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Responding to accounting restatement risk

A fundamental tenet of financial reporting is that a company’s internal controls over financial reporting (ICFR) are sufficiently robust to ensure transactions are properly recognized and disclosed in its financial statements.  The appropriateness of financial statements hinges on the fair presentation in conformity with GAAP.  Furthermore, the concept of materiality is the deciding factor of what is “fair” and what is not.

However, at times companies misstate their financial statements.  In some situations these misstatements are simple, unintentional errors; whereas, in other cases they may be intentional.  When misstatements occur, companies must determine whether or not these misstatements result in materially misleading financial statements.  For purposes of clarity, an error is defined in ASC 250, Accounting Changes and Error Corrections as “[a]n error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of [GAAP], or oversight or misuse of facts that existed at the time the financial statements were prepared.”

Because identified misstatements that relate to the current period can be addressed by management without any required restatements, today’s post will address certain risk areas and requirements that companies will want to address in assessing misstatements in prior periods.

Materiality

In a previous post I wrote about materiality considerations, which should be considered in assessing whether or not the prior period financial statements are materially misstated.  Indeed, it is well established that calculating a quantitative threshold of materiality is an important step in a materiality assessment (such as 5-10% of pre-tax income).  However, companies should give consideration to qualitative factors as well.  The SEC’s staff issued SAB No. 99 to provide some guidance to considering qualitative factors.  Notwithstanding its guidance, SAB No. 99 does not address what might be considered not material.

Types of restatement

Depending on the outcome of a materiality assessment, companies may find themselves in one of two categories:

  1. Reissuance restatement – referred to as “Big R” restatement because this means the previously issued financial statements were materially incorrect and, therefore, are unreliable and must be reissued/restated.  In these cases, the prior period financial statements must be amended.
  2. Revision restatement – referred to as “Little r” restatement because, although there are errors in the previously issued financial statements, they were not material to the prior periods.  A company may choose to either make the error correction in the current period or it may recast its prior period financial results in connection with issuing its current period financial statements.  When a company elects to recast its prior period financial statements in connection with issuing its current period financial statements, it revises its financial statements.  In these circumstances, the prior period financial statements do not need to be amended.

Sarbanes-Oxley Act certification requirements

In the context of restatements, SEC registrants must be aware of risk exposure related to Sarbanes-Oxley Act (SOX) certification requirements.  As a refresher, as early as 2004 SEC registrants were required to implement certain provisions of SOX.  These provisions address requirements that the principal executive officer or officers (CEO or equivalent) and the principal financial officer or officers (CFO or equivalent) must certify.  The first requirement, Section 302, is found in SOX’s Title III – Corporate Responsibility.  The second requirement, Section 906, is found in SOX’s Title IX – White-Collar Crime Penalty Enhancements.

  • SOX Section 302 – In connection with filing of periodic financial reports with the SEC, the CEO and CFO (as signing officers) are required to certify in each quarterly and annual report:
    • the signing officer has reviewed the report;
    • based on the signing officer’s knowledge, the report doesn’t contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading;
    • based on the signing officer’s knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report;
    • the signing officers:
      • are responsible for establishing and maintaining internal controls
      • have designed such internal controls to ensure that material information relating to the issuer and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared;
      • have evaluated the effectiveness of the issuer’s internal controls as of a date within 90 days prior to the report; and
      • have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date;
    • the signing officers have disclosed to the issuer’s auditors and the audit committee of the board of directors (or persons fulfilling the equivalent function):
      • all significant deficiencies in the design or operation of internal controls which could adversely affect the issuer’s ability to record, process, summarize, and report financial data and have identified for the issuer’s auditors any material weaknesses in internal controls; and
      • any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer’s internal controls; and
    • the signing officers have indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
  • SOX Section 906 – In connection with filing of periodic financial reports with the SEC, the CEO and CFO (as signing officers) are required to certify in each quarterly and annual report:
    • the periodic financial report containing the financial statements fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer.

Section 906 provides for criminal penalties if the CEO and/or CFO:

  • certifies any statement within Section 906 knowing that the periodic report accompanying the statement does not comport with all the requirements set forth in Section 906 shall be fined not more than $1,000,000 or imprisoned not more than 10 years, or both; or
  • willfully certifies any statement as set forth in Section 906 knowing that the periodic report accompanying the statement does not comport with all the requirements set forth in Section 906 shall be fined not more than $5,000,000, or imprisoned not more than 20 years, or both.

In light of these certification requirements and the potential criminal penalties, signing officers must be confident that their financial reporting controls are reliable.  With this in mind, when Big R restatement risk is heightened, companies should be cognizant of the regulatory and legal exposure associated with potential non-compliance.

Furthermore, when it comes to material misstatements in the company’s prior period financial statements, there is a rebuttable presumption that a material weakness in ICFR exists.  Another thing to keep in mind is that even though a Little r restatement may end up being the correct solution to addressing misstatements, the SEC registrant may end up concluding that a material weakness still exists in ICFR.  This gets at the concept of the “could” factor in assessing deficiencies in ICFR, which I previously wrote about.

Tips for companies

I recently listened to a webcast discussing 10 pitfalls to avoid when navigating a Big R restatement (replay link).  For convenience, I’ve listed these 10 pitfalls:

  1. Engaging inexperienced counsel and advisors for the investigation
  2. Forming a special committee when the audit committee might suffice
  3. The run-away or open-ended investigation
  4. Failing to keep auditors apprised of the investigation and errors found
  5. Indecisiveness and inability to reach conclusions
  6. Waiting too long to deal with wrongdoers
  7. Not self-reporting findings to the SEC
  8. Audit committee micromanagement of the restatement
  9. Failing to remediate
  10. Creating an unnecessarily detailed SAB 99 materiality analysis

In addition to these tips, companies should ensure they follow the standards governing accounting restatements in ASC 250 and that they assess misstatements for each reporting period.  Although certain misstatements may be insignificant in any given reporting period, they could aggregate to a material amount over time (such as the impact to the balance sheet).

When restatements arise, SEC registrants will need to disclose relevant information on SEC Forms 10-K/A and 8-K (for Big R) and SEC Form 10-K (for Little r).

Influencing the narrative

I’m going to fast forward the process of restating financial statements to communicating with outsiders what the facts are.  When management becomes aware of material misstatements in prior periods, the company should be clear and assertive with users of its financial statements about the nature and extent of the misstatements identified.  In connection with its assessment, management should be able to, at a minimum, address the following concerns:

  • explain the magnitude of the misstatement;
  • identify which accounts were affected;
  • describe what was done to remediate the misstatement (both in the financial statements and in ICFR);
  • explain what programs and controls have been put in place to avoid misstatements from occurring in the future; and
  • explain the implications of misstatements on the company’s future financial reporting and forecasts

It goes without saying that if companies do not take active measures to effectively management the risks I’ve discussed, users of their financial statements may call into question whether or not the root-causes in the company have been addressed.

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Materiality — consolidated level vs. segment level

I often work on litigation consulting engagements where the concept of materiality is front and center.  A key question that I have encountered is, for a consolidated entity, whether or not materiality is to be assessed at the consolidated level or at the segment level from a financial reporting disclosure perspective.

Materiality

The guidance is clear that materiality is supposed to be assessed in the context of the “financial statements taken as a whole”, or at whatever level the issuer is reporting its financial statements.  However, there are some items for consideration that can provide some color to this discussion and that can assist those involved with these types of decisions to understand the implications of making materiality decisions at a level lower than the consolidated level.

Auditor Considerations

When the external auditor opines, the auditor refers to the highest level of financial statements, typically the “consolidated” financial statements, presenting fairly, in all material respects, the financial position/results of operations/cash flows, etc.  When the auditor plans and performs an audit, the auditor considers “materiality”, which, according to auditing standards, is also based on the “financial statements taken as a whole” concept.

Auditing Standard (AU) No. 312 titled “Audit Risk and Materiality in Conducting
an Audit” addresses materiality for particular items of lesser amounts than the materiality level determined for the financial statements taken as a whole.  Paragraph 31 states:

When establishing the overall strategy for the audit, the auditor should consider whether, in the specific circumstances of the entity, misstatements of particular items of lesser amounts than the materiality level determined for the financial statements taken as a whole, if any, could, in the auditor’s judgment, reasonably be expected to influence economic decisions of users taken on the basis of the financial statements. Any such amounts determined represent lower materiality levels to be considered in relation to the particular items in the financial statements.

Paragraph 32 provides some items for consideration by the auditor.  However, at the end of the audit, as I’ve explained previously, the auditor generally opines on the financial statements taken as a whole.  This is important to remember.

Issuer Guidance

SFAS 131, Disclosures about Segments of an Enterprise and Related Information, discusses disclosure requirements for segments of a filer.  Within par. 78, it states:

Paragraph 125 of Concepts Statement 2 states that “. . . magnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, will not generally be a sufficient basis for a materiality judgment.” That guidance applies to segment information. An understanding of the material segments of an enterprise is important for understanding the enterprise as a whole, and individual items of segment information are important for understanding the segments. Thus, an item of segment information that, if omitted, would change a user’s decision about that segment so significantly that it would change the user’s decision about the enterprise as a whole is material even though an item of a similar magnitude might not be considered material if it were omitted from the consolidated financial statements. Therefore, enterprises are encouraged to report information about segments that do not meet the quantitative thresholds if management believes that it is material. Those who are familiar with the particular circumstances of each enterprise must decide what constitutes material.  (emphasis added)

It seems the FASB intentionally made the requirement to disclose something at the segment level a higher standard than the requirement to disclose something at the consolidated/enterprise level, for the reason that the focus should be on the “financial statements taken as a whole” and not at the level of a segment.

Interpretation

In the end, the question as to whether materiality is to be assessed at the consolidated level or at the segment level from a financial reporting disclosure perspective more clear.  Decisions regarding materiality at a lower level than at the consolidated level, barring an exceptions (as described in SFAS 131), tend to get swallowed up in materiality at the reporting, or consolidated, level.  Users of financial statements, including forensic accountants, should keep these concepts in mind.

Applicability

When a dispute or allegation comes forth that accuses an entity of not disclosing something that perhaps it should have, these concepts should be reviewed.  SAB No. 99 also provides some color and should be consulted.  I assist clients with these complex issues on a regular basis and often the answer is not black or white.  The specific facts and circumstances should be understood, particularly the more macro factors (such as industry peer disclosures).  In the end, professional judgment should be applied in a manner that is well-thought out, documented, and defensible.

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Materiality in financial statements

All too often the concept of materiality in the context of financial statements is not black and white, as some like to think.  Over and over again my experience has been that materiality is commonly misunderstood and misapplied.  Those dealing with disputes who don’t have a solid understanding of materiality can find themselves fighting a tough uphill battle.

Definition

So, to begin, what is “materiality”?

When I was a financial statement auditor, my engagement team would compute a quantitative threshold and call it overall materiality.  This was typically 5% of the audit client’s pre-tax income from continuing operations for profit-oriented entities, or, if pre-tax income from continuing operations was volatile or perhaps a loss was realized in one year and a gain in another year, we would sometimes compute an alternative materiality, taking into account other financial statement metrics (such as revenues, assets, equity, etc.) and apply judgment in deciding on a quantitative threshold (SAS No. 107 at ¶ 4).  This overall materiality calculation was the starting point in planning the audit, assessing risk, and performing audit testing.  Although qualitative factors are considered in audits, the quantitative threshold is often the primary tool to measure the significance of misstatements.

However, in the context of a litigation, contractual dispute, or other matter, materiality is more broad than a simple quantitative threshold.  The SEC Staff elaborated (in 1999) on this concept of materiality in Staff Accounting Bulletin No. 99, Materiality, stating:

The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.

This formulation in the accounting literature is in substance identical to the formulation used by the courts in interpreting the federal securities laws. The Supreme Court has held that a fact is material if there is –

a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.

Under the governing principles, an assessment of materiality requires that one views the facts in the context of the “surrounding circumstances,” as the accounting literature puts it, or the “total mix” of information, in the words of the Supreme Court. In the context of a misstatement of a financial statement item, while the “total mix” includes the size in numerical or percentage terms of the misstatement, it also includes the factual context in which the user of financial statements would view the financial statement item…

The FASB has long emphasized that materiality cannot be reduced to a numerical formula.

Rules of Thumb

The SEC Staff also weighed in on the common 5% threshold that many market participants applied in the past.  Although this SEC Staff guidance has been publicly known and relied upon for over 16 years, I still find this mentality:

The staff is aware that certain registrants, over time, have developed quantitative thresholds as “rules of thumb” to assist in the preparation of their financial statements, and that auditors also have used these thresholds in their evaluation of whether items might be considered material to users of a registrant’s financial statements. One rule of thumb in particular suggests that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances, such as self-dealing or misappropriation by senior management. The staff reminds registrants and the auditors of their financial statements that exclusive reliance on this or any percentage or numerical threshold has no basis in the accounting literature or the law.

The SEC also acknowledged widespread use of a 5% – 10% threshold range, which was referenced to FASB’s Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, at paragraph 167.

Deeper Understanding

There are some key phrases in SAB No. 99, namely “surrounding circumstances” and “total mix of information.”  I’d like to touch upon these key phrases next.

Although something may be perceived as immaterial on the surface, particularly quantitatively small misstatements, the following, at a minimum, should be considered:

  • whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate
  • whether the misstatement masks a change in earnings or other trends
  • whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise
  • whether the misstatement changes a loss into income or vice versa
  • whether the misstatement concerns a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operations or profitability
  • whether the misstatement affects the registrant’s compliance with regulatory requirements
  • whether the misstatement affects the registrant’s compliance with loan covenants or other contractual requirements
  • whether the misstatement has the effect of increasing management’s compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation
  • whether the misstatement involves concealment of an unlawful transaction.

The Staff made sure that users of this guidance understood that this above list “is not an exhaustive list…”  All relevant facts and circumstances should be considered.  By the way, I want to mention that a key criticism of SAB No. 99 is that it does not clearly define what is not considered to be material.  This “gap,” of course, can be an area of frustration for registrants.

Applicability

Another thing I want to make clear is that all of this talk about materiality is, unless specific contractual terms dictate otherwise, in the context of “the financial statements taken as a whole.”  Further, the same context applies to auditors when they plan and perform audits (SAS No. 107 at ¶ 7 and 11d).  For those who like to refer to the “old school” auditing standards, SAS No. 47, which was superseded by SAS No. 107, has similar language (see ¶ 3, 8).

Recently I assisted an expert take a firm, reliable position that materiality must be considered in the context of the financial statements taken as a whole and not on a subset of a subset of the financial statements.   The litigation I refer to involved allegations that the defendant client materially misstated its financial statements such that one of its primary users relied on allegedly materially misstated information.  Having a strong grasp of materiality and how to assess specific transactions, disclosures, or business segments for materiality is a game changer for clients involved in disputes or investigations.  Attorneys should seek out practitioners that have a solid understanding of these materiality concepts.

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