At times, errors may arise when issuing financial statements. When such an error is identified, a correction must be made. The scope and nature of these corrections dictate a company’s next steps and may provide useful information into financial reporting trends.
The corrections databases maintained by Audit Analytics recognize three distinct types of error corrections:
- Non-Reliance Restatement: Material errors that undermine reliance on previously filed financial statements. To correct material errors, companies are required to restate previously filed financial statements. Companies must file an 8-K Item 4.02 to warn investors that previously filed financial statements should no longer be relied upon. This type of error correction is also known as a reissuance or “Big R” restatement.
- Revision Restatement: Immaterial errors on previously filed financial statements, but material in aggregate to the current financial statements. These errors are corrected by revising the previously filed financial statements. This type of error correction is also known as a “little r” restatement.
- Out-of-Period Adjustment: Immaterial errors in current or previously filed financial statements. These errors are corrected as an aggregate adjustment in the current period and no revision of previously filed financial statements is required.
Our recently published annual restatement report analyzed restatements filed between January 1, 2001 and December 31, 2019. Similar to years past, this post provides a subsequent analysis of error corrections through December 31, 2019, to determine if out-of-period adjustments follow the same general patterns as restatements.1
As of August 23, 2004, companies that file a 10-K with the SEC as an annual report are required to disclose when past financial statements should no longer be relied upon in Item 4.02 of a form 8-K. As shown in the restatement report, since 2005 – the first full year after this new reporting requirement took effect – reissuance restatements have steadily declined, reaching a low of 85 in 2019.
Inversely, out-of-period adjustments were on the rise between 2011 and 2016, reaching a high of 327 adjustments in 2016. Following that high point, adjustments decreased in the subsequent years, with 202 out-of-period adjustments filed in 2019.
This trend implies that errors are being corrected through a revision restatement or an out-of-period adjustment before evolving to a magnitude necessitating a reissuance restatement to rectify the error. This may be a sign that companies are taking steps to make revisions or adjustments to correct the mistakes before the errors rise to an even bigger problem.
Several quantitative criteria can be measured to understand the severity of restatements and out-of-period adjustments: magnitude of impact on net income and commonly cited issues.
Largest Negative Impact on Net Income
Perhaps one of the most telling metrics of severity involves the largest negative impact on net income each year. Since 2010, the largest restatement exceeded the largest out-of-period adjustment in all 10 years. This indicates that restatements have a more significant impact on financial statements than out-of-period adjustments.
The largest out-of-period adjustment in 2019 was disclosed by Xerox Holdings Corp [XRX]. The correction was required to fix immaterial errors related to consolidation issues with Fuji Xerox in the first quarter of 2018, and decreased net income by $110 million.
While useful to look at the quantitative aspects of error corrections, the most common types of issues remedied via restatements versus out-of-period adjustments may provide deeper insight into whether different types of issues are corrected using different error correction methods. In other words, it’s interesting to see which issues tend to be corrected by means of restatements and which lean more towards adjustments.
Since 2010, several issues have consistently been disclosed with the highest frequency each year for restatements: debt, quasi-debt, warrants & equity security issues, cash flow statements, revenue recognition, taxes, and liabilities. As errors related to issues with cash flow statements are infrequently corrected via adjustments, the remaining four top issues were compared to the frequency of correction through an out-of-period adjustment.
While taxes were cited as an issue in 22% of adjustments in 2019, only 13% of restatements were filed to correct an error related to tax issues. Revenue recognition was a top issue cited in both restatements and adjustments, comprising just over 16% of both types of error corrections filed during 2019. The amount of restatements filed to correct issues with liabilities has been relatively steady since 2010, but 2019 saw a drop in the number of adjustments citing liabilities as an issue. Though issues with securities were cited in 15% of restatements in 2019, only 6% of adjustments cited the same issue.
2019 Top Five Most Common Issues Cited in Restatements
- Revenue recognition (16.7%)
- Cash flow statement classification errors (16.1%)
- Securities – debt, quasi-debt, warrants & equity (15.3%)
- Taxes (13.0%)
- Liabilities (12.2%)
2019 Top Five Most Common Issues Cited in Adjustments
- Taxes (22.3%)
- Revenue recognition (16.3%)
- Expense recording (9.9%)
- Inventory (9.9%)
- Value/diminution of PPE intangibles or fixed assets (7.4%)
Irrespective of the scale of the error correction and the issues contributing to the errors, both restatements and adjustments negatively impact the financial reporting of a company. Even immaterial errors in financial reporting may predict future material weaknesses and errors in financial statements.
For more information about Audit Analytics or this analysis, please contact us.
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1. The population used in the restatement and out-of-period adjustment analyses excludes subsidiaries when the parent also disclosed an error correction, as well as interconnected registrants that each filed a corresponding correction. ↩