Restatement Effect and Prevention

In June of 2014, Hertz Global Holdings (Hertz) announced that significant accounting errors¹ would require the company to revise and reissue financial statements from 2011 to 2013. The public reacted to this accounting disaster violently: Hertz’s stock price fell close to 10 percent on the same day, the SEC launched an investigation of the company’s internal controls, and shareholders filed a lawsuit against Hertz. The repercussion caused the company to postpone filing its 2014 quarterly financial statements, leaving investors in the dark. In July, 2015—more than one year after the initial announcement, Hertz finally completed the restatement process for fiscal year 2011, 2012, and 2013; at that point, this accounting nightmare had wiped out close to 40 percent of Hertz’ stock value. (see chart below).

Restating financial statements is rarely good news to the company and investors. The cost of not getting the financial statements right the first time can be grave, as illustrated by the Hertz example. Interestingly, according to a 2017 study by the CPA Journal, at least 50 percent of the financial misstatement cases involve relatively small public companies (market capitalization of less than $250 million), suggesting that smaller companies are at a higher risk of financial misstatement.

What exactly are financial restatements? How does the pubic react to them? How can your startup or growth firm prevent future restatements? This article aims to answer these questions by analyzing facts and trends surrounding restatements and help your company implement solutions to prevent restatements.

Restatements Defined

Regulations require public companies to prepare and file financial statements that are “fairly presented, in all material aspects” in accordance with Generally Accepted Accounting Principles (GAAP). However, sometimes the management, the auditor, or the regulator finds a material mistake in the already-filed financial statements. According to regulations, companies at this point need to announce an imminent revision to correct an error if the company or its auditor concludes that “any previously issued financial statements…should no longer be relied upon because of an error in such financial statements.”

Restatement Types and Trends

Restatements generally have two types: reissuance restatements and revision restatements, each with different restatement requirements and trends.

Reissuance Restatements

Also known as the “Big R Restatement,” this type of restatement occurs when a material error exists in the prior period’s financial statements. Companies with this type of error are required to first inform the public of the discovery within four business days by filing a form 8/K, then restate the previously filed financial statements and correct the error by filing an amendment to the previous financial statements (e.g., 10-K/A or 10-Q/A).

The Sarbanes-Oxley Act of 2002 (SOX) enhanced corporate internal controls over financial reporting; consequently, public companies identified many unnoticed errors, and reissuance restatements came to an all-time high of 943 in 2006. After 2006, with more effective internal controls in place, the number of reissuance restatements has steadily declined (see chart below).

Revision Restatements

Also known as the “small r restatement” or “stealth restatement,” this type of restatement occurs when the error in one single period is not material but the aggregated errors spreading across multiple periods are material. Since making a one-time adjustment to amend the aggregated errors may cause a material misstatement in the current period’s financial statements, companies generally restate the misstatements for the prior periods that are included in the current period’s financial statements and disclose them in footnotes. Notice that revision restatements do not require companies to refile financial statements for previous periods.

While the number of total restatements has declined in recent years, the total number of revision restatements has not; in fact, revision restatements reached an all-time high of 605 in 2014 and have made up the majority of restatements since 2008 (see chart below). Some studies suggest that companies generally favor revision restatements over reissuance restatements because of the relatively milder and kinder market reactions.

According to Investopedia, some leading causes for restatements include, but are not limited to, the following:

• Change of accounting guidance
• Unraveling of industry-wide improper accounting practices
• Heightened regulatory scrutiny
• Non-compliance to GAAP
• Fraud
• Misrepresentation
• Clerical error

These complications can lead to errors in various accounting areas. The following chart utilizes data from Audit Analytics and summarizes the issues that occurred most frequently in all restatements during 2017:

Owners/managers of startups and growth firms should make sure their companies have the capability to accurately record and generate GAAP compliant reports in these error-prone areas to prevent future restatements.

Restatement Effect

For companies going through an IPO, the SEC scrutinizes the financial statements in detail and often sends comment letters requesting clarification or changes in accounting practice. Audit Analytics found that in the past decade, between 6 to 12 percent of all IPO companies made restatements in registration prospectuses, and it is likely that an even higher percentage of companies have made restatements before filing the prospectus. When issuing a restatement, companies risk affecting investor interests and spending too much time correcting financial statements to pass the SEC’s scrutiny and consequently missing the IPO window.

According to multiple academic studies, restatements generally lead to higher audit fees and litigation risk for public companies. This increase in audit fees is due to the increase in billable hours spent trying to understand the nature and impact of restatements. Fearing that investors might sue, or that the SEC might open an investigation, auditors may bill a higher number of hours than usual to ensure the audit quality is high.

Note that the market response to restatements can vary. Though restatements generally indicate that prior financial statements were less credible and of lower quality, the market reacts to restatements on a case-by-case basis, depending on the nature, magnitude, and timespan of restatements.

Most academic and industry research indicates that the market reacts to reissuance restatements (like Hertz’s restatements between 2014 to 2015) more harshly than to revision restatements, causing on average a 3 percent sharper drop in stock price (see Audit Analytics report for more market reactions to restatements).

A similar dichotomy exists between the issues causing restatements. In general, operation issues (e.g., revenue and expense recognition) and integrity issues (e.g., executive compensation disclosure) experience a sharper decline in stock price (often between 10 to 15 percent per Audit Analytics’ report) than other accounting areas. If the restatements are due to new, industry-wide accounting regulations or have little impact on earnings (e.g., minor clerical errors), the market reaction is generally minimal.

Restatement Prevention

As illustrated by the Hertz example and the section above, restatements often undermine company valuations, exhaust legal and accounting resources, and cripple public image. The following are recommendations for owners/managers of startups or growth firms to prevent a restatement nightmare.

Employ Qualified Accounting Professionals

Accounting systems and regulations are complex and ever-evolving, as evidenced in the common restatement items mentioned above. Hiring competent accounting personnel or outsourcing your accounting function to a qualified financial service firm may seem expensive, but doing so will pay dividends in the long run, especially if you hope to be in the IPO-ready position. In addition to routine accounting functions, third-party consultants often provide a pair of fresh eyes, which is often what it takes to discover mistakes. Thus, hiring experienced third-party consultants to review and improve your finance/accounting processes is beneficial. Plus, many professional firms can also assist with non-routine accounting projects such as implementing internal controls, converting the accounting method from a cash basis to an accrual basis, preparing documents for formal audits, and drafting the S-1 for an IPO.

Implement Sufficient and Effective Internal Controls

No matter how capable your accounting department is, honest mistakes or fraud can still happen. Thus, designing and implementing sufficient and effective internal controls should be a priority to ensure the reliability of financial statements. The market has found that with more stringent internal controls in place per SOX’s requirements, the number of restatements has decreased drastically in the past decade (see above chart titled “Reissuance and Revision Restatement Count by Year”). This is convincing evidence that sufficient and effective internal controls may reduce the likelihood of a restatement. Conduct root-cause analyses on important controls and evaluate their effectiveness regularly to assess the need for adjustments.

Establish a Culture of Integrity and Conservativism

Though only a small percentage of restatements are due to fraud or earnings management, the cost of this type of restatement is more detrimental (e.g., Enron Corp’s accounting scandal). Establishing a top-down ethical and conservative culture with no room for “creative accounting” or fraud may prevent your company from deviating from GAAP. Communicate regularly and appropriately with regulators and stakeholders on complex accounting issues.

Conclusion

The capital market is sensitive to financial restatements, as they often signal unreliability of financial statements, and cause a decrease in company valuation and reputation. Startups and growth firms should take the actions described above to prevent loss of funding or interruption of operation due to restatements.

Resources Consulted

• EY Publication: Understanding the Differences and Significance of Financial Restatement
• Georgetown and IU Study: The Effect of 10k Restatements on Firm Value, Information Asymmetries, and Investors' Reliance on Earnings
• CPA Journal: Characteristics of Financial Restatements and Frauds
• IRABF: The Impact of Financial Restatements on Audit Fees
• Audit Analytics 2016 Financial Restatements Review
• Seeking Alpha: Hertz's Accounting Disaster