During June, Ideagen Audit Analytics (IAA) and the Center of Audit Quality (CAQ) each released studies of public company financial statement restatements. Both studies show that the number of restatements filed annually by SEC-reporting companies is at or near historic lows and broadly indicate that financial reporting quality, as measured by restatements, is high. However, the studies also suggest a note of caution. Both find that the share of Big R or reissuance restatements has recently risen. Also, the CAQ (which employed a different methodology than IAA to count restatements; see below) finds that the total number of restatements has begun to increase.
Although the two studies address many of the same topics, their specific findings are not directly comparable. The studies cover different periods (2004 to 2023 for IAA and 2013 to 2022 for the CAQ). Also, the IAA study includes all SEC filer restatements, while the CAQ disregards special purpose acquisition company (SPAC) restatements that were based on a 2021 SEC staff statement discussing the accounting treatment of SPAC warrants. In addition, even for years before 2021, the two studies differ on the number of restatements that occurred. However, the overall themes that emerge from both studies are similar.
Big R and Little R Restatements
There are two types of restatements -- Big R (reissuance or Form 8-K Item 4.02) restatements and little r (revision) restatements. A Big R restatement occurs when a company determines that users can no longer rely on previously issued financial statements due to a material error in those statements. The company must disclose that determination by filing SEC Form 8-K within four business days and file corrected financial statements as promptly as possible. In contrast, little r restatements result from errors in previously issued financial statements that are determined to be immaterial but that have a cumulative effect that would be material to the current period, either if left uncorrected or if corrected in the current period. Little r restatements do not require a Form 8-K filing, and the company can correct the error in the current period’s comparative financial statements by restating the prior period information.
Little r restatements attract less public attention (and securities market impact) than Big R restatements. In 2022, the SEC’s then-acting Chief Accountant warned that companies and auditors may be biased in favor of little r restatements and urged greater objectivity in evaluating whether an error is material. See SEC Acting Chief Accountant Warns Against Bias in Restatement Materiality Decisions, March 2022 Update.
Ideagen Audit Analytics
On June 24, IAA released Financial Restatements – IAA’s annual report on trends in financial restatements. (For a summary of the prior IAA report and a discussion of the 2021 spike in restatements due to SPACs, see After a SPAC-Driven Surge, Restatements Are Returning to “Normal”, November-December 2023 Update). IAA finds that restatements decreased by approximately 6 percent, from 458 in 2022 to 430 in 2023, “plateauing at the levels seen in the years just prior to 2021.” The number of companies that filed restatements also remained relatively stable, falling from 424 to 401 between 2022 and 2023.
Highlights of IAA’s report include:
Restatement period. In 2023, the average period covered by restatements increased from 393 days in 2022 to 438 days, slightly shorter than the average restatement period prior to the 2021 SPAC restatement spike. IAA observes that “Lengthy restatement periods (greater than 360 days) indicate that an annual report, as well as quarter(s), were restated. An annual report restatement suggests that not only management but likely an independent accounting firm failed to identify a material error or omission.”
Number of accounting issues. The average number of accounting issues per restatement has risen in each of the last three years. In 2023, the average was approximately 1.5, and restatements with only one issue represented 54 percent of restatements. In 2020, 70 percent were one-issue restatements.
Nature of accounting issues. Debt/equity accounting was the issue most frequently involved in restatements in 2023; this has also been the most frequent issue for the 20 years from 2004 to 2023. (Most SPAC restatements would be classified as based on debt/equity accounting errors.) The percentage of total restatements disclosing debt/equity errors in 2023 was 21 percent. The other top five issues in 2023 were revenue recognition (16 percent); expense recording (13 percent); liabilities, payables, reserves, and accrual estimates (12 percent); cash flow statement classification (10 percent); and tax expense/benefit/deferral (10 percent).
Restatement type. In 2023, the total number of Big R or reissuance restatements increased to 209 from 191 in 2022, representing 52 percent of all domestic filer restatements; in 2022, Big R restatements were 44 percent of the total. Conversely, little r or revision restatements fell to 194 or 48 percent of the total, down from 239 in 2022.
Income impact. In 2023, 52 percent of restatements disclosed an impact on net income or retained earnings. The net income impact was negative for 68 percent of these companies and positive for 32 percent. (Negative income impact restatements occur when the original financials overstated income.) During the past 20 years, negative restatements were at least 66 percent of all restatements that had an income impact. In 2023, the average amount of restatement negative impact on net income increased 27 percent to nearly $16 million. For the 71 restatements that had a positive net income effect, the average increase in income was $14.5 million. In 2022, the average negative restatement impact on net income was $11.6 million, while the average positive net income effect was $10.5 million.
Filer type. As has been the case every year in the IAA study, smaller public companies filed most of the 2023 restatements. Nonaccelerated filers accounted for 215 restatements (62 percent of total restatements). (In 2022, non-accelerated filers made 245 restatements--54 percent of total restatements.) At the other end of the size spectrum, large accelerated filers accounted for 75 restatements (21 percent of the total). Accelerated filers (the size tier between non-accelerated filers and large accelerated filers) submitted 56 restatements (16 percent of the total).
Filer industry. Companies in the technology industry accounted for 18 percent of 2023 restatements (76 filings). The trade and services industry sector was second, with approximately 15 percent of restatements. Energy and transportation companies disclosed the fewest restatements in 2023, with only 31 restatements, representing 7 percent of all restatements.
Center for Audit Quality
In late June, the CAQ also released a report on restatements. Financial Restatement Trends in the United States: 2013 – 2022 focuses on restatements announced from January 1, 2013, through December 31, 2022 (the sample period). The introduction to the CAQ’s report lists eight key findings:
Restatements have declined overall with 4.02 [Big R] restatements exhibiting the most consistent decline throughout the sample period. According to the online summary of its report, the CAQ found “a steady decline in the total number of restatements * * * until the final year of the sample period.” There were 858 restatements in 2013, the first year of the study period, and the year with the highest annual number. In 2021, there were 362 restatements, the lowest annual number. However, total restatements rose to 402 in 2022. The percentage of Big R restatements declined from 28 percent in 2013 to 18 percent in 2021. In 2022, that trend reversed, and Big R restatements grew to 38 percent of total restatements – the highest Big R share during the sample period.
Expenses, specifically the misapplication of reporting rules for accruals, reserves, and estimates, are cited most frequently in restatement announcements. Thirty percent of restatement announcements referenced inappropriate accounting for accruals, reserves, and estimates. The second most common category of accounting issues was the misapplication of accounting standards for financing activities (e.g., accounting for the measurement of debt, quasi-debt, equity securities, and derivatives). Twenty percent of restatement announcements cited these issues. (As noted above, the CAQ excluded restatements based on the SEC’s SPAC warrants guidance, which impacted debt/equity accounting.)
Fraud is implicated in 3% of the total population of restatements and 7% of 4.02 [Big R] restatements overall. Approximately three percent of all restatements during the sample period were associated with fraud, as defined in the CAQ’s study. For the Big R restatement subset, seven percent involved fraud during the ten years studied. In 2017, eleven of 109 Big R restatements (ten percent) involved fraud, but over the second half of the sample period (2018-2022), fraud dropped to only three percent (five of 153 Big R restatements).
The industries contributing the most to the population of restatements are: 1) Financial, Banks & Insurance, 2) Healthcare & Pharmaceuticals, and 3) Computer & Software. Together, companies in the Financial, Banks & Insurance; Healthcare & Pharmaceuticals; and Computer & Software industries accounted for 45 percent of all restatements during the sample period. Healthcare & Pharmaceutical increased from eleven percent of restatements in 2013 and 2014 to 20 percent in 2021. Conversely, restatements by Energy, Mining & Chemicals companies decreased from 13 percent of all restatements in 2013 to only four percent in 2022. The industries with the lowest percentage of restatement filers during the sample period were Utilities & Water and Telecom & Broadcast; each accounted for three percent of total restatements.
Companies that have announced restatements over the sample period are relatively small, in terms of average assets, and are increasingly traded on the NASDAQ. When compared to the population of U.S. companies covered by Compustat, restatement companies were smaller, as measured by average assets, in eight of the 10 years studied. Overall, restatement companies had average assets of $13 billion, compared to an average of $18 billion for all Compustat companies. The subset of companies announcing Big R restatements was even smaller, with average assets of $2.3 billion.
Public companies that have announced restatements are more likely to have ineffective internal control over financial reporting (ICFR) based on management’s assessment. In each sample period year, management at 80 percent of non-restating companies reported that the company had effective ICFR. In contrast, for restating companies, approximately 70 percent of management reports disclosed effective ICFR each year. For issuers that announced Big R restatements, about 55 percent of managements reported that ICFR was effective.
Ineffective ICFR reports are generally issued after a restatement is announced, i.e., ICFR reports are not predictive of restatements. In advance of little r restatements, management reported a material ICFR weakness between 8 percent and 17 percent of the time. In the three years before a Big R restatement, restating companies reported at least one accounting issue underlying the subsequent restatement between 8 percent and 26 percent of the time. The CAQ report concludes that “regardless of the materiality of the restatement, ICFR reports do not appear to be predictive of restatement events.”
Early evidence suggests CAMs do not provide information about restatement risk. The average number of critical audit matters (CAMs) per audit opinion for Big R restatement companies is only slightly higher than that of non-restating companies. Between 2019 and 2022, the years that CAM reporting has been in effect, restating companies had only three percent more CAMs than companies that did not restate. The CAQ’s online summary concludes: “Based on the subset of restatements announced over the four years CAM reporting has been in effect (2019 to 2022), critical audit matters do not contribute to the public’s understanding of restatement risk.”
Audit Committee Takeaways
Both studies make clear that the long-term trend in restatements is down. The investments that companies have made in strengthening their internal control over financial reporting in the wake of the Sarbanes-Oxley Act seem to have paid off in less frequent material financial statement errors. Restatements today are concentrated in smaller public companies which typically lack the reporting and internal control resources of larger businesses.
The uptick in restatements in 2022 that the CAQ – but not IAA – reports is difficult to evaluate. It may be an artifact of the differences in methodology between the CAQ and IAA (see above). Even if the uptick is real, it is, as the CAQ recognizes, “too early to tell if the increase in restatements toward the end of the sample period is a true inflection point or simply a brief disruption of the previous downward trend.” The 2022 increase in Big R restatements, which both studies report, is likely the result of SEC Chief Accountant Paul Munter’s warning in March 2022 that the SEC staff believes companies and their advisors have been taking an unduly narrow view of materiality and that many errors treated as immaterial should have triggered a Big R restatement. See SEC Acting Chief Accountant Warns Against Bias in Restatement Materiality Decisions, above. Mr. Munter’s statement may also have led to an increase in total restatements.
As the Update has suggested in the past, audit committees confronted with errors in prior financial reporting and questions concerning whether and how to restate should make sure they fully understand management’s materiality analysis and the reasons for its choice between a Big R or little r restatement. The SEC may inquire into the audit committee’s role in cases where it disagrees with a company’s decisions regarding the handling of a financial statement error. Audit committees should be prepared to show that they provided active oversight.