Audit Analytics (AA) has released its annual report on public company restatements, 2021 Financial Restatements: A Twenty-One-Year Review. AA found that SEC filers disclosed 1,479 restatements in 2021 – quadrupole the 364 restatements in 2020. These restatements were filed by 1,039 companies, a 194 percent increase in restatement filers. But the restatement explosion was entirely the result of restatements by SPACs (special purpose acquisition companies) and SPAC merger companies; SPAC-related restatements accounted for 77 percent of the 1,470 filings. Excluding SPACs, restatements in 2021 fell 10 percent compared to 2020, and the number of companies disclosing a restatement declined by 15 percent. (For an analysis of AA’s 2020 restatement report, see Restatements Decline for the Sixth Straight Year, Notching a New Twenty-Year Low, November-December 2021 Update.)
SPAC Restatements
The dramatic increase in SPAC restatements was primarily in response to a statement issued in April 2021 by the Acting Director of the Division of Corporation Finance and the Acting Chief Accountant. See Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”). This statement urged SPACs to reconsider the accounting treatment of redeemable shares and warrants. Most SPACs recorded shares that included a redeemable feature as permanent equity. The SEC objected and requested the shares be recorded as temporary equity. In addition, the SEC staff asked SPACs and companies that had gone public as a result of a SPAC merger to consider whether warrants recorded as equity should instead be treated as liabilities, subject to fair market value adjustments. The SEC staff statement resulted in over 1,100 restatements.
Big and Little R
As explained in Restatements Hit Another New Low, and SOX Could Be the Reason, July 2017 Update, restatements fall into two categories. When a company determines that users can no longer rely on previously issued financial statements due to a material error, it is required to disclose that determination by filing SEC Form 8-K within four business days. Restated financial statements would normally be filed sometime later, after the company has had the opportunity to analyze and correct the error or errors. This type of restatement is referred to as a “reissuance” or “Big R” restatement.
In contrast, if a company determines that previously issued financial statements contain immaterial errors, and that, despite the errors, users can continue to rely on the prior financial statements, it is not required to file Form 8-K. Corrected financial statements may simply be included in a subsequent SEC periodic filing with the restatement disclosed in the footnotes to the current financial statements. These less significant restatements are called “revision” or “little r” restatements. Revision restatements typically attract less public attention and market reaction than reissuance restatements.
Out-of-period adjustments (OPAs) are a third method of correcting immaterial errors in prior financial statements. OPAs are corrections of prior period errors in the current period. OPAs are not restatements because previous financial statements are not affected.
2022 Report Highlights
In addition to the spike in restatements noted above, highlights of the 2022 AA report include:
Big R restatements tripled, but, ex-SPACs, little r restatements continued to predominate. Sixty-two percent of restatements were reissuance restatements, the highest proportion since 2005. However, excluding SPAC restatements, only 24 percent of 2021 restatements were reissuances, a 3 percent increase from the prior year.
The average net income impact of restatements fell. In 2021, the average restatement net income impact was roughly negative $5 million, down from negative $17.6 million in 2020. Excluding SPAC-related restatements, the average appears to be about negative $10 million, also a drop from the prior year. Overall, 26 percent of restatements had a negative effect on net income, 6 percent had a positive impact, and 68 percent had no impact.
The average number of accounting issues per restatement rose, but without SPACs it declined. In 2021, the average number of issues disclosed per restatement was 1.85, compared to 1.52 in 2020. However, excluding SPAC-related restatements, the average fell to 1.4. AA notes that accounting issues per restatement can provide insight into the quality of the company’s controls.
Ex-SPACs, annual report restatements rose slightly. Thirty-three percent of 2021 restatements were of an annual report, while the remaining 67 percent were of a quarterly filing. However, excluding SPAC-related restatements, 61 percent of restatements were of an annual report, reflecting a modest three percent increase in annual report restatements. AA states that the “restatement of an annual report can reflect the severity of a restatement because annual reports must be audited by an independent accounting firm. An error or misstatement in an annual report is not only missed by management but also by the firm conducting the audit.”
The average number of days restated dropped for the fifth consecutive year. Days restated is also a measure of restatement severity. In 2020, the average was 447 days. While AA does not provide exact numbers, a graph included in the report indicates that, including SPAC-related restatements, days restated in 2021 fell slightly; excluding SPACs, it appears to have dropped substantially into the mid-300s.
Reissuance restatements were filed more quickly. AA tracked the period of time that elapsed between disclosure of an error and the filing of a restatement. This measure only applies to Big R restatements, since little r restatements are not pre-announced. The average number of days to file a restatement in 2020 was 39.9. While AA does not provide exact numbers, a graph included in its report indicates that, including SPAC-related restatements, the “disclosure window” in 2021 was less than 15 days; excluding SPACs, it appears to have dropped to about 30 days.
Larger companies and foreign issuers were less likely to restate. Restatements by non-accelerated U.S. filers increased from 53.3 percent of all restatements in 2020 to 73.1 percent in 2021. (SPACs are generally non-accelerated U.S. filers.) Large accelerated U.S. filers accounted for 10.2 percent of restatements in 2021, and accelerated U.S. filers were 4.5 percent. Foreign company restatements were 12.3 percent of the total in 2021, down from 15.4 percent in 2020.
Thanks to SPACs, revenue recognition fell out of first place as the accounting issue most frequently involved in restatements. Overall, 80.4 percent of restatements cited “Debt and equity securities” as an accounting issued involved in the restatement. This is, of course, the issue that drove SPAC-related restatements. Revenue recognition, the perennial top issue, came in second at 2.8 percent. The next three most-frequently cited issues were Liabilities and accruals, Expenses, and Taxes. Excluding SPAC-related restatements, Revenue recognition retained its top spot; it was cited in 19.1 percent of non-SPAC restatements, followed by Debt and equity issues at 12 percent.
Comment: SPACs clearly had a major impact on 2021 restatements. However, when this one-time event is excluded, AA’s report reveals that the long-term trend toward improved reliability of financial reporting –at least as measured by restatement frequency and severity – continued in 2021. As the Update has previously observed, the substantial investment companies have made in strengthening and monitoring the effectiveness of their controls seems to have paid off. The 2006 restatement peak occurred during the period when public companies and their auditors were devoting a new level of scrutiny to internal control over financial reporting (ICFR) in the wake of the implementation of the Sarbanes-Oxley Act requirement to assess and report on ICFR effectiveness. Since 2006, restatements (ex-SPACs) have declined substantially and continue to decline.
Audit committees should however also bear in mind that some of the decline in restatements may be the result of a change in restatement “culture” – and that that culture may be in the midst of a reset. In a recent statement, SEC Acting Chief Accountant Paul Munter discusses the concept of materiality and its application to financial statement errors. His remarks signal that the SEC staff believes companies and their advisors have been taking an unduly narrow view of materiality and that many errors that have been treated as immaterial should have triggered a reissuance restatement of the affected financial statements. See SEC Acting Chief Accountant Warns Against Bias in Restatement Materiality Decisions, March 2022 Update. It would not be surprising to see an upsurge in restatements – particularly Big R restatements --this year in response to Mr. Munter’s comments and to increased SEC scrutiny of restatement practices.
Audit committees confronted with errors in prior financial reporting and questions concerning the need to restate should make sure they fully understand the reasons for management’s proposed course of action. As stated in SEC Acting Chief Accountant Warns Against Bias in Restatement Materiality Decisions, above, audit committees should take seriously Mr. Munter’s view of their responsibilities with respect to restatements and make sure that they are informed of and involved in materiality determinations regarding errors. The SEC may inquire into the audit committee’s role in cases where it disagrees with a company’s determination regarding the handling of a financial statement error, and committees should be prepared to show that they provided active oversight.