Avoiding Unnecessary Restatements

There are too many restatements.

I’d wager that everybody reading this column agrees with those first five words, and that’s why I used them to start off my first column for Compliance Week. Of course, those words don’t provide any insight. In the rest of this column and the columns that follow, I do hope to provide Compliance Week readers with insight into the sometimes opaque world of public company financial reporting: how it works, how it should work, and how it can be improved. I’ve seen the issues as an auditor, as a member of Arthur Andersen’s professional standards group, as a professional accounting fellow, deputy chief accountant, and acting chief accountant at the Securities and Exchange Commission, and as a consultant to companies of various sizes, which is what I do now. In these columns, I’ll look at what is going on in the financial reporting world, with a goal of providing some thoughts on how to make the process easier, smoother, less taxing, and more effective.

I know it’s possible to do this, because if there’s one thing I’ve learned over my career, it’s that we often (unintentionally, to be sure) make financial reporting harder than it needs to be.

In some cases, we even restate previously issued financial statements without good reason. We all know that there are cases where a company restates based on comments from the SEC staff, even though the company itself does not believe restatement is necessary. That will happen (and I believe it should happen) because the role of a securities regulator should, at times, include requiring changes in disclosure that the regulator considers necessary. What troubles me, however, is that I believe that quite a number of those restatements that the issuers in question considered unnecessary also would have been considered unnecessary by the SEC staff if the issue had been discussed further. Which gets us back to the focus of this column: Don't restate unnecessarily.

‘Large’ Errors Still Might Be Immaterial

All things being equal, a larger error is more likely to be important to investors. There was a time when many thought that an error (or group of errors) whose effect on net income was less than 5 percent could be deemed immaterial with little further analysis. This was inappropriate for many reasons (those reasons could be a column unto themselves, and may be, should recent calls from some parties to establish such a safe-harbor continue) and neither the SEC, its staff, nor well-meaning issuers and auditors agreed with it. Nonetheless, the belief that small things shouldn’t be deemed material, no matter the situation, was common enough that former SEC Chairman Arthur Levitt asked his staff to clarify this issue as part of Staff Accounting Bulletin No. 99. SAB 99 acknowledges that the use of quantitative tests is a logical starting point in looking at materiality, but then goes on to provide examples of factors that might lead to a conclusion that a quantitatively small error is nonetheless material. It is silent on whether, and when, a quantitatively large error could be immaterial.

That silence, combined with experiences in working with the staff on particular issues, have led many to conclude that the SEC staff would never accept that a quantitatively large error was immaterial. That conclusion isn't correct. While at the SEC, I was involved in several situations where we did agree that a “large” error was immaterial. In a December 2006 speech, Todd Hardiman, a member of the SEC staff, intended to communicate the staff’s openness on this issue.

Unfortunately, when SEC staff members speak, they are (for good reason) worried that if they “give an inch,” issuers will “take a mile,” so caveats and cautions are always abundant. The caveats and cautions worked too well in this case, because the speech has been taken as confirmation that the staff believes it isn’t really ever possible for a large error to be immaterial. Because of this perception of the SEC staff’s views, when an error that exceeds the magic 5 percent of income threshold is discovered, companies may feel like they have no option but to restate—even when company management, the board of directors, and the auditors believe that the error is immaterial and not important to understanding the company’s financial position, results of operations, or capacity to generate future cash flows.

One reason that so many believe the SEC staff takes a harsh line on evaluating large errors is that when a company does assert that a large error is immaterial, the supporting analysis is often not convincing. Simply asserting that the market won’t (or doesn’t) care isn’t sufficient, at least partly because such an assertion is so difficult to corroborate. In addition, merely asserting the absence of any of the factors cited in SAB 99 isn’t enough, because those factors were designed to provide insight on when a small error might be material, not when a large one might be immaterial. Think of it this way: When the error is large, the presumption is that it is material. Confirming that the SAB 99 qualitative indicators of materiality don’t exist merely confirms that there isn’t additional evidence that the error is material other than its size. The size problem still exists, and the SEC staff will ask for further evidence that the error is immaterial.

It’s important to recognize that factors that might suggest that a large error is immaterial are likely to be specific to the situation in question. For example, if the measure by which the error is deemed large is one that is unusually low during the period in question (for example, if net income is much closer to zero than usual), that might indicate the error is really smaller than it looks. Perhaps the error only affects financial statement measures that are considered unimportant by financial statements users. Maybe the company has since emerged from bankruptcy with a new group of shareholders, and the accounting error relates to an issue that was thoroughly vetted during the bankruptcy proceedings.

The difficulty in identifying factors that might commonly be relevant in showing that large error is immaterial is likely why the SEC staff hasn’t produced a list of such factors, as a counterpoint to the list in SAB 99 of things that might commonly indicate that a small error is material. But that doesn’t mean that facts in a particular situation would never be sufficient to conclude that a larger error is immaterial. A good analysis that explains the situation and states why the company and its advisers believe the error is immaterial in an intelligent way should carry significant weight with the SEC and its staff.

Be Careful When Reacting To SEC Comment Letters

When writing comment letters, the staff in the SEC’s Division of Corporation Finance is never working with as much information as the preparer of the financial statements has. And, especially early in the review process, their comments are likely to be geared toward obtaining information and gaining understanding, even when the comment letters use wording along the lines of, “Please revise or advise.”

It is not uncommon for companies to restate in response to these comments. This is the right response if the staff’s question leads the company to conclude its original accounting was inappropriate. But sometimes the restatement occurs even though the company doesn’t fully understand the reason for the comment or agree with the SEC staff’s apparent position. A company may do this because it believes this is the quickest path to getting its registration statement declared effective, or its review completed.

This is unfortunate. In some of these instances, the staff at the SEC doesn’t fully understand the issue and would not ask for a restatement if it saw that full picture. Other times, the company may not have completely understood the SEC staff’s views and winds up restating the restatement—a particularly painful outcome. To make matters worse, when one of these events occurs, it often leads to confusion in financial reporting circles as other companies, auditors, and financial statement users try to make sense of the situation and determine how it relates to their own accounting. Indeed, this can lead to a broad acceptance of new “SEC staff position” that, in fact, has never been thoroughly vetted.

Instead of rushing to restate before discussing the issue in full, it’s far better to provide a complete explanation of the facts and the accounting rationale the company used. Technical accounting experts (perhaps from an auditor’s national office) can often be helpful in this regard, ensuring that there is a strong analysis of what literature applies and why. If a common understanding doesn’t develop, elevating the issue to senior staff at the SEC, including those in the Office of the Chief Accountant, is perfectly appropriate. SEC procedures provide for this specifically to encourage central vetting of the most difficult issues. Not only will this avoid unnecessary restatements, it will also help ensure that the market only perceives an “SEC staff position” when, in fact, all of the appropriate members of the staff were involved in the issue. And for those who worry that “appealing” a decision of the reviewing staff will result in the company being blacklisted or branded uncooperative, let me assure you that nobody at the SEC keeps a list of such things. If such a list existed, I’d have found it in my 4 ½ years there.

Evaluating Accumulated Errors In Interim Financial Statements

Staff Accounting Bulletin No. 108 has clarified that the cumulative amount of an error that grows over time must be considered when evaluating whether the error is material in regard to annual financial statements. Confusion remains, however, about how an accumulated error should be evaluated in regard to interim or quarterly financial statements. Many auditors and others believe that the SEC staff position on this topic is that if an accumulated error is too large to be corrected in a quarter without materially misstating that quarter, restatement is required. I was told that some number of the 250 or so lease accounting restatements that occurred in 2005 were situations where the error was immaterial to all annual periods but was cumulatively too large to fix in a quarter; the company and the auditor therefore concluded that the SEC staff would expect restatement in such a situation.

As I was deputy chief accountant at the time and didn’t think restatement should always be required in such a situation, I began to explore this issue. I found that most SEC accountants agree that, presuming the original error and its correction weren’t undertaken in a manipulative manner, this situation doesn’t require restatement. Rather, correction in the current quarter with disclosure (see paragraph 29 of APB Opinion No. 28) is an acceptable alternative.

Over the years that I was deputy chief accountant, a small number of issuers took that approach, but many others didn't, mistakenly believing that looking to APB Opinion No. 28 would be a “non-starter” with the SEC staff. In the same speech I mentioned earlier in this column, Todd Hardiman attempted to communicate that the staff would be more than willing to consider alternatives to restatement in these situations. Once again, the caveats and cautions seem to have overwhelmed the intended message, and many view that speech as confirmation that the staff considers restatement the only option if the cumulative error is too big to correct in a quarter. The end of that speech does, quite clearly, make an offer to discuss materiality issues with interested parties. I know that some have taken up Todd and the rest of the SEC staff on that offer, and I hope others will do so as well.

There are many situations in which the SEC staff and an issuer truly disagree about the need for a restatement. No doubt, there will continue to be such situations, and issuers will continue to feel that they were treated unfairly. But I hope that this column has identified for Compliance Week readers a few situations in which there really isn’t—or wouldn’t be, after sufficient discussion—a disagreement about the need for a restatement. Perhaps if we can eliminate these restatements, we can engage in a more useful dialogue regarding the situations in which there are true conceptual disagreements about whether to restate.

Let me make one final comment about errors. Although the above situations are ones in which restatements can be avoided, I hope that companies will cease the practice of leaving a known error uncorrected. If it is determined that restatement is not necessary, the best answer seems to be to correct the error in the next period. Financial statement users understand that companies may make mistakes in doing the books, and they don’t expect routine, understandable mistakes to result in restatements. But it’s much harder to explain why such mistakes wouldn’t be corrected once they are discovered. Furthermore, fixing immaterial errors once they are identified also eliminates the possibility that the error eventually becomes material due to changes in circumstance. Perhaps this would help avoid another group of restatements.