Accounting Errors, Restatements and Materiality

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Accounting Errors, Restatements and Materiality

• Scott A. Taub
• June 4, 2008

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Agenda

• Statistics on Restatements
• Why so many?
• Unnecessary restatements
• Evaluating Materiality
• Quantifying errors
• Large errors
• Quarters
• Errors that dont affect income
• Responding to errors
• Looking ahead/improvements

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First, Some Statistics

• Number of restatements (Audit Analytics)
• 2003 876
• 2004 1029
• 2005 1545
• 2006 1801
• 2007 1237
• Accelerated filer restatements dropped in 2006
  and 2007, non-accelerated first drop in 2007
• Numbers are still very highabout 1 in 11 public
  companies

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Why So Many Restatements?

• The accounting literature is too complicated
• Auditors are not accepting accounting treatments
  that they used to accept
• Companies are being forced to restate for things
  that are not important or material
• SEC second-guessing
• Accountants are making too many mistakes
• There are restatements that didnt have to happen

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Why So Many Restatements?

• Plumlee, Yohn study in resource materials
• Follow-up to work done by SEC Office of the Chief
  Accountant
• Most common cause of restatements is simple
  errors without any exacerbating factor
• Less common were errors with contributing factors
  like complex literature and differing judgments

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Unnecessary Restatements

• SEC comment letter says Please revise
• Often SEC staff just needs more information
• Dont restate if you dont think you have an
  error
• Appeal to more senior staff if necessary
• Auditor suggests a restatement based on a
  technical issue or unwritten rule
• Make sure issue is fully fleshed out and that
  principles of the relevant GAAP are understood
• Consider talking to SEC staff
• These restatements often confuse others

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What is Material?

• Important to a reasonable investor
• Judgmental and difficult to know for sure
• Not simply based on size Qualitative factors
  are important
• Total Mix of information
• SAB 99 intended to help with analysis
• Companys responsibility to analyze
• Company, then auditor, then (perhaps) SEC staff
• If company and auditor havent concluded, SEC
  staff wont answer, or will just say material

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Quantifying Errors

• SAB 108 Quantifying Misstatements
• Use both rollover and iron curtain methods to
  quantify error
• Doesnt change qualitative considerations
• Allowed for cumulative catch-up for errors that
  had built up on balance sheet

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Can Large Errors Be Immaterial?

• What is large anyways?
• SAB 99 says small not necessarily immaterial
• SAB 99 doesnt say that large is always material,
  but many have applied it that way
• SEC staff does NOT believe large must be material
• However, issues that could make a large error
  immaterial are difficult to generalize
• Company must thoughtfully consider
• Nobody cares about our financial statements is
  a bad argument

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Quarters

• Securities law treats interim periods as
  important
• Investors certainly care about quarterly results
• APB 28 might suggest that interim periods are
  only evaluated as part of the year
• Diversity in reading, however
• Doesnt square with investor behavior
• Errors material to a quarter, but not the year
• APB 28 fix in the next quarter if not material
  to any prior period -- SEC staff generally
  agrees
• But remember, qualitative factors important

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Errors that Dont Affect Income

• Classification
• Consider what captions and subtotals are affected
• Consider debt covenants and non-GAAP measures
• Disclosure
• Cash Flow
• Dont say Its just classification
• Dont assume immaterial
• Consider qualitative factors

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If an Error is Identified

• Conclude immaterial and do not correct at all
• Some errors dont self-correct
• Conclude immaterial and fix in current quarter
• Creates out-of-period item in period of
  correction
• Conclude material and restate in next filing
• No amending of prior 10-Ks and 10-Qs
• May be appropriate if next filing is immediate
• May be appropriate if error built up over time
• Conclude material and amend prior filings
• The usual way errors are corrected

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Improvements

• Why are restatements dropping?
• Section 404 is working
• Makes sense in light of Plumlee, Yohn study
• SAB 108 allowed some to clean-up before a
  restatement was tripped
• That was its purpose
• SEC staff isnt as rigid as might have been in
  the past
• No big issue like leases in 2005, exotic debt in
  2006

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Improvements -- Issuers

• Fix all errors when discovered
• Either by restatement or in current period
• Consistent with CIFR recommendation
• Eliminates long-term tracking and demonstrates
  intent to keep books accurate
• Restate for intentional errors
• Failed accounting-motivated transactions
• SEC staff has no sympathy, nor do investors
• Continue to improve controls
• Dont seek advantageous accounting
• Talk to SEC staff

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Improvements -- Regulators

• What can the SEC staff do?
• Accept reasonable judgments and diversity
• Provide some thoughts on large errors, quarters,
  and errors that dont affect income
• Without it, many err on the conservative side,
  and restate rather than arguing
• Encourage companies to make the dark period
  shorter and less dark
• What can FASB staff do?
• Write less complex standards

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QUESTIONS?

• Scott A. Taub