Five years ago, in my first Compliance Week column, which was on restatements, I suggested that companies should always correct an error once it is found, and I'm happy to say that this has become common practice.
At that time, I discussed the process of correcting an error as a choice between correcting it in the current period or restating prior periods.
In fact, though, the choice isn't that simple, as there are multiple ways to correct an error by changing previously reported numbers, and the reasons for the multiple treatments are not intuitive, especially to those who deal with restatements infrequently. In addition, the word “restatement” has become highly charged and is used inconsistently and incorrectly, and sometimes people refuse to use the word to describe something that absolutely is a restatement. So let's consider the multiple meanings of “restatement.”
Restatement, as Defined
The authoritative literature and SEC regulations regarding restatements seem straightforward:
- The Accounting Standards Codification Master Glossary defines restatement as “the process of revising previously issued financial statements to reflect the correction of an error in those financial statements.”
- ASC 250, Accounting Changes and Error Corrections, states, “Any error in the financial statements of a prior period discovered after the financial statements are issued shall be reported as an error correction, by restating the prior-period financial statements.”
- ASC 105, Generally Accepted Accounting Principles, notes that the provisions of GAAP apply only to material items. Read in conjunction ASC 250, this means that restatement is required only for material errors.
- AU Section 508 requires that auditors' make reference to the correction of a material misstatement in the auditors' report the first time the corrected statements are issued.
- SEC regulations require that correction of a material error in a previously filed form 10-K or 10-Q be reported by amending the previous filing.
- SEC regulations require a Form 8-K Filing if the company concludes that previously issued financial statements should not be relied upon because of an error.
When a company needs to change previously issued financial statements to correct an error, a straight reading of the guidance above would result in a Form 8-K filing to end reliance on the financial statements for all periods affected, and amendments of every 10-K and 10-Q containing financial statements that need to be changed. Auditors' opinions on applicable annual financial statements would reference the restatement. The SEC requires companies to label the affected periods as “restated.”
Now and then, that is the way it's handled. The general view, however, is that such a mass restatement is burdensome and often adds little value for users of the company's financial reports. As such, practice has developed alternatives which, while technically in violation of the rules, are commonly accepted.
Restatement, as Generally Accepted
The focus in practice is on getting the corrected information to the public as soon as possible in an understandable way. To accomplish that goal, companies that make corrections to prior financial statements typically amend only the most recent 10-K and any subsequent 10-Qs. A Form 8-K to indicate that all affected financial statements should no longer be relied upon is still necessary. The 10-K/A in such a situation generally includes:
- Audited financial statements for the three years covered by that 10-K, with applicable periods labeled as “restated,” and an audit opinion that makes reference to the restatement;
- A restated selected financial data table that includes corrected information for all 5 years, again with changed columns labeled as “restated”;
- An MD&A discussion based on the corrected figures;
- Restated quarterly income statement data for the two years covered by the quarterly disclosure requirements of Regulation S-K, with appropriate figures labeled as “restated”; and
- Footnote disclosure about the correction of the error as required by GAAP, with detailed disclosure of the effect of the restatement on the annual and quarterly financial statements.
The SEC staff has only expressed in writing its willingness to accept this kind of solution in a handful of specific situations (for example, see the January 2007 “Sample Letter Sent in Response to Inquiries Related to Filing Restated Financial Statements for Errors in Accounting for Stock Option Grants”). Nonetheless, practice has coalesced around this model as an appropriate way to correct multiple periods of financial statements. Although the SEC staff rarely raises concerns about this approach, prior notification to the SEC staff of plans to proceed in this manner is a good idea.
Restatement Without Amendment
An easier way to effect a restatement is sometimes available to companies who find a material error in previously issued financial statements just before the next 10-K is to be filed. In this situation, the restatement is sometimes simply incorporated into that upcoming 10-K, by including in it all of the information that would be included in a 10-K/A.
Hopefully, I've provided a little transparency to a process that is often confusing and opaque. Like many other accounting problems, if practitioners focus on being transparent with the markets, though, they'll usually make the right decisions.
Because the goal is to get the information to market as quickly as possible, this is typically acceptable when the amount of time it would take to amend the previous 10-K would mean that a 10-K/A couldn't be filed before the filing of the next 10-K. The same January 2007 letter explicitly accepted this method when the filing of the next 10-K was scheduled to occur within two weeks. In some instances, longer time frames may also be acceptable. Again, a Form 8-K filing is still necessary to indicate that prior financial statements should not be relied upon.
Restatement Without Admission
In some instances, it is determined that an error did not materially misstate prior year financial statements, but that those financial statements must be changed, nonetheless, because correcting the error currently would materially misstate the current period. While that finding requires some intellectual flexibility (and perhaps, acceptance of something illogical), the SEC staff has indicated that it can occur, most notably in a speech by then Associate Chief Accountant Mark Mahar in December 2008. If the prior period financial statements were not themselves materially misstated, amending the prior 10-K is not required because it did not contain financial statements that included a material error.
In this situation, the correction may be reflected in the next 10-K, even if there is a significant delay until that 10-K will be filed. As the prior information is not considered materially incorrect, there is no need to rush to get the corrected information out, and no need to file a Form 8-K to indicate the prior financial statements shouldn't be relied upon.
Some even go so far, in this situation, as to say it isn't really a “restatement” at all, because restatements are for material corrections, and none of the periods being restated were materially wrong. Proponents of such a view might also say that there is no need to label the changed periods “restated” or to reference the correction in the audit opinion. Sometimes, this is called a “revision” of prior period numbers, or a “restatement with a small “r,” rather than a true “Restatement.” I've seen filings that even call such a change the correction of an immaterial error.
I don't buy any of that. The definition in the Accounting Standard Codification is pretty clear. If you must change prior financial statements because of an error, don't get cute and try to call it anything other than a restatement. If you can somehow get everybody comfortable that the need to restate is driven only by current period concerns, take the reduced administrative work that comes from not having to amend prior filings or file a non-reliance 8-K as a stroke of good luck, and don't press that luck.
While I don't like ducking the term “restatement” when correcting an error causes a change in previously filed financial statements, there are times when that term isn't warranted. For example, when a company finds an error after its earnings release but before the 10-Q or 10-K is filed, so that the filing doesn't match the earnings release. Calling this a restatement is unfair to the company involved, and puts unfair pressure on an earnings release.
Moreover, it doesn't meet the definition. ASC 855, Subsequent Events, states that “Financial statements are issued…when they are widely distributed…in a form and format that complies with GAAP.” SEC commentary notes that “the issuance of an earnings release does not constitute issuance of financial statements because the earnings release would not be in a form and format that complies with GAAP…” As GAAP defines restatement as a change to previously issued financial statements, changing the numbers between the earnings release and the SEC filing isn't a restatement at all, although it isn't exactly something to be proud of either.
More troubling is when the word “restatement” is used in a situation where a change in the company's structure or a new accounting standard requires retrospective changes to the financial statements. These aren't even a result of errors, yet they are sometimes wrongly labeled restatements, and become something that companies worry about because of it.
Restating the Point
If you need to change prior financial statements to correct an error, you're in a tough situation. The fact that there are multiple methods to accomplish this doesn't make the situation any easier. Hopefully, I've provided a little transparency to a process that is often confusing and opaque. Like many other accounting problems, if practitioners focus on being transparent with the markets, though, they'll usually make the right decisions.