Robert Pozen is a senior lecturer at Massachusetts Institute of Technology's Sloan School of Management. Olga Usvyatsky is vice-president of research at Audit Analytics.
When a Canadian company publicly restates its financial statements, the restatement suggests a material weakness in its internal controls. Those controls comprise the checks and balances, which are supposed to provide investors with reasonable assurances that their financial statements are accurate and complete.
To examine these issues, we reviewed all financial restatements by Canadian-listed companies (with a market capitalization above $75-million except for dual-listed companies) between Jan. 1, 2009, and Dec. 31, 2016. In this period, there were 78 financial restatements by such Canadian companies.
However, only 18 of those 78 financial restatements led to a public disclosure by the company of a material weakness in its internal controls. Under Canadian laws, any public company with a material weakness in its internal controls is required to publicly disclose the nature of the weakness, its impact on the company and its plan for remediation.
To be conservative, we did a further analysis of these 78 restatements to see which ones were material, either quantitatively or qualitatively. A total of 43 restatements were material, of which only 14 led to a public disclosure by the company of a material weakness in its internal controls.
We looked first to see whether the revised financial statements decreased the company's net income by 5 per cent or more – the standard criterion for quantitative materiality. Under this criterion, 29 restatements were quantitatively material. For example, the financial restatement of Orca Exploration Group involved over $2-million, a 30-per-cent decrease from previously reported net income. Yet the company did not believe it had a material weakness in its internal controls.
Moreover, Canadian accounting rules make clear that a restatement can be material based on qualitative factors such as fraud by a senior officer, investigation by outside counsel or review by a regulator. These were the reasons for three restatements. For instance, a restatement by Martinrea International resulted from a fraud by a division's controller; nevertheless, the company declined to publicly disclose a material weakness in its internal controls.
Similarly, repeated restatements by the same company within a few years usually mean that internal controls are weak, regardless of quantitative materiality. There were 11 instances of second or even third restatements by the same company – which we classified as qualitatively material for this reason. These are illustrated by Boston Pizza Royalty and the ADF Group, which both restated their financial statements twice within three years, but neither made a public disclosure that its internal controls had a material weakness.
What can be done to provide investors with better disclosures about internal controls in Canada?
At present, these disclosures are one of many possible subjects discussed in a lengthy section of regulatory filings called the MDA – management, discussion and analysis. Despite our repeated efforts, we were not able to find an agency or board with a list of Canadian companies reporting a material weakness in their internal controls.
The solution is straightforward. Canadian regulators should add a set of questions to be answered by public companies in their annual filings, in a place separate from the MDA:
1. During the past year, did your company restate its financial statements? If so, a) explain why the restatement was needed; and b) quantify its impact on the company's net income.
2. During the past year, did the company have a material weakness in internal controls? If so, a) explain the nature of the weakness; b) quantify the impact of the weakness; and c) specify any plan to remedy the weakness and the extent to which this plan has been carried out.
More fundamentally, Canadian legislatures might consider adding a requirement that the external auditor of any public company, above a certain size, issue an attestation report on the company's internal controls. Currently, only management must evaluate the effectiveness of its own internal controls. In an attestation report, the external auditor would provide an independent review of management's judgment on its own internal controls.
In the United States, the external auditor generally issues an attestation report on the internal controls of any public company with a market capitalization over $75-million. Of course, an attestation report would entail costs to the company as well as benefits. So Canadian legislators might choose to require attestation reports only for a Canadian public company with a market capitalization over $250-million or $500-million.
In short, this study of restatements by Canadian public companies strongly suggests that company managements are not sufficiently objective in evaluating their own internal controls. Nor are they sufficiently candid in publicly reporting on material weaknesses in their internal controls.
To address these problems, securities regulators should tighten existing reporting rules on material weaknesses in internal controls, and enhance enforcement of these rules. Canadian legislators should also consider whether they should add a requirement that the external auditor of a public company, above a certain size, perform an independent review of its internal controls.