In November 2021, Audit Analytics posted its 20-year review of restatements, showing that the number of "Big R" reissuance restatements in 2020, the last year of the review, was at a record low. According to the report, there were "81% fewer restatements in 2020 than the high in 2006 and 26% fewer than 2019." Notably, however, while in 2005 reissuance restatements represented the majority of restatements, in 2020, reissuance restatements represented only 24.3% of restatements; revision restatements represented 75.7% of all restatements. At yesterday's Northwestern Pritzker School of Law's Annual Securities Regulation Institute, Lindsay McCord, Corp Fin Chief Accountant, raised a question: were companies being properly "objective" in assessing whether a restatement should be a "Big R" or "little r" restatement?
What's the difference between a "Big R" or "little r" restatement? In this December Statement, Acting Chief Accountant Paul Munter said that "if an error is identified in the financial statements, management must determine whether the error is material, which is based on what is important to the user. If that analysis indicates that previously issued financial statements are materially misstated, those financial statements would need to be restated and reissued." In that event, companies are required to file a Form 8-K indicating that the previous financial statements should not be relied upon. "By comparison," Munter continued, "if the error is not material to previously issued financial statements, but correcting the error in the current period would be material to the current period, an entity is not precluded from correcting the error in the current period comparative financial statements by restating the prior period information and disclosing the error, which is commonly referred to as a 'little r' restatement." In essence, in a "little r" revision, companies can correct the error in revisions to the comparative financial statements and disclose the error in the current period or correct the error in the current-period financial statements if it is immaterial. Munter cautioned that "under existing accounting guidance assessing whether an error is material to prior periods is not a mechanical exercise, nor is it based solely on a quantitative analysis. Rather, management must judiciously evaluate the total mix of information, taking into consideration both quantitative and qualitative factors to determine whether an error is material to investors and other users."
[Below based on my notes, so standard caveats apply.]
At SRI, the accounting panel emphasized that the test of materiality set forth in Basic v. Levinson still applies in this context and that the analysis under SAB 99 must include both quantitative and qualitative factors. But McCord stressed that, while it's not inevitable, it's very difficult to conclude that an error is immaterial when it is quantitatively large. In that context, the SEC often ended up disagreeing with management and requiring a "Big R" restatement. On the other hand, the errors could be quantitatively small but material from a qualitative perspective.
According to Bloomberg, at the December 2021 AICPA Conference on Current SEC and PCAOB Developments, Munter asked whether restatement analyses were "'being done from an objective perspective? Or are the analyses starting with, potentially, a bit of a bias and trying to develop arguments for why something is not a 'Big R' restatement? I would encourage folks to start out with an objective evaluation.' Munter encouraged auditors and companies to review SEC staff guidance on materiality, as outlined in SAB 99, to consider when an accounting error is material enough to require a formal restatement. Recent conversations with companies and auditors about materiality have involved arguments from them that an error may be numerically material but not important to investors. 'And I'm not saying that couldn't be the outcome,' Munter told the conference. 'But what I am saying is that's not the way that the SAB 99 is written. So I think the analysis requires a more objective evaluation of the totality of the fact pattern.'"
McCord also observed that, in the SPAC context—where the SEC staff had provided guidance on warrants and equity classification that required many companies to restate—some companies attempted to use a "passage of time" argument, that is, they contended that errors in financial statements were not really material because those old financial statements were not really important to investors, who were instead focused only on the latest financial statements. But, she said, investors aren't focused only on the current financial results; many also consider historical information as well. For example, a pattern of error could lead to questions about reliability. Former Corp Fin Chief Accountant Mark Kronforst, how back at EY, observed that you're probably not in a good place if your argument to the SEC is that the financial statements are not important.
In April 2021, Munter and then-Acting Corp Fin Director John Coates released this Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies ("SPACs"). The primary issue identified in the Statement was whether the warrants issued in connection with de-SPAC transactions should be classified as equity or liability, which depends largely on the specific terms of the warrant and the entity's specific facts and circumstances. If warrants were classified as a liability, according to the Statement, they should be "measured at fair value, with changes in fair value reported each period in earnings." If the company and its auditors determined that, in light of this Statement, there was an error regarding the classification of warrants in previously filed financials, the company had to consider the materiality of the error in assessing whether it needed to restate its financials—which could involve amending one or more periodic reports—and file an 8-K. In addition, the Statement observed, the company needed to consider whether it had to upgrade its ICFR and disclosure controls and procedures and amend its prior disclosures on the evaluation of ICFR and disclosure controls. (See this PubCo post.)
Then in November, Bloomberg reported that the SEC was requiring many SPACs to "Big R" restate their financial statements because they tripped over the classification of certain shares they offered to investors. Auditors with whom Bloomberg spoke said that the SPAC accounting snafu related to incorrect categorization of Class A shares—which are typically redeemable—as "permanent equity instead of temporary equity." One auditor described the issue as "pervasive[:] everyone's dealing with it because everyone did it wrong." SPACs typically issue non-redeemable founders' shares and redeemable Class A shares as part of their capital structures. The redemption feature in the Class A shares provides part of the appeal of SPACs for many investors: if they aren't satisfied with the de-SPAC merger transaction, they can simply redeem their shares for cash. However, under ASC 480, "if an equity instrument is redeemable and this redemption feature is outside the control of the company, that instrument can't be considered permanent," advised another auditor, whose firm, he insisted, consistently applied the proper accounting treatment. Apparently, "most audit firms considered the errors small enough to be fixable with a revision, a minor correction that gets disclosed in the next period's financial statement," the article reported. However, according to one auditor cited in the article, "the SEC came back and made it clear that they believe it's a big R." (See this PubCo post.) According to this Bloomberg article, Munter said that investors "care about the distinction between equity that is considered permanent versus equity that is temporary.... In some situations, SPACs ended up with no permanent equity when they corrected their accounting. And if SPACs drop below a certain equity threshold, they may not be able to list on certain exchanges, he said." He found it hard to understand how, in that circumstance, a "little r" was "responsive to the information needs of investors."
In October 2021, the SEC re-opened the comment period for the rules proposed in 2015 to implement Section 954 of Dodd-Frank, the clawback provision. Section 954 required the SEC to direct the national securities exchanges to adopt listing standards obliging each listed company to adopt, disclose and enforce a policy for recouping executive compensation that was paid on the basis of erroneous financial information, the theory being that it was compensation to which the executives were never really entitled in the first place. Under the 2015 proposal, new Rule 10D-1 would require exchange-listed companies to adopt and implement clawback policies under which they must recover from current and former executive officers the amount of erroneously awarded "incentive-based compensation" received during the three years preceding the date of an accounting restatement that resulted from the company's material noncompliance with any financial reporting requirement under the securities laws. The "amount erroneously awarded" means the amount that exceeds the amount the executive would have received had the compensation instead been determined based on the restated amount. In re-opening the comment period, the SEC asked what should be considered as an accounting restatement for purposes of the rule? Essentially, the proposal considered restatements to be only "reissuance" restatements, but what about "revision" restatements? Since 2015, the SEC noted, concerns have been raised about whether companies are making appropriate materiality determinations for errors identified—perhaps because they are attempting to avoid application of clawbacks. In addition, commenters suggested that the clawback provisions also be made applicable in the event of revision restatements. The SEC believed that expanding the proposal to cover both types of restatements would be appropriate to trigger recoveries and asks for comment about that possibility. (See this PubCo post.)
Although it's totally unrelated to restatements, it's worth noting that the panel reminded us about the new requirement in the Holding Foreign Companies Accountable Act applicable to all registrants. (See this PubCo post.) To help the SEC with its process of identifying auditors that the PCAOB has been unable to inspect, the final HFCAA rules include a new Inline XBRL tagging requirement related to three additional data elements: identification of the auditor who provided the opinion on the financials in the report, the location where the report was issued and the PCAOB ID number of the audit firm. Under the rules, "all registrants will be required to use the updated taxonomy,...for any annual report filed for a period ended after December 15, 2021."
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