Errors may arise when issuing financial statements and 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.
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. Companies are also required to file an 8-K Item 4.02 and 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.
- Errors that are immaterial to the previously filed financial statements, but material in aggregate to the current financial statements. These errors are corrected by revising previously filed financial statements. This type of error correction is also known as a revision or “little r” restatement.
- Errors that are immaterial to either 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. This type of error correction is also known as an out-of-period adjustment.
Our annual report analyzed restatements filed between January 1, 2001 and December 31, 2017. Similar to last year, this post provides a subsequent analysis of out-of-period adjustments to determine if they follow the same patterns as restatements.
As of August 23, 2004, companies that file a 10-K as an annual report are required to disclose when past financial statements should no longer be relied upon in Item 4.02 of an 8-K. As shown in our report, since 2005, the first full year after this new reporting requirement took effect, these reissuance restatements have steadily declined, reaching a low of 109 in 2017. Inversely, out-of-period adjustments were on the rise between 2009 and 2016, reaching a high of 330 in 2016 before dipping to 276 in 2017.
This trend implies that errors are being corrected before evolving to a magnitude necessitating a reissuance restatement to rectify the error.
Several quantitative criteria can be measured to understand the severity of restatements and out-of-period adjustments:
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 2009, the largest restatement exceeded the largest out-of-period adjustment in eight out of nine years.
The largest out-of-period adjustment in 2017 was disclosed by an insurance conglomerate American International Group, Inc. [AIG]. The immaterial correction was primarily related to income tax liabilities and ceded loss adjustment expenses, which increased 2016 Net Loss Attributable to the company by $174 million; the reported loss that year was $849 million. Notably, AIG disclosed out-of-period adjustments of similar magnitude in five out of the most recent nine years.
Percentage with No Impact
The percentage of error corrections having no impact on the financial statements can also be used as a measure of the severity of restatements during a specific year.
The percentage of restatements with no impact remained relatively stable between 2009 and 2011, at which point it began increasing, reaching a high of 60.0% in 2014. In 2017, 53.7% of restatements and 38.8% of adjustments had no impact on the financial statements.
Common Issues
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 type 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 2009, four main issues have consistently been disclosed with the highest frequency each year for restatements. In 2017, the top issue has involved securities (debt, quasi-debt, warrants & equity), comprising 15.7% of restatements, while securities issues totaled only 4.3% of adjustments. On the other hand, taxes were the reason behind 26.8% of adjustments, almost twice as much as the 13.9% of restatements.
Irrespective of the scale of the error correction, 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 on financial restatements or out-of-period adjustments, email us at info@auditanalytics.com or call (508) 476-7007.