19 May Why Financial Restatements Happen & How to Prevent Them
When companies reissue prior financial statements, it raises a red flag to investors and lenders. However, not all restatements are bad news. Some result from an honest mistake or misinterpretation of an accounting standard, rather than from incompetence or fraud. Below is a closer look at restatements and how external auditors can help a company’s management get it right.
Avoid Automatic Responses
The Financial Accounting Standards Board (FASB) defines a restatement as “a revision of a previously issued financial statement to correct an error.” Accountants decide whether to restate a prior period based on whether the error is material to the company’s financial results. Unfortunately, there are not any bright-line percentages to determine materiality.
When you hear the word “restatement,” do not automatically think of the frauds that occurred at Xerox, Enron, or WorldCom. Some unscrupulous executives do use questionable accounting practices to meet quarterly earnings projections, maintain stock prices, and achieve executive compensation incentives. However, many restatements result from unintentional errors.
Spot Error-Prone Accounts
Accounting rules can be complex. Recognition errors are one of the most common causes of financial restatements. They sometimes happen when companies implement a change to the accounting rules (such as the updated guidance on leases or revenue recognition) or engage in a complex transaction (such as reporting compensation expense from backdated stock options, hedge accounting, the use of special purpose or variable interest entities, and consolidating with related parties).
Income statement and balance sheet misclassifications also cause a large number of restatements. For instance, a borrower may need to shift cash flows between investing, financing, and operating on the statement of cash flows.
Equity transaction errors, such as improper accounting for business combinations and convertible securities, can also be problematic. Other leading causes of restatements are valuation errors related to common stock issuances, preferred stock errors, and the complex rules related to acquisitions, investments, and tax accounting.
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Restatements also happen when a company upgrades to a higher level of assurance (say, when transitioning from reviewed statements to audited statements). That is because audits are more likely than compilation or review procedures to catch reporting errors from prior periods. An external auditor is required to “plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”
However, after the initial transition period, audits typically catch errors before financial statements are published, minimizing the need for restatements. Auditors are trained experts on U.S. Generally Accepted Accounting Principles (GAAP) – and they must take continuing professional education courses to stay atop the latest changes to the rules.
In addition to auditing financial statements, our auditors can help implement cost-effective internal control procedures to prevent errors and accurately report error-prone accounts and transactions. Contact us for help correcting a previous error, remedying the source of an error or upgrading to a higher level of assurance.