3.7 Restatements and Corrections of Accounting Errors
Financial statement restatements can be expensive and time-consuming. However, the level of effort and cost required to restate financial statements is often dwarfed by the loss of public confidence that can result from such restatements. An entity that is preparing its initial registration statement or another initial public filing for submission to the SEC will benefit from designing a thorough set of processes and internal controls that ensure the completeness and accuracy of its financial statements and from working with its auditors to provide assurance that the financial statements are free from material misstatement. This section discusses the evaluation of potential accounting errors, alternative responses to such errors, and other matters that apply to entities filing with the SEC for the first time.
3.7.1 Identifying Accounting Errors
ASC 250-10-20 defines a restatement as “[t]he process of revising previously
issued financial statements to reflect the correction of an error in those
financial statements.” Further, an error in previously issued financial
statements is defined as follows:
An error in recognition,
measurement, presentation, or disclosure in financial statements resulting
from mathematical mistakes, mistakes in the application of generally
accepted accounting principles (GAAP), or oversight or misuse of facts that
existed at the time the financial statements were prepared. A change from an
accounting principle that is not generally accepted to one that is generally
accepted is a correction of an error.
If the amount, presentation, or disclosure was not in accordance with the
applicable financial reporting framework, the SEC’s rules, or the applicable
basis of presentation in the originally issued financial statements, a
misstatement exists. However, as stated in Section 3.1, adopting public-entity U.S.
GAAP and providing SEC-required disclosures for the first time do not constitute
the correction of an accounting error under ASC 250.
3.7.2 Evaluating Accounting Errors
In evaluating accounting errors, an entity must consider the materiality of such
errors, including the omission of required disclosures and accounting
information, to determine whether the financial statements need to be restated.
When assessing materiality, an entity must consider all facts and circumstances related to a
misstatement. SAB Topic 1.M (codified in ASC 250-10-S99-1) indicates that “[i]n the context of a
misstatement of a financial statement item,” while the relevant facts and circumstances include “the size
in numerical or percentage terms of the misstatement, [they also include] the factual context in which
the user of financial statements would view the financial statement item” (e.g., disclosures). Therefore,
both quantitative and qualitative factors are important to assessing an item’s materiality. An entity
evaluates whether a restatement is necessary or appropriate on the basis of such factors.
If a misstatement does not have a material effect on
prior-period financial statements (i.e., the evaluation under the “rollover”
approach) and its correction in the current period would not have a material
effect on the current-period financial statements (i.e., the evaluation under
the “iron-curtain” approach), the prior-period financial statements ordinarily
would not be restated; instead, the misstatement would be corrected in the next
filing. For additional details related to the evaluation of errors under the
iron-curtain and rollover approaches, see Section
6.7.5.2.
On March 9, 2022, SEC Chief Accountant Paul Munter delivered a
speech on the importance of objectivity in
the assessment of the materiality of errors. Mr. Munter pointed out that in
determining whether an error is material, a registrant should consider “all
relevant facts and circumstances surrounding the error, including both
quantitative and qualitative factors.” He emphasized that the SEC is seeing more
registrants argue that a large quantitative error is not material as a result of
qualitative factors and indicated that, in the SEC’s view, it may be “difficult
for qualitative factors to overcome the quantitative significance of the error”
in such circumstances. Other common arguments that the SEC has not found
persuasive when considering registrants’ assessments of the materiality of
errors include:
- “Financial statements or specific line items . . . are irrelevant to investors’ investment decisions.”
- Errors in previously issued financial statements are not material because other registrants also made the error.
- One error is not material because it is offset by another error.
Mr. Munter also emphasized an error’s impact on the assessment of the
effectiveness over ICFR.
3.7.3 Corrective Action
In deciding whether a restatement is necessary or appropriate, an entity must
determine whether an accounting error (or accumulated errors) is material or
immaterial. This determination should include evaluation of both quantitative
and qualitative factors. For material errors, the entity must restate the
prior-period financial statements. When material errors are identified in
previously issued financial statements and there are persons who are currently
relying on, or who are likely to rely on, those financial statements and the
audit report, the entity should act in a timely manner to prevent further
reliance thereon. When preparing the restatement, the entity must comply with
the following requirements in ASC 250-10-45-23:
- “The cumulative effect of the error on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.”
- “An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.”
- “Financial statements for each individual prior period presented shall be adjusted to reflect correction of the period-specific effects of the error.”
The following list comprises the primary disclosure and communication requirements for material
restatements:
- Inclusion, in the auditor’s report, of an additional paragraph referring to the restatement.
- Individual financial statements labeled “as restated.”
- Disclosures in the financial statements in accordance with ASC 250.
SAB Topic
1.N (SAB 108) also addresses “immaterial restatements,”
which may be necessary if a prior-period error (or errors) identified is not
material to the prior periods presented but is material to the current period if
the prior-period error (or accumulated errors) is corrected in the current
period. In this instance, the immaterial errors are corrected the next time
comparative financial statements are issued. The disclosure and communication
requirements for immaterial restatements differ from those described above in
the following ways:
- Financial statement column headings do not have to be labeled “as restated.”
- An additional paragraph in the auditor’s report is typically not necessary.
3.7.4 Impact on Internal Control
An entity must evaluate financial statement misstatements to determine whether they are indicative of
a deficiency in internal control. Further, a deficiency in internal control must be assessed to determine
whether it is related to a design or operating deficiency.
Once the control deficiency has been identified, its severity must be evaluated to determine the
disclosure requirements, communication requirements, or both. Appendix A of PCAOB AS 2201 provides
the following definitions to assist entities with this evaluation:
- “A deficiency in [ICFR] exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.”
- “A significant deficiency is a deficiency, or a combination of deficiencies, in [ICFR] that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting.”
- “A material weakness is a deficiency, or a combination of deficiencies, in [ICFR], such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”
Registrants are not required to make a written assertion on ICFR in their initial registration statement filing or in the first filing of a Form 10-K after going public. However, the auditor’s requirement to communicate significant deficiencies and material weaknesses to those charged with governance still applies. In addition, after consulting with SEC counsel, it is likely that a registrant may need to disclose an identified material weakness in internal control in the risk factors section of the registration statement. For more information, see Chapter 6.
3.7.5 Additional IPO Considerations
Entities preparing an initial registration statement or another initial public filing for submission to the
SEC should also be aware of the following additional considerations:
- As stated in Section 1.4.1, depending on the length of time between amendments, financial statements and other information included in the registration statement may need to be updated to reflect subsequent periods. Such an update may include adding an additional year of audited financial statements. In some cases, an error or errors may be identified during the audit for the subsequent year (or years). Depending on the materiality of the error(s), figures may be restated after the initial registration statement has been submitted to the SEC. Once the effects of a correction of an error on prior periods have been disclosed in issued annual financial statements, disclosure of the restatement does not need to be repeated when the restated amounts are presented as prior-period comparative amounts in subsequently issued annual financial statements. In this context, interim financial information is not considered the equivalent of issued annual financial statements. In addition, the reissuance of financial statements that do not include any additional annual periods (e.g., a subsequent registration statement amendment that does not yet include an additional annual period of audited financial statements) does not meet this requirement, and the “as restated” or similar language should be retained to identify the period(s) restated. The restatement language may be removed once the subsequent issuance of annual audited financial statements is completed.
- Restatements can prolong the registration process because each amendment can result in additional SEC comments.
- CEOs and CFOs of newly public companies are subject to certain provisions of Sarbanes-Oxley and Dodd-Frank that may compel them to disgorge bonuses or other compensation earned during periods for which related financial information is subsequently restated. Specifically, under Section 304 of Sarbanes-Oxley, CEOs and CFOs may be required to return compensation received within the 12-month period following the public release of financial information if there is a restatement of such financial information because of material noncompliance, due to misconduct, with financial reporting requirements under the federal securities laws.
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Executive officers, including the CEO and CFO, of newly public companies listed on national exchanges will be subject to expanded executive compensation clawback policies as well. In October 2022, the SEC issued a final rule to implement the Section 954 mandate of Dodd-Frank to ensure that executive officers do not receive “excess compensation” if the financial results on which previous awards of compensation were based are subsequently restated because of material noncompliance with financial reporting requirements. Such restatements would include those correcting an error that either (1) “is material to the previously issued financial statements” (a “Big R” restatement) or (2) “would result in a material misstatement if the errors were corrected in or left uncorrected in the current report” (a “little r” restatement).Specifically, the final rule requires issuers to “claw back” excess compensation for the three fiscal years before the determination of a restatement regardless of whether an executive officer had any involvement in the restatement. The final rule also requires an issuer to disclose its recovery policy in an exhibit to its annual report and to include new checkboxes on the cover page of its annual report to indicate whether the financial statements “reflect correction of an error to previously issued financial statements and whether [such] corrections are restatements that required a recovery analysis.” Additional disclosures are required in the proxy statement or annual report when a clawback occurs. Such disclosures include the date of the restatement, the amount of excess compensation to be clawed back, and any amounts outstanding that have not yet been clawed back.Companies undertaking an IPO are required to adopt a clawback policy that complies with the requirements before being listed on a national exchange. However, compensation received before the company is listed on a national exchange does not have to be clawed back under the SEC rule. For further details on the final rule, see Deloitte’s November 14, 2022, Heads Up.