Restatements: The Costly Result of an Error

By July 26, 2019 August 9th, 2019 Audit
restatement of financial statements

Corporate officers, auditors and audit committees all work towards ensuring US publicly traded companies provide accurate corporate financial reports to investors. However, even with all of the different components working diligently to present clear and accurate reports, errors do occur. How the error is rectified depends on the timing and severity of the offense.

In some cases, the error is alleviated through a restatement. While innocent sounding, a restatement can be devastating. Thus, it is important to understand when they are necessary, how it can affect you, and how to avoid the situation altogether.

What is a restatement of a financial statement?

The Financial Accounting Standards Board (FASB) defines a restatement as a revision of a previously issued financial statement to correct an error. Restatements are required when it is determined that a previous statement contains “material” inaccuracy. However, FASB offers minimal guidance in defining materiality. Accountants are responsible for determining whether a past error is “material” enough to need a restatement. The Securities and Exchange Commission (SEC) suggests companies and auditors conduct quantitative and qualitative analysis to identify any errors in prior financial statements.

Often, “material” inaccuracies stem from accounting mistakes, noncompliance with generally accepted accounting principles (GAAP) or other frameworks, fraud, misrepresentation or clerical errors.

In what instances are restatement filed?

A “material” error affecting part or all of a financial statement often triggers a restatement.

Typically, these errors are a result of innocent mistakes and/or basic misinterpretation. Some leading causes for restatements include:

  • Recognition errors – For example, when accounting for leases or reporting compensation expense from backdated stock options.
  • Income statement and balance sheet misclassification – For instance, a company may need to shift cash flows between investing, financing and operating on the statement of cash flows.
  • Mistakes reporting equity transactions – This includes improper accounting for business combinations and convertible securities.
  • Valuation errors related to common stock issuances
  • Preferred stock errors
  • Complex rules related to acquisitions, investments, revenue recognition and tax accounting
Restatement of Financial Statements Infographic image

In addition, companies often issue restatements when their financial statements are subjected to an elevated degree of scrutiny. For example, restatements occur when a private company converts from compiled financial statements to audited financial statements or decides to file for an initial public offering (IPO). Other cases of restatements include when an owner elects to utilize additional internal (or external) accounting expertise, such as a new controller or audit firm.

The Molson Coors Brewing Co. Case

No company, regardless of their size, is given a pass for accounting errors – whether those mistakes are innocent or malicious. The announcements can be very public and the effects can hinder even the most robust companies.

In February 2019, Molson Coors Brewing Co. (brands include Coors Light, Blue Moon, and Killian’s Irish Red) revealed it was issuing restatements for fiscal years 2016 and 2017. The restatements came after auditors discovered accounting errors for income taxes related to deferred tax liabilities.

Their explanation filed with regulators placed the blame on the acquisition of the remaining 58% stake of MillerCoors in 2016. By understating deferred tax liability and income tax expense, the net profits ballooned by nearly $400 million in 2016. Overall, Molson Coors claims the understated value of the taxes owed, but not yet paid on its balance sheet, amounted to $248 million. Their equity was overstated by the same amount.

Company shares fell by 6.4% following the restatement announcement.

What are the restatement requirements?

In the event that a publicly held company must file a restatement it takes two main steps:

  1. File a Form 8-K to notify the investment community.
  2. Issue replacement Forms 10-Q and 10-K, as applicable.

Companies must file SEC Form 8-K within four days in order to alert investors of “non-reliance” on the previously issued financial statements.

Amended Form 10-Q is required for affected quarters, and Form 10-Ks are necessary depending on how many prior periods are affected.

How does the SEC factor in?

It is the primary focus of the SEC to ensure US companies are presenting accurate information to investors and other stakeholders. As such, the SEC reviews public companies, and some private ones, to verify no violations of security laws have occurred and the companies have complied with financial reporting standards. These more thorough reviews typically take place following press releases, media reports, anonymous tips or amended filings of periodic reports.

More specifically, the SEC may initiate a formal investigation into a potential restatement or fraud case. This decision hinges on factors such as available resources, potential discoveries of misstatements, company-specific characteristics and relevance on emerging accounting and financial reporting matters.

In fact, the SEC’s Enforcement Division instituted a Financial Reporting and Audit (FRAud) Group as part of their efforts to identify and prosecute securities law violations related to reporting and audit failures. The FRAud Group is specifically focused on identifying and exploring areas susceptible to fraudulent financial reporting. These dedicated efforts include an ongoing review of financial statement restatements and revisions.

What happens when the SEC steps in?

When restatements are announced, it can shake investor confidence in the company. However, when the SEC takes action, it can be costly and devastating.

For example, in early January 2019 the SEC imposed a $16 million civil penalty on Hertz Global Holdings and their rental car subsidiary, Hertz Corporation, for misstating pretax income as a result of accounting blunders. According to the SEC, the company’s public financial filings “materially misstated” pretax income due to errors in a number of business units, particularly in areas subject to management estimates.

Subsequently in February 2019, Kraft Heinz revealed they received an SEC subpoena in October 2018 as part of an investigation into their accounting and procurement policies. The company claimed to launch an internal investigation into the matter. Following the conclusion of their investigation, the company posted a $25 million increase to the cost of products sold after determining it was “immaterial to the fourth quarter of 2018 and its previously reported 2018 and 2017 interim and year to date periods.” Kraft Heinz explained they were cooperating fully with the SEC subpoena. They also announced efforts to improve internal controls and procedures to prevent future mishaps. Upon the subpoena disclosure, shares in the company crumbled by nearly 25% in futures trading.

Later, in May 2019, Kraft Heinz announced the restatement of three years’ worth of financial reports following their investigation.

They acknowledged that the errors resulted from lapses in procurement procedures by some employees. In the same announcement, the company revealed they received an additional subpoena from the SEC related to the assessment of goodwill and asset impairments. The subpoena also called for the documents regarding procurement operations.

There are two major takeaways from these very recent cautionary tales:

  1. The SEC will take severe civil action against inaccurate financial statements.
  2. Once the SEC discovers some errors in accounting procedures, they will continue to dig deeper and deeper into your policies. Even if they do not exact penalties, the effects can be felt in the stock market.

What preventative steps can I take to avoid a restatement?

It is in the best interest of companies to take the necessary precautionary steps to avoid future restatements. Seeing as restatements are public admissions of unreliable financial statements, a common outcome following a restatement is a sudden decline in the stock price of an organization. In fact, the American Institute of Certified Public Accountants (AICPA) specifically lists “restatement of previously issued financial statements to reflect the correction of a material misstatement due to fraud or error” as an indicator of material weaknesses in internal controls.

So what can you do to avoid a restatement and maintain investor confidence?

  1. First and foremost, preventing financial restatements begins with an ongoing identification of potentially susceptible areas of your financial reporting processes. Management and other senior leadership should lend particular scrutiny to financial reporting steps involving complex accounting standards, significant use of estimates, and recently issued accounting standards.
  2. Implementation of controls designed to mitigate risks. Upon integrating these controls, it is critical to monitor their effectiveness over time.
  3. Consider qualitative factors, in conjunction with quantitative ones, throughout decision making processes involving significant estimates or matters of judgment.
  4. Maintain timely awareness of evolving accounting standards, as well as new standards, and how they affect your company’s financial reporting. Allocate sufficient and proper resources necessary to ensure the accounting standards are properly applied.

Reporting your financial statements is a standard procedure for you and your company. It is vital to make sure you are exercising extensive awareness about your internal controls and ensuring the information reflected in those statements is accurate. You do not have to take this on by yourself.

Squar Milner is here to help. In fact, we are one of the few California-based accounting firms to audit publicly-held companies. We have an experienced team with exceptional experience ready to help. Check out more about our auditing services, particularly in relation to Sarbanes-Oxley compliance, and see how we can best serve you.

Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner.  All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.