June 30, 2014
Under Generally Accepted Accounting Principles (GAAP), most errors in previously issued financial statements are corrected via an amendment called a “restatement.” Restatement is a dreaded word in corporate accounting circles. One commentator likened a restatement to a “death in the family.” A company forced to restate faces a panoply of hazards, from ratings downgrade to indenture default or even bankruptcy. Although the reputational sting has lessened since the financial crisis, restatement remains grueling and traumatic.
Section 250 of the Financial Accounting Standards Board’s Accounting Standards Codification gives an inkling of the cavalcade of errors that can infect financial statements, including math mistakes, incorrect application of GAAP, oversights, misuse of facts, fraud, and use of non-GAAP accounting standards. However, only an error deemed “material,” defined by GAAP as one that “makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement,” triggers restatement.
Most financial statement errors are uncovered through some kind of internal review, often in consultation with the company’s independent auditor. Last year, only a small number of errors were discovered by outside entities like the Securities and Exchange Commission.
Restatement is considerably more complex for SEC reporting companies. Such companies must proceed through the restatement gauntlet while also navigating the disclosure requirements of the securities laws. When an SEC reporting company becomes aware of an error in previously reported financial statements it must, in addition to determining if the error is material under GAAP, decide whether the error makes the prior, erroneous financial statements unreliable. A finding of unreliability means the company has four days to file a Form 8-K, item 4.02: Non-Reliance on Previously Issued Financial Statements.
A “non-reliance” finding does not follow automatically from the discovery of an error. SEC Associate Chief Accountant Louise M. Dorsey explains that a 4.02 filing is “not automatically required for every error in the financial statements. It would depend on … quantitative and qualitative analysis” under Staff Accounting Bulletin 99: Materiality (Louise M. Dorsey, Remarks Before the 2006 AICPA National Conference on Current SEC and PCAOB Developments, December 12, 2006). In other words, the obligation to file 8-K, item 4.02 is triggered by a finding that the error is material under SAB 99.
In addition, if the restatement process will delay a required continuous disclosure filing, the company must file a form 12b-25: Notification of Late Filing.
The flowchart below gives a simplified overview of key decisions in the restatement process for SEC reporting companies.
Last year, 281 SEC reporting companies filed a form 8-K, item 4.02. Companies of all sizes were forced to restate financials, but most were small -– 50 of the 281 had a market capitalization of less than $10 million. The smallest, with a market capitalization of $100,000, was protein drink marketer Attitude Drinks, Inc. (8-K, ATTITUDE DRINKS INC, November 05, 2013). Attitude’s errors involved the accounting treatment of an instrument that tripped up at least a dozen other companies in 2013: convertible securities. Attitude’s independent auditor discovered that the company’s in-house accountant had employed “an incorrect conversion price in the determination of the total fair value of the convertible notes payable,” as well as “an incorrect interest rate and incorrect conversion rate.” The largest company required to restate, with a market capitalization of over $25 billion, was Tesla Motors, Inc., one of 25 over-one-billion-dollar companies restating in 2013 (8-K, TESLA MOTORS INC, March 07, 2013). Tesla’s error was jumping the gun: moving debts from the “payable” column to the “paid” column before money had changed hands. The effect of the restatement was a “decrease in purchases of property and equipment included in cash flows … and a corresponding increase in the change in accounts payable.” Tesla urged investors not to fret; “the restatements have no impact on previously reported total cash and cash equivalents, consolidated income statements, consolidated balance sheets, or free cash flows.”
Our next post will delve into the who, what, why, and wherefore of last year’s public company restatements.