Restatements may raise red flags with investors, lenders and other financial statement users. After reporting an “unprecedented spike” in restatements in 2021, Audit Analytics, an independent accounting research firm, revealed that total restatements declined by 69% in 2022. Here’s an overview of the methods that companies use to correct errors and misstatements in prior periods, the top reasons companies restated financial results in 2022, and ways that errors may be identified in the financial reporting process.
Restating financial results
Financial restatements help gauge financial reporting quality. A financial restatement occurs when a company discovers an error or misstatement in previously issued financial statements, and the company corrects it by adjusting previous periods, using one of three methods:
- Reissuance restatements,
- Revision restatements, or
- Out-of-period adjustments.
The appropriate accounting method is a matter of materiality. That is, material errors or misstatements may cause a company to reissue its financial statements. But an immaterial error or misstatement may simply require a footnote about the revision or an out-of-period adjustment. An error or misstatement is considered “material” if it would influence a reasonable investor.
Evaluating recent trends
In November 2023, Audit Analytics published “Financial Restatements: A Twenty-Year Review.” It examines the underlying causes of public company restatements from 2003 to 2022.
A previous Audit Analytics study found that the number of financial restatements filed by public companies in 2021 increased significantly, due to the use of special purpose acquisition companies (SPACs). Most of these restatements (62%) were reissuance restatements, which are reserved only for material errors and misstatements.
The latest study found that the number of SPAC-related restatements fell by 91% in 2022. And the total number of restatements has returned to pre-2021 levels.
In 2022, the top issue cited for restatements was disclosing debt and equity security issues. Examples include:
- Errors made in the application of accounting principles related to debt, equity or quasi-debt/equity instruments with conversion options,
- Errors in approach, theory or calculation associated with the proper classification of a debt instrument as short-term or long-term, and
- Misclassifications between debt and equity accounts.
Debt and equity security issues as a percentage of total restatements fell to 22% in 2022 (down from 81% in 2021). In 2021, 63% of debt and equity security restatements were attributed to SPACs. In 2022, only 38% of debt and equity restatements were SPAC-related.
Other top reasons cited for 2022 restatements include:
- Revenue recognition (12% of total restatements),
- Liabilities (11% of total restatements),
- Expenses (9% of total restatements), and
- Deferred, stock and executive compensation (9% of total restatements).
Additionally, in 2022, the average negative impact from restatements on net income in 2022 was $11.6 million — the lowest since 2009.
Uncovering errors
Although the Audit Analytics study evaluated only public company filings, privately held businesses that follow U.S. Generally Accepted Accounting Principles (GAAP) may also issue restatements. Some restatements may be for mundane reasons. For instance, management might have misinterpreted GAAP, requiring the company’s external accountant to adjust the numbers. Or they simply may have made minor mistakes and need to correct them.
Often, errors are identified when the company’s financial statements are subjected to a higher level of scrutiny. For example, restatements may occur when a private company upgrades from reviewed financial statements to audited financial statements or decides to file for an initial public offering. They also may be needed when the owner brings in additional internal (or external) accounting expertise, such as a new controller or audit firm.
Audit Analytics reports that material restatements may indicate material weakness in internal controls over financial reporting, especially if multiple errors are found. In rare cases, a financial restatement also can be a sign of incompetence — or even fraud. Such restatements may signal problems that require corrective actions.
Communication is key
Regular communication with interested parties — including lenders and shareholders — can help businesses overcome the negative stigma associated with financial restatements. Management also needs to reassure employees, customers and suppliers that the company is in sound financial shape to ensure their continued support. Contact your CPA for help understanding the evolving accounting rules to minimize the risk of restatement and effectively manage the restatement process.
© 2023