Accounting corrections are arguably one of the most important metrics in understanding trends in financial reporting. In some of our previous blogs, we discussed the differences between material and immaterial errors, and different regulatory requirements associated with different types of error corrections.
Audit Analytics’ corrections databases recognize three distinct types of error corrections:
- Material errors that undermine reliance on previously filed financial statements. To correct material errors, companies are required to restate previously filed financial statements. The companies are also required to file an 8-K Item 4.02 and warn investors that previously filed financial statements could no longer be relied upon. This type of error correction is also known as a “Big R” restatement.
- Errors that are immaterial to the previously filed financial statements, but that are material in aggregate to the current financial statements. The errors are corrected by revising previously filed financial statements. This type of error correction is also known as a “little r” restatement.
- Errors that are immaterial to either current or previously filed financial statements. The errors are corrected as an aggregate adjustment in the current period, no revision of previously filed financial statements is required. This type of error correction is also known as an out-of-period adjustment.
In our annual report we provide detailed analysis of Big R and little r restatements. But what about out-of-period adjustments? Do they follow the same trend and how do they compare to restatements?
As we can see (and as discussed in our annual restatements report), Big R restatements experienced a steady decline between 2009 and 2016. Out-of-period adjustments, on the other hand, are steadily increasing. One possible explanation is that improved internal controls allow for a faster identification of the errors, so the errors are promptly corrected without reaching the level that would necessitate a full-scale Big R restatement.
When it comes to which types of issues are being corrected via out-of-period adjustments, taxes topped the list for the last 8 years. In 2016, companies recorded 85 tax related out-of-period adjustments – 26% of all the out of period adjustments recorded during the year. Second and third of the top issues were liabilities (14%) and revenue recognition (12%).
The most common issues being corrected differ when looking at restatements. Securities (debt, quasi-debt, warrants & equity) issues ranked at the top, comprising 17.6% of restatements in 2016, whereas they account for only 5.8% of out-of-period adjustments during the same year. Classification issues was the next most common restatement issue (14.2% of all 2016 restatements).
Still, while the ranking of issues is different between out-of-period adjustments and restatements, the most important differentiator is materiality, which is governed by SAB 99 (codified into ASC 250). The charts below look at some of the quantitative characteristics of the out of period adjustments, namely – largest negative impact of the adjustments.
The largest restatement exceeded the largest out-of-period adjustment for a majority of the time.
While restatements tend to have a greater negative affect, overlap between restatements and out-of-period adjustments has been shown to exist in a previous research paper as a result of qualitative factors being applied in materiality judgments.
Immaterial errors also carry negative impacts for investor assessments (as shown by share price responses) regardless of the quantitative extent to which it affects financial statements. It appears that this negative connotation to investors stems from the predictive nature of immaterial errors. Whether corrected as a revision or out-of-period adjustment, immaterial errors can be indicative of poor reporting quality which may lead to future material weaknesses and material errors.