AQRM Red Flags: Financial Reporting

The Audit Analytics Accounting Quality + Risk Matrix (AQRM) makes it easy to identify accounting, audit, and governance red flags for public companies. This blog series breaks down the risks associated with specific firm-level events included in the AQRM.

Misstating financial statements is a significant accounting quality red flag.

Unreliable financial statements reduce stakeholder confidence in companies and the ability of their control environment to prevent or detect errors. Misstatements also expose companies to increased shareholder litigation and regulatory risks.

A report by professor Susan Scholz and the Center for Audit Quality (CAQ) found that “the average stock price reaction to restatements was -1.5%.” Returns were even more negative (-2.3%) for companies with Item 4.02 restatements.

Big R restatements, or non-reliance restatements, are corrections of misstatements that are disclosed through the issuance of Item 4.02 on Form 8-K. Big R restatements are the most material restatements and are often accompanied by an ineffective internal control assessment. They also require the reissuance of previously issued financial statements to correct the misstatement.

In addition to negative returns, reissuing financial statements can be costly. A paper by Her, et. al. found that “the presence of restatements leads to higher audit fees in a subsequent period.”

Further, a paper by Chakravarthy and Rajgopal found that, on average, companies take 2.2 actions to repair reputational damage post-restatement. These include improving governance, firing senior leadership, and improving internal controls. This compares to just .31 actions, on average, in pre-restatement periods. These additional actions have significant costs for a company.

Little r restatements, or revision restatements, are corrections of misstatements that are disclosed without reissuing previously issued financial statements. Instead, prior periods are revised in the next financial report. Though not as material, Scholz found that little r restatements result in -0.6% returns.

Adjustments are corrections that do not result in impacts to previous periods. Instead, misstatements are corrected in the current period. Less research is available to determine the market reaction to adjustments. However, companies that are required to make an adjustment to their financial statements also face challenges with their control environment and potential costs to strengthen their control environment.

Kraft Heinz Co. [KHC] has disclosed several restatements and adjustments over the past few years, including restatements related to revenue recognition. Scholz found that restatements involving revenue recognition saw, on average, -4.0% returns.

Example of AQRM Red Flags: Kraft Heinz

Material, negligent, or fraudulent misstatements can lead to shareholder litigation and regulatory action.

BorgWarner’s [BWA] 2018 Big R restatement resulted in both. In August 2020, the SEC issued an Accounting and Auditing Enforcement Release (AAER) related to BorgWarner’s accounting for incurred but not reported (IBNR) asbestos claims from 2012 to 2016. In December 2020, shareholders filed a derivative lawsuit for the same issue. BorgWarner was ordered to pay $950,000 related to the SEC’s AAER while the derivative suit was dismissed in April.

The Audit Analytics Accounting Quality + Risk Matrix (AQRM) can be used to monitor, compare, and evaluate the severity of company misstatements along with many other “red flag” disclosures. For more information, please contact us.

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