Accounting Horizons

Vol. 24, No. 1

2010
pp. 4164

American Accounting Association

DOI: 10.2308/acch.2010.24.1.41

An Analysis of the Underlying Causes

Attributed to Restatements
Marlene Plumlee and Teri Lombardi Yohn
SYNOPSIS: The dramatic increase in the number of restatements filed over the past
years has been attributed to numerous causes, including the complexity of the accounting standards, internal control reviews, changes in materiality thresholds, the overly
conservative nature of auditors, earnings management, increased transaction complexity, and the second-guessing of management judgments by a variety of interested parties. However, empirical evidence on the underlying causes of restatements has been
lacking. This study provides such evidence by directly addressing these questions: 1
To what causes do companies attribute restatements? 2 To what characteristics of the
accounting standards do companies attribute restatements? Relying on the restating
companies disclosures about restatements, we find that companies most often attribute restatements to basic internal company errors unrelated to any specific characteristic of the accounting standards. We also find that, for those restatements attributed
to some characteristic of the accounting standards, the primary contributing factor is the
lack of clarity in applying the standards and/or the proliferation of the literature because
the original standard lacked clarity. These findings should interest standard setters and
regulators addressing the proliferation of restatements and academics using restatements as proxies for constructs of interest in research.
Keywords: restatement; restatement causes; accounting standards; accounting complexity.
Data Availability: The data are available from public sources.
JEL Classifications: K22; M41; M43; M49.

INTRODUCTION
ccounting restatements have been filed at record levels in the past few years: Glass Lewis
& Co. 2006 documents that 1,538 restatements were filed in 2006, more than three times
the 475 restatements filed in 2003. Although the rapid increase in the number of restatements filed in the United States is apparent, a significant 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 benefited from discussions with SEC staff, especially Scott Taub, and senior auditing staff from
Big 4 and other audit firms, in designing and implementing the research design in this study. We appreciate the helpful
comments of workshop participants at the University of CaliforniaBerkeley and the University of Michigans Harvey
Kapnick Accounting Conference. Marlene Plumlee and Teri Lombardi Yohn acknowledge the generous support of the
David Eccles Faculty Fellowship and the PricewaterhouseCoopers Fellowship, respectively.

Submitted: December 2008

Accepted: September 2009
Published Online: March 2010
Corresponding author: Marlene Plumlee
Email: marlene.plumlee@utah.edu

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cause of this increase. Various groups have posited plausible reasons for restatements, including
accounting complexity, second-guessing of management judgment, proliferation of accounting
rules and implementation guidance, application of the Sarbanes-Oxley Act of 2002 SOX Section
404 requirements, transaction complexity, and earnings management. The various constituents
have also suggested specific measures that could be taken to reduce restatements based on the
causes suggested. However, measures proposed to curtail restatements based on one suggested
cause may contradict measures proposed based on another suggested cause. This conflict highlights the necessity for first understanding the underlying cause of restatements before implementing measures to curtail them. To date, as the Advisory Committee on Improvements to Financial
Reporting SEC 2008 noted, definitive evidence on the drivers of restatements is lacking.
In this study, we analyze disclosures surrounding restatements filed from 2003 to 2006 to
provide empirical evidence of the restating companies explanations of the underlying cause of
restatements. Relying on these disclosures, we classify each restatement as having been attributed
to 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 restatements attributed to some characteristic of the accounting standards, we also consider whether the
companies 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 the
misapplication of detailed and complex rules. While restating companies may have strategic
incentives regarding how they disclose restatements, we argue that these disclosures are informative and that classifying the restatements based on an analysis of those disclosures improves our
understanding of the underlying causes of restatements and of the attributes of accounting standards that might contribute to them.
For a subset of our sample, we calculate the net income effect of the restatement to better
understand whether materiality levels related to restatements have become more conservative over
time and to compare with prior research. Finally, we examine whether a companys reporting of a
material internal control weakness relates to the underlying cause of the restatement identified.
We document that the majority of restatements 57 percent filed from 2003 to 2006 are
attributed to internal company errors, inconsistent with the conventional wisdom that the complexity of the accounting standards drives most restatements. The second most commonly attributed cause of restatements filed during the four-year period is some characteristic of the accounting standards 37 percent. Of those restatements, 58 percent are related to a lack of clarity in the
standard, and 37 percent are related to the use of judgment in applying the standard. Overall, we
document that the mean net income effect of restatements is negative 0.013, although a significant number of restatements have no net income effect 26 percent. The proportion of restatements for which the absolute net income effect is greater than 5 percent of total assets decreased
over the four-year period, consistent with a change in the quantitative materiality threshold across
time. Finally, we find that only 66 percent of the restatements attributed to manipulation and 44
percent attributed to internal errors are from companies that report material internal control weaknesses. This suggests deficiencies in the implementation of SOX internal control weakness attestation and reporting requirements.
Our results provide insights to regulators and standard setters regarding the causes to which
companies attribute restatements, which might aid in designing and implementing initiatives to
reduce the number of restatements. In addition, our finding that companies frequently attribute
restatements to an internal company error is consistent with SOX reviews working as expected and
suggests the number of restatements will decline as improved controls are established. The findings regarding restatements attributed to judgment in the standards are especially important to
consider as the United States moves toward convergence with International Financial Reporting

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An Analysis of the Underlying Causes Attributed to Restatements

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Standards, which are often considered more principles-based and reliant on judgment. Finally, the
finding of inconsistencies between restatement filings attributed to basic internal company errors
and manipulation and reported material internal control weaknesses suggests a need to address
issues related to improving the attestation of internal controls and the reporting of material weaknesses.
Our results are also useful to academic research that employs restatements. Researchers may
benefit by identifying a subset of restatements based on the attributed underlying cause that most
closely relates to the construct of interest to ensure that the restatement sample is appropriate for
the research question. Prior academic research that examines restatements either does not distinguish between different types of restatements or merely sorts restatements into unintentional errors
or intentional manipulations i.e., Hennes et al. 2008; Palmrose et al. 2004. This study considers
a broader range of causes and factors related to restatements, distinguishing between those attributed to unintentional internal books and records deficiencies, misapplications of accounting standards because of their specific characteristics, transaction complexity, and intentional errors. The
study also identifies the characteristics of accounting standards that companies attribute to restatements. This classification provides important insights relative to prior research that primarily
focuses on whether the restatement can be classified as intentional or unintentional.
The remainder of this study is organized as follows. First, we provide background information
about restatements and their suggested causes as motivation for our study. We then detail our data
collection and classification process and provide descriptive statistics regarding restatement causes
and contributing factors. In the next section we report the empirical findings related to the net
income effect and the reporting of material internal control weaknesses. We end with a summary
of the findings and some general conclusions.
BACKGROUND AND MOTIVATION
Clearly, the number of restatements filed 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 Board
FASB have each identified accounting complexity as a formidable problem; some argue that this
complexity is a primary driver of restatements Ciesielski and Weirich 2006. In response to this
concern, the SEC formed the Advisory Committee on Improving Financial Reporting ACIFR
whose aim is to reduce the complexity of financial reporting. The ACIFR has outlined plans to
move toward more principles-based standards. They and many others argue that rules-based standards, 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 reduce
the number of restatements. However, others contend that restatements are driven by auditors and
regulators unforeseeable reinterpretations of management judgments Pozen 2007. They argue
that 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 accounting standards. Dzinkowski 2007 and others suggest that companies struggle to find the
paragraphs 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 the
interpretation 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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Plumlee and Yohn

Pozen 2007, 2.1 In response to these concerns, the FASB has codified the accounting standards
to allow for logical and expeditious access to the rules related to a specific topic and has worked
to limit the guidance issued for standards.
Still others attribute the recent increase in restatements to the implementation of SOX Section
404 internal control reviews, which has uncovered past errors, as expected. In contrast, some claim
that the creation of the Public Company Accounting Oversight Board PCAOB has caused auditors to act too conservatively, requiring restatements for technical corrections with dubious materiality Pozen 2007. They argue that auditors went from an anything goes perspective in the
late 1990s to an extremely conservative perspective after the collapse of Arthur Andersen Taub
2005. To address this issue, the FASB, SEC, and PCAOB encourage a communicative relationship between auditors and companies managers.
Increasingly complex business transactions without a corresponding change in financial reporting 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 companies focus on meeting or beating earnings benchmarks. This, in turn, causes companies to misapply 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 increase
in recent years; various parties e.g., FASB, SEC, and PCAOB have taken steps to address the
concerns based on these explanations. It is important, however, to distinguish among the proposed
alternative explanations for accounting restatements using empirical evidence on the drivers of
restatements to properly address the problem. Such evidence assists regulators and standard setters
in focusing their efforts on initiatives that are more likely to curb the incidence of restatements.
Empirical evidence on restatement causes will benefit academics as well, who have made
implicit or explicit assumptions about the causes of restatements. Restatements have been used to
proxy for earnings management Efendi et al. 2007; Lee et al. 2006; Desai, Krishnamurthy, and
Venkataraman 2006; Desai, Hogan, and Wilkins 2006, for accruals quality Doyle et al. 2007, for
internal company errors from inexperienced financial executives Aier et al. 2005, and for poor
corporate governance Srinivasan 2005. However, if restatements are not the appropriate proxy
for the underlying construct of interest, interpretations of the findings from these studies may be
misleading. Evidence on restatement causes will therefore facilitate the use of restatements as a
proxy for the appropriate construct in academic research.
Prior research highlights the importance of distinguishing between restatements that are intentional or unintentional. For example, Palmrose et al. 2004 and Hennes et al. 2008 sort
restatements into intentional and unintentional misstatements and document that the market reaction to restatements is significantly greater for restatements classified as intentional relative to
those classified as unintentional. Hennes et al. 2008 also find that sorting restatements into these
two groups increases the power of tests that rely on restatements as an indicator of deliberate
misreporting.
As the objective of our study differs from that of prior work, we contribute significantly to the
literature and note many differences in the sample and the analysis. First, we examine a much
larger 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 restatements. 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 Certified Public Accountants
AICPA 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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An Analysis of the Underlying Causes Attributed to Restatements

45

examine a sample of 630 restatements from approximately the same period. Plumlee and Yohn
2009 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 restatements
will 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 our
sample and eliminate observations where the investigation their indicator of intentional misstatement did not lead to a restatement. Finally, Hennes et al. 2008 employ only two categories
unintentional errors and intentional irregularities, whereas we consider a broader group of categories. We consider manipulation as only one of the causes to which companies may attribute a
restatement and are also interested in how the standards and the characteristics of the standards
relate to the incidence of restatements.
DATA AND DESCRIPTIVE STATISTICS
Our analysis includes restatements filed in 2003, 2004, 2005, and 2006, compiled by Glass
Lewis & Co. The Glass Lewis & Co. data set includes restatements filed to correct accounting
errors as defined by Accounting Principles Board Opinion No. 20; therefore, restatements are not
included if they are because of a change in accounting principle, a change in estimate, the adoption
of a new standard, a change in the discussions of results, a minor wording change, or a typographical error.2
The original Glass Lewis & Co. data set includes 4,070 restatement filings. For each restatement, we analyzed the corporate disclosures and outside news sources surrounding the restatement
to ascertain the underlying restatement cause.3 If no information regarding a cause was available, the restatement was excluded from the sample. When necessary, we gathered additional
information from other company filings and the accounting literature to classify the restatement.
Each co-author independently analyzed each restatement, identified differences in classifications,
and reconciled them to arrive at the final classifications.4 We consulted extensively with the staff
in the Office of the Chief Accountant at the SEC and with senior audit managers at Big 4
accounting firms for assistance in identifying the restatement cause and contributing factor
classifications. Our final sample includes 3,744 restatements filed from 2003 through 2006.
We also employ what Glass Lewis & Co. labels the restatement type the accounting issue
to which the restatement relates in our analysis. Glass Lewis & Co. identifies a minimum of one
restatement type for each restatement filing; for 70 percent of the restatement filings a single
restatement type is identified. When more than one restatement type is identified, we include only
the primary type in our analysis.

This definition of an error includes a mathematical mistake, a mistake in applying generally accepted accounting
principles, an oversight or misuse of facts that existed at the time the financial statements were prepared, or a change
from a nonaccepted accounting method to a generally accepted accounting principle.
We use company disclosures to ascertain the cause of the restatement primarily because the footnote disclosure is often
the only place the information about the restatement is available. The SEC audits and reviews footnote disclosures, and
prior research suggests that companies are forthcoming about disclosing bad news Skinner 1994, which lends credibility to these disclosures. However, we do not make predictions about the strategic disclosure choices made by a
company or posit reasons for specific disclosure choices, leaving this to future research e.g., Plumlee and Yohn 2009.
We argue that classification from the restating companys perspective is interesting and informative in its own right.
Although the process of determining the four classification categories and the classification process itself is designed to
be objective, an inherently subjective part of the process exists. To mitigate this subjectivity, we 1 consulted with
professionals, including senior audit managers and the staff at the SEC, to determine the four categories and contributing
factors; 2 established the categories and factors based on discussion with the professionals, analysis of over 100
random disclosures, and reading of the prior literature related to restatements; and 3 employed two coders who
independently categorized each disclosure. For about 2 percent of the restatements, the classifications between the two
coders differed, requiring reconciliation.

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Restatement Causes
For each restatement filing, we classify the underlying cause to which the company attributes
the restatement into one of four categories: an internal company error INTERNAL ERROR, an
intentional manipulation MANIPULATION, transaction complexity COMPLEXITY, or some
characteristic of the accounting standards STANDARD. A restatement is classified as being
caused by INTERNAL ERROR if the disclosures suggest that the error was because of a books or
records deficiency or a simple misapplication of an accounting standard, and the company disclosures include no discussion that suggests these errors were intentional or because of any notable
characteristic of the accounting standard or the transaction. A restatement is classified as being
caused 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 was
intentional, it is classified as such. A restatement is classified as being caused by COMPLEXITY if
the disclosures suggest that the transaction itself created difficulties in the accounting that caused
the error. Finally, a restatement is classified as being caused by a STANDARD if the disclosures
suggest that the error was caused by a misapplication of an accounting standard and some factor
related to the accounting standard contributed to the restatement.
Table 1 provides descriptive statistics on the cause classifications. Panel A includes the number of restatements on an annual basis along with the proportion of those restatements by each
restatement 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 deficiencies and
simple 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 the
second most commonly attributed cause. In each year and across the sample as a whole, disclosures suggest that restatements are attributed to MANIPULATION and COMPLEXITY less than 8
percent of the time.6
Panel B of Table 1 begins with the number of restatements by restatement cause and then
details the percentage of restatements by cause and type. Restatements attributed to INTERNAL
ERROR are significantly more likely to be associated with Expense, Inventory, Liability/
Contingency, Misclassification, or Tax issues, while restatements attributed to MANIPULATION
are significantly more likely to be associated with Reserve/Allowance or Revenue Recognition
issues. Restatements attributed to COMPLEXITY are significantly more likely to be related to
Equity, OCI, or Acquisition/Investment issues; restatements attributed to STANDARD are significantly 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, Misclassi5

We use a Fisher Exact Test because it provides a nonparametric test of whether the frequencies of two independent
samples differ significantly across two mutually exclusive classes. In this case, we examine whether the frequency of
restatements in not in the specified row category differs significantly across restatements in not in the specified
column category. Therefore, the Fisher Exact Test provides a test for each 2 2 contingency table.
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 as
being intentional, respectively. We attribute these differences to the samples examined. Palmrose et al. 2004 examine
restatements during a period when restatements were less prevalent and when revenue recognition misstatements
represented a greater proportion of the restatements. Hennes et al. 2008 examine a much smaller sample of restatements that were announced via 8-K reports, eliminate restatements with no net income effect, and eliminate restatements
in which an investigation did not lead to a restatement. Consistent with our finding of fewer restatements classified as
MANIPULATION than in prior research, we document that a large proportion of the restatements in our sample have no
net income effect and that the market reaction to restatements during our sample period is frequently not different from
zero.

Accounting Horizons
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Panel A: Restatement Causeby Year

# of Restatements
% of Restatements
INTERNAL ERROR
MANIPULATION
COMPLEXITY
STANDARD

2003

2004

465

588

56
4
3
37

Panel B: Restatement Causeby Restatement Type

INTERNAL ERROR
2,132
24
11
3
4
20
3
1
11
8
7
4
5

2006

1,186

62
4
3
31

1,505

52
3
3
42

MANIPULATION
98
23
2
4
1
2
0
9
53
0
0
1
4

Total
3,744

59
2
4
35

COMPLEXITY
120
12
28
0
3
8
9
1
6
0
23
6
6

57
3
3
37

STANDARD
1,394
17
31
1
1
12
6
1
8
6
7
7
2

Total
3,744
21
19
2
3
16
3
1
10
6
8
5
4

(continued on next page)

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# of Restatements
% of Restatements
Expense
Equity
Inventory
Liability/Contingency
Misclassification
OCI
Reserve/Allowance
Revenue Recognition
Tax
Acquisition/Investment
Capital Assets
Other

2005

An Analysis of the Underlying Causes Attributed to Restatements

Accounting Horizons

TABLE 1
Restatement Causes

, , and , , and reflect that the percentage for the cause for the particular year/cause category is significantly greater less than the percentage for the other year/cause
categories at the 1 percent, 5 percent, and 10 percent significance levels, respectively, using a Fishers Exact Test.
Restatement Cause is classified 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; and
STANDARD if the disclosures indicate that the restatement was caused by some characteristics of the accounting standards.
Restatement Type refers to the restatement classification by Glass Lewis & Co. based on the accounting issue to which the restatement relates.

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49

fication 16 percent, and Revenue Recognition 10 percent. In additional untabulated results, we

find an increase decrease across the four-year period in the percentage of restatements related to
Equity, OCI, and Acquisition/Investment Expense, Reserves/Allowances, and Revenue Recognition.
STANDARD RestatementContributing Factors
For each restatement classified as STANDARD, we also identify a contributing factor based
on the restatement disclosures. Specifically, 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 restatements
attributed to STANDARD 37 percent of our sample and 1,394 restatements. Within this set of
restatements, CLARITY is the most common contributing factor, identified for 58 percent of the
restatements. 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 a
whole based on untabulated results, CLARITY is a contributing factor for 21 percent of the
restatements; 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 significantly fewer restatements and CLARITY to be a contributing factor for significantly more restatements in 2005 and 2006 relative to the earlier years.7 The increased incidence of restatements
attributed to RULES during 2005 can be directly traced to lease restatements as a result of the
letter sent by the SEC to the AICPA, stating the regulators stand on the accounting for leases in
2005. The decrease in restatements attributed to JUDGMENT across the sample period may
suggest that auditors and regulators have been more tolerant with respect to management judgment
over time, although it may also reflect a change in managers use of judgment. The increase in
restatements attributed to CLARITY provides support for the notion that accounting complexity via
a 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. We
find that restatements where judgment is considered a contributing factor are significantly more
likely 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 associated with Expense, Equity, and Liability/Contingency issues.
INCOME EFFECTS AND INTERNAL CONTROL WEAKNESSES
Net Income Effect of Restatements
To address the stated concerns that companies have become more conservative in their decisions to restate, we examine changes in a materiality threshold based on the restatement net
income effect using hand-collected data from the restated filings. The net income effect EFFECT
is the difference between the restated net income and the originally reported net income, scaled by
the companys total assets prior to the restatement filing. 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 significance of the
time trends. Thus, although we discuss the trends in general terms throughout the paper, our inferences should be
interpreted with caution.

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TABLE 2
Restatements Caused by STANDARD
Panel A: Contributing Factorby Year
2003
# of Restatements
% of Restatements
JUDGMENT
CLARITY
RULES

168
60
35
5

2004

2005

2006

Total

183

514

529

1,394

54
41
5

30
63
7

32
66
2

37
58
5

Panel B: Contributing Factorby Restatement Type

JUDGMENT
516
5
13
3
2
13
2
3
16
16
10
17
2

808
26
46
0
10
11
5
0
4
0
4
1
1

RULES
70
12
3
0
6
5
45
2
3
0
5
3
17

Total
1,394
17
31
1
1
12
6
1
8
6
7
7
2

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Plumlee and Yohn

# of Restatements
% of Restatements
Expense
Equity
Inventory
Liability/Contingency
Misclassification
OCI
Reserve/Allowance
Revenue Recognition
Tax
Acquisition/Investment
Capital Assets
Other

CLARITY

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Accounting Horizons

, , and , , and reflect that the percentage for the cause for the particular year/factor category is significantly greater less than the percentage for the other year/factor
categories at the 1 percent, 5 percent, and 10 percent significance levels, respectively, using a Fishers Exact Test.
All the restatements included in this analysis are classified as:
STANDARD the disclosures indicate that the restatement was caused by some characteristics of the accounting standards.
Contributing factors are classified 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 difficulty in applying cumbersome rules was a contributing factor.
See Table 1 for variable definitions.

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The results of our analysis are reported in Table 3. Panel A reports EFFECT by year for the
1,306 restatement filings for which we have available data.8 Overall, we document a significantly
negative mean net income effect. However, this effect is driven by the first year of our sample
period 2003. Median values are never significantly different from zero. Consistent with this
result, we find that ABEFFECT is significantly greater in 2003 0.037 than in the other three years
of our sample. We also document that the proportion of restatements with a net income effect that
exceeds 5 percent of total assets FIVE is significantly higher in 2003 than in the other sample
years; 17 percent of restatements filed in 2003 resulted in an income effect that exceeded 5 percent
of total assets. In contrast, only 10 percent of the restatements filed in 2006 resulted in an income
effect that exceeded 5 percent of total assets. As a comparison with our finding of a mean
restatement 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 filed
in the more recent periods being less consequential, as the popular press suggests. These findings
provide limited support for the notion that quantitative materiality thresholds for restatements may
have fallen over time. The materiality threshold may have decreased because of factors such as
increased 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. See
Keune and Johnstone 2009 for an analysis of the impact of this SAB. Overall, we document that
20 percent of the restatements result in an increase in net income POS; 26 percent have no net
income 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 accounting standards and internal errors are unintentional, we expect restatements attributed to
STANDARDS, INTERNAL ERROR, and COMPLEXITY to be equally likely to have positive and
negative 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 negative
income effect. Consistent with expectations, MANIPULATION restatements are significantly more
likely to decrease net income and significantly less likely to have no effect on net income.
INTERNAL ERROR restatements are significantly more likely to have no income effect and significantly less likely to have a negative effect on net income than restatements with other causes.
In contrast, STANDARD and COMPLEXITY restatements are significantly more likely to have a
negative income effect and significantly less likely to have a no-income effect. This finding may
suggest that companies that attribute the restatement to STANDARDS COMPLEXITY exploit the
ambiguity within or the judgment allowed in the accounting standards the complexity of the
transaction to their benefit. An analysis of the specific factor related to the standard that contributed 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 and
STANDARD restatements are significantly more likely to result in material income effects.
Panel C reports the net income effect by contributing factor for the 501 restatements attributed
to STANDARD for which we have income data. We expect that if auditors and regulators allow for
discretion in the use of judgment then restatements attributed to JUDGMENT will have larger
income statement effects. Consistent with this, we find that restatements where JUDGMENT is a
contributing factor are significantly more likely to have an income effect greater than 5 percent of

Data were collected for restatement filings for the subset of firms 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 firms. These firms may differ
from the sample as a whole, so our results should be interpreted with some caution.
In untabulated analyses, we find no significant difference in the frequency of POS and NEG effects between restatements that result in a material adjustment FIVE and those that do not.

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March 2010

Panel A: Net Income Effectby Year

2003
# of Restatements
EFFECT
ABEFFECT

152
0.026
0.001
0.037
0.003

Mean
Median
Mean
Median

***

2004

2005

231
0.011
0.000
0.021
0.002

536
0.006
0.001
0.016
0.003

2004

2005

2003
% of Restatements
FIVE
POS
ZERO
NEG

17
17
28
55

9
19
32
49

7
20
20
60

2006
387
0.020
0.000
0.029
0.003
2006
10
21
29
50

Total
1,306
0.013***
0.001
0.023
0.003
Total
9
20
26
54

Panel B: Net Income Effectby Cause

POS

ZERO

NEG

Total

113

237

303

675

1,215

36
4
4
56

51
3
3
43

67
1
1
31

44
6
4
46

52
4
2
42
(continued on next page)

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# of Restatements
% of Restatements
INTERNAL ERROR
MANIPULATION
COMPLEXITY
STANDARD

FIVE

An Analysis of the Underlying Causes Attributed to Restatements

Accounting Horizons

TABLE 3
Net Income Effect

# of Restatements
% of Restatements
JUDGMENT
CLARITY
RULES

61

101

48
43
9

32
57
13

54

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Panel C: Net Income EffectSTANDARD Cause by Contributing Factor

FIVE
POS

ZERO

NEG

94

306

50
48
2

30
62
8

Total
501
34
58
8

*** Indicates that the value is statistically different from zero at a 0.05 level.

, , and , , and reflect that the percentage for the net income effect/cause/contributing factor for the particular year/net income effect category is significantly greater
less than the percentage for the other year/net income effect categories at the 1 percent, 5 percent, and 10 percent significance levels, respectively, using a Fishers Exact Test.

Variable Definitions:
EFFECT (ABEFFECT) difference absolute value of the difference between the restated net income and the originally reported net income, scaled by the companys total
assets prior to the restatement filing;
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 definitions.

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total assets than are other restatements. In addition, if managers exploit the use of judgment or the
lack of clarity in the standards to manage earnings upward, then we expect JUDGMENT- and
CLARITY-related restatements to result in more negative restatements. We find no evidence consistent with this expectation for the use of JUDGMENT, but we do find evidence consistent for
CLARITY. Restatements with JUDGMENT CLARITY as a contributing factor are significantly
more less likely to have no effect on net income and significantly less more likely to have a
negative income effect. These results are consistent with auditors and regulators being more
tolerant of misstatements associated with standards requiring management judgment than for other
errors. In addition, the evidence is inconsistent with managers using the judgment allowed with
respect 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 Weaknesses
Our final analysis, reported in Table 4, explores the relation between reported material internal
control weakness and restatements. Although many believe that the filing of a restatement is
tantamount to a material internal control weakness within the company, a large proportion of
companies that file restatements do not indicate a material weakness. In Panel A, we document
that only 46 percent of companies that file restatements indicate a material weakness. This proportion increases across time56 47 percent of restatement filers in 2005 2006 report material
weaknesses, whereas only 20 41 percent do so in 2003 2004. This is consistent with more
companies uncovering errors as they apply the provisions of the SOX internal controls requirements.
Panel B reports the proportion of restating companies that report WEAKNESS by restatement
cause. We expect companies with restatements attributed to INTERNAL ERRORS and MANIPULATION to be more likely to report material internal control weaknesses than companies with
restatements attributed to STANDARDS and COMPLEXITY. We argue that errors related to a
characteristic of the related accounting standard or to the complexity of the transaction are less
likely to reflect a deficiency in a companys internal controls than errors related to books and
records deficiencies, simple misapplications of accounting principles, or intentional manipulation.
However, we find that companies are significantly more likely to report a WEAKNESS if the
restatement is because of COMPLEXITY or MANIPULATION and significantly less likely to
report a WEAKNESS if the restatement is because of INTERNAL ERROR. The result for MANIPULATION is as expected, such that companies with fraudulent reporting are likely to have severe
internal control deficiencies. The COMPLEXITY result could be driven by the type of companies
that engage in more complex transactions. Smaller and higher growth companies that engage in
more complex transactions are perhaps more likely to have internal control weaknesses. The result
for INTERNAL ERROR is a bit counterintuitive. By definition, a restatement caused by a books or
records deficiency or a simple misapplication of the accounting principles INTERNAL ERROR
would be more likely to have an internal control weakness. Our results are inconsistent with
intuition, although they provide support for concerns expressed in Turner and Weirich 2006 that
many restatements are issued by companies that report no deficiencies in internal controls.10 The
Institute of Management Accountants 2008 argues that this discrepancy might be because of a
lack of standards for internal control attestation. Our results are consistent with the concerns
surrounding 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 restatements
attributed to COMPLEXITY or MANIPULATION. However, given the small proportion of our restatements attributed to
these 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 Year
2003

2004

2005

2006

Total

# of Restatements
% of Restatements

588
41

1,186
56

1,505
47

3,744
46

465
20

Panel B: Reported Material WeaknessesRestatement Cause

INTERNAL
ERROR
MANIPULATION
# of Restatements
% of Restatements

2,132
44

98
66

Panel C: Reported Material Weaknesses by Factor

CLARITY
# of Restatements
% of Restatements

806
48

COMPLEXITY

STANDARD

Total

120
54

1,394
46

3,744
46

JUDGMENT

RULES

Total

511
42

66
62

1,383
46

, , and , , and reflect that the percentage for the cause for the particular year/auditor type/company size/cause category is significantly greater less than the percentage
for the other year/auditor type/company size/cause categories at the 1 percent, 5 percent, and 10 percent significance levels, respectively, using a Fishers Exact Test.
See Tables 1 and 2 for variable definitions.

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attestations either fail to uncover or companies are not reporting material weaknesses related to
misstatements attributed to basic internal company errors.
Panel C reports the proportion of restating companies that report WEAKNESS, sorted by the
contributing factor for restatements attributed to STANDARD. Because this analysis is limited to
restatements attributed to STANDARD, our sample size is reduced. In this case, we document that
companies with restatements related to RULES or CLARITY JUDGMENT are significantly more
less likely to report a WEAKNESS than other companies. This result is intuitive, given that the
questioning of judgment is less likely to reflect an internal control weakness than the misapplication of specific rules within a standard.
CONCLUSIONS
Although various individuals and groups have posited numerous explanations for both the
number and increase in restatements over the past years, empirical evidence on the underlying
causes of restatements has been lacking. This study analyzes the causes to which companies
attribute restatements and the characteristics of the accounting standards that relate to restatements. 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 relation
between the restatement cause and the effect of each restatement on net income and the reporting
of internal control weakness.
We document that internal company error is the primary cause to which company disclosures
attribute restatements, although a significant portion of restatements are attributed to accounting
standards. Restatements attributed to a characteristic of the accounting standards are most often
associated with a lack of clarity in applying the standards and/or the proliferation of the literature
because the original standard lacked clarity. Judgment-related restatements are less common and
declined over the sample period. We find some evidence that the proportion of restatements with
signed net income effects that exceed 5 percent of total assets, a commonly used materiality
threshold, decreased over the four-year period. Finally, we find an increase in the reporting of
material internal control weaknesses by restating companies over the sample period, although
many companies with restatements attributed to basic company errors fail to report material
internal control weaknesses.
Overall, the results are inconsistent with claims that the underlying complexity of the accounting is the primary driver of restatements. Rather, the majority of restatements are attributed to
basic books and record deficiencies within the company and to simple misapplications of generally
accepted accounting standards. When the restatements are attributed to accounting standards, the
lack of clarity in applying the standard and/or the proliferation of the literature which many
consider a significant source of accounting complexity is the primary underlying factor.
Our results provide information useful to the FASB and the SEC as they seek to implement
measures to reduce the number of restatements. The results suggest that improved internal financial reporting controls from the application of SOX provisions may reduce the number of restatements. Our results also provide useful insights for the SEC as it moves forward in responding to
the proposals included in the ACIFR report, providing them with empirical evidence on the
sources of avoidable complexity. It may be that the FASBs codification project and the SECs
efforts to limit detailed implementation guidance will reduce the number of restatements attributed
to this issue, as long as these efforts do not also reduce the clarity of the standards. The results also
suggest that a move to more principles-based standards may increase the number of judgmentrelated restatements which have declined over time, perhaps suggesting that auditors and regulators will continue to become more tolerant of management judgments. Our results also suggest
that 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 deficiencies and simple misapplications of accounting standards are not associated with companies that report material internal
control weaknesses.
Finally, our results should interest academic researchers who use restatements to proxy for
earnings management and other corporate events. While using restatements as a proxy for various
constructs, researchers should consider that all restatements are not alike; it is important that
researchers understand the underlying causes of restatements that they include in their samples
when considering whether restatements serve as an appropriate proxy.
As a final note, we emphasize that we rely on company disclosures about restatements for our
classifications and that companies may have strategic incentives regarding these disclosures. We
highlight that the disclosures reviewed were extremely terse, provided few details about the
restatement, and may have presented inaccurate or incomplete explanations regarding the underlying cause of the restatement. Our reliance and investors likely reliance on restatement disclosures underscores the potential need for the SEC to more closely review the disclosures about and
the related explanations provided for restatements. As regulators focus attention on strategies to
curtail the number of restatements, they should perhaps also pay heed to restatement disclosure
requirements.

APPENDIX
EXAMPLES 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 Officer and the Audit Committee of the Board of Directors
concluded that the financial statements covering the fiscal year ended December 31, 2004 should
no longer be relied upon because of certain errors in the financial statements.
During the year ended December 31, 2004, the Registrant recorded marketable securities at
cost. During the preparation of its financial statements for the year ended December 31, 2005, the
Registrant determined that the marketable securities should have been recorded at fair value. The
effect 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 financial statements for the year ended December
31, 2005, the Registrant determined that certain accounts receivable at December 31, 2004, which
had been outstanding for over one year, should have been offset by an allowance for doubtful
accounts. The Registrant is restating its 2004 financial statements to reflect a provision for bad
debt 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 accumulated 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 financial statements for fiscal year
2004, the Company determined that it had incorrectly excluded the after-tax effects of temporary
differences 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 the
computation 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 to
its deferred tax assets as of January 29, 2005 and prior to fiscal year 2003, the error had no impact

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on the net deferred tax assets reflected in the balance sheet as of January 29, 2005 or on the
provision for income taxes in the accompanying consolidated statements of operations for the
years ended January 29, 2005 and January 31, 2004. However, the below disclosures give effect to
the 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 findings of the investigation that
would result in a restatement of the Companys consolidated financial results for fiscal years 2001
through 2004 and the first and second quarters of fiscal year 2005. The restatement reduces
previously reported net income for these periods by $2.1 million, in the aggregate, and reduces
previously reported retained earnings as of January 1, 2001 by $347,000.
Consistent with the conclusions reached by the Audit Committee, the Company has included
in this filing the restated audited consolidated financial statements for the years ended December
31, 2003 and 2004, and restated selected financial data for the years ended December 31, 2001 and
2002 and certain of its unaudited condensed consolidated financial information for the first and
second quarters of 2005.
Refer to Item 7, Managements Discussion and Analysis of Financial Condition and Results
of Operations and Note 3 in the consolidated financial statements for further discussion of the
restatement-related adjustments and schedules reconciling the various restatement-related adjustments. Refer to Item 1A, Risk Factors, for further discussion of potential legal and other matters
that could have a material adverse effect on the Companys financial condition and results of
operations.
The Company did not amend its previously filed Annual Reports on Form 10-K or Quarterly
Reports on Form 10-Q for the restatement. Accordingly, the financial statements and other information contained in such reports should no longer be relied upon.
Restatement of Financial Statements. On October 24, 2005, the Company announced that
the 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 significant forensic experience to assist in the investigation.
The Company voluntarily reported the issues being investigated to the staff of the SEC and, since
that time, the Company has cooperated with the SEC in an informal inquiry it is conducting, as
well as with the office of the United States Attorney for the Middle District of Tennessee, and
intends to cooperate fully with all government inquiries. Although the investigation focused on a
number of items, the investigation was primarily conducted to determine whether SPP provided
pricing of pharmaceuticals in accordance with applicable contract terms and whether some of the
accruals and reserves maintained by SPP were established and utilized in accordance with generally accepted accounting principles.
On March 15, 2006, the Company announced that the Audit Committee had concluded its
investigation and reached certain conclusions with respect to findings of the investigation that
would result in a restatement of the Companys consolidated financial results for fiscal years 2001
through 2004 and the first and second quarters of fiscal year 2005. The restatement reduces
previously reported net income for these periods by $2.1 million, in the aggregate, and reduces
previously reported retained earnings as of January 1, 2001 by $347,000.
Pricing Adjustment. In certain instances, SPP did not charge its customers including PHS
in accordance with applicable contracts. The Audit Committees investigation involved testing the
amounts SPP charged for pharmaceuticals against SPPs purchase invoice cost or the applicable
third-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 realized
in purchasing certain pharmaceuticals from alternative sources buy-in savings, and the dollar
amounts of returns to SPP of pharmaceutical products. The Company, in consultation with special
pharmaceutical counsel, determined the requirements of each of PHSs or SPPs contracts with
respect 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 more
than SPPs purchase invoice cost or the applicable third-party reference price. The Company
further concluded that SPP failed to properly credit customers with discounts, rebates or buy-in
savings and, in certain instances, failed to provide customers with contractually required credit for
the return of pharmaceutical products. As a result, the Company intends to provide aggregate
refunds to affected customers of approximately $3.7 million through June 2005, plus $0.6 million
of interest calculated using the applicable federal rate which ranged from 4 percent to 9 percent
during the period covered by the investigation. The Company also concluded that SPP charged
some customers less than should have been charged under applicable contracts relative to SPPs
purchase invoice cost or the applicable third-party reference price. Such amounts total approximately $5.9 million from September 2000 to June 2005; however, because collectability of such
amounts is uncertain, these amounts have not been recognized as revenue.
Accruals and Reserves. The Company determined that accruals and reserves maintained by
SPP were not established and utilized in accordance with generally accepted accounting principles
as key members of SPPs senior management inappropriately established and used certain reserves
during various periods over the last five years to more closely match SPPs reported earnings to its
budgeted results. The effect of the adjustments related to this matter necessitated by the internal
investigation has been determined by the Company to be an increase in previously reported pre-tax
income of approximately $355,000, in the aggregate, since January 1, 2001.
Other. The Audit Committees investigation identified certain other issues, relating to accruals for rebates and inventory valuation, which resulted in changes to the Companys previously
reported financial results. To correct the identified issues, the Company determined that adjustments representing an increase in previously reported pre-tax income of $146,000, in the aggregate, since January 1, 2001 was needed.
Income Tax Adjustments. Income tax adjustments were recorded to correct the Companys
income 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 see
also Note 6 a. The $50,000 deposit was paid through the advancement of the funds by a
shareholder as the Company had no other funds at that time with which to acquire the interest in
the Todd Creek Property. At December 31, 2004, with no funds available to complete the acquisition and with no apparent ability to derive a benefit from the acquisition, a decision was made for
the Company to write off the $50,000 advance. Although the amount should have been capitalized
pursuant to SFAS No. 19 it was written off as it appeared that there were no opportunities to raise
the 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 the
Todd Creek interest.
(a) Participation Proposal Agreements. On January 25, 2005, the Company closed two
participation 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 exploration
projects 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 a
payment of $147,258 from Win for the sale of 50 percent of the Companys 10 percent interest in
the 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 5
percent 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 an
additional $207,383 to Win, but the option expired on July 1, 2005 unexercised. The Hillsprings
Property currently has no proven reserves.
(b) Farm-out and Option Agreement with Related Party.
Sawn Lake Property
On 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-in
to a 5 percent interest in a test well, and a similar interest in an additional option well in the Sawn
Lake area located in Alberta, Canada. The Company will earn 100 percent of the farmouts interest
an 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 its
interest in the initial test well, total costs of the test well, estimated to be $173,200, up to the point
of commercial oil sales are to be borne 100 percent by the Company in order to earn its undivided
interest.
Other
The Company has an option to acquire an interest in a similar well located in Alberta, Canada. In
order 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 further
action on the agreement as of the date of this report.
CauseStandard
Example 1: Contributing Factor Judgment
From 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, the
Registrant issued i certain stock options; ii certain warrants for the purchase of the Registrants
Common Stock; iii Series J Convertible Preferred Stock described below; and iv Series K
Convertible 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 Convertible 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 Convertible
Securities. The Registrants use of the $0.7587 per share valuation was previously disclosed in the
footnotes to the Registrants unaudited, pro forma combined financial statements dated June 20,
2006, which were included in the Registrants Form 8-K filed with the Securities and Exchange
Commission SEC on September 26, 2009 and our previously filed Form 10-QSB for the threemonth period ended September 30, 2006, filed 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 reflect the fair market value of the Common Stock. The Board relied on a
number 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; the
Registrant had no ongoing business and was a shell company, as defined under the rules and
regulations of the SEC; trading in the Registrants Common Stock was extremely limited and
sporadic in nature; and the Registrant had obtained a third-party valuation in August 2006 that
stated that the value of the equity of the Registrant as a shell company was $0.42 on a fullydiluted basis.
To finance the Acquisition, the Registrant issued $28,500,000 of shares of its Series J Convertible Preferred Stock hereafter, the Series J Preferred with a conversion price of $0.7587 per
share of underlying Common Stock. The Series J Preferred was the senior equity security of the
Registrant, with a liquidation preference over the Common Stock, as well as other preferential
rights, including an 8 percent preferential dividend.
Based on the above factors, the valuation of the Series J Preferred, and other factors, and
given the lack of certainty involving the valuation of the Common Stock of the Registrant, the
Board determined to set the value of the Common Stock underlying the September 2006 Convertible Securities as $0.7587, the same valuation as the shares of Common Stock underlying the
Series J Preferred.
Subsequent to filing its Form 10-Q for the quarter ended September 30, 2006, the Registrant
discussed 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 financial
reporting purposes, rather than the $0.7587 share price. Accordingly, the Board concluded that the
financial statements of the Registrant issued for the period ended September 30, 2006 should be
restated to reflect a valuation of the shares of Common Stock underlying the September 2006
Convertible 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 matters
disclosed herein with the Registrants independent accountants, McKennon, Wilson & Morgan,
LLP.
The Registrant intends to file an amended Form 10-QSB/A for the quarterly period ended
September 30, 2006 to reflect the restatement discussed above as soon as practicable.
Example 2: Contributing Factor Clarity
From 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 warrants
see Note C.
In its original accounting for the debentures and detachable warrants, the Company recognized an embedded beneficial 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. The
Company has determined that the embedded conversion feature should have been accounted for in
accordance 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 to
reflect the relative fair value method.
In accordance with SFAS No. 154, the necessary corrections to apply the accounting principles on the aforementioned transactions are currently reflected in the reported Consolidated
Statements of Losses for the three and six months ended June 30, 2005 and the Consolidated
Statement of Cash Flows for the six months ended June 30, 2005.
REFERENCES
Aier, J., J. Comprix, M. Gunlock, and D. Lee. 2005. The financial expertise of CFOs and accounting
restatements. Accounting Horizons 19 3: 123135.
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