiscussed the valuation of the September 2006 Convertible Securities with the staff of the SEC.Based on such discussions, the Registrant determined to utilize the $3.10 valuation for nancial

reporting purposes, rather than the $0.7587 share price. Accordingly, the Board concluded that thenancial statements of the Registrant issued for the period ended September 30, 2006 should berestated to reect a valuation of the shares of Common Stock underlying the September 2006Convertible Securities at $3.10 per share instead of $0.7587 and should no longer be relied upon.In reaching this conclusion, the Board and the Audit Committee of the Board discussed the mattersdisclosed herein with the Registrants independent accountants, McKennon, Wilson & Morgan,LLP.

The Registrant intends to le an amended Form 10-QSB/A for the quarterly period endedSeptember 30, 2006 to reect the restatement discussed above as soon as practicable.

Example 2: Contributing Factor ClarityFrom Grant Life Sciences, Inc. 10-QSB with a Filing Date of August 14, 2006 . During the

year ended December 31, 2005, it was determined the correct application of accounting principles

had not been applied in the 2005 accounting for convertible debentures and detachable warrantssee Note C .In its original accounting for the debentures and detachable warrants, the Company recog-

nized an embedded benecial conversion feature present in the convertible note and allocated a

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portion of the proceeds equal to the intrinsic value of that feature to additional paid in capital. TheCompany has determined that the embedded conversion feature should have been accounted for inaccordance with SFAS No. 133, EITF 98-5, EITF 00-19, EITF 00-27, and APB 14. Accordingly,the proceeds attributed to the common stock, convertible debt, and warrants have been restated toreect the relative fair value method.

In accordance with SFAS No. 154, the necessary corrections to apply the accounting prin-ciples on the aforementioned transactions are currently reected in the reported ConsolidatedStatements of Losses for the three and six months ended June 30, 2005 and the ConsolidatedStatement of Cash Flows for the six months ended June 30, 2005.

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