Regulation

Mixed Signals: A New Reason to Revisit Materiality

A report says most restatements made on the sly have only a minor negative effect on net income. So, were the fixes even necessary, especially in l...
Sarah JohnsonSeptember 24, 2009

Regulators have long criticized companies for restating their financial results without providing investors with a large red flag — a Form 8-K — to announce that previously issued financial statements should no longer be trusted. Indeed, over the past few years the Securities and Exchange Commission has threatened to issue guidance that clarifies the point that companies should file 8-Ks every time they restate their financial results.

Meanwhile, many companies have balked at the idea, and continue making so-called stealth restatements by burying their adjusted results in quarterly or annual filings — without making any formal public announcement. In fact, these types of adjustments accounted for more than half of all the restatements made last year, according to research firm Audit Analytics.

However, recent analysis by the firm shows that, for the most part, stealth restaters weren’t holding back news on large swings in net income or cash flow from operations. By the time they did reveal corrections to previously issued financial statements, most of the companies made minor adjustments — within 10% of their initial results.

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Investors’ comfort level with those findings could depend on their interpretations of materiality and transparency. Complicating matters further, regulators have given companies mixed signals on materiality since the passage of the Sarbanes-Oxley Act of 2002, which brought to a head a heightened focus on audit quality and disclosures.

And while there’s no bright-line definition of materiality, or what constitutes a significant enough change to warrant a restatement, some companies Audit Analytics called out for making stealth restatements fell outside the 10% mark of their initial results — and clearly should have made the change. For instance, 8 of the 62 firms that didn’t file an 8-K before restating their operational cash flow eventually reported a negative impact of more than 40%.

Still, the researchers’ results raise questions about whether all of the restatements were necessary.

The idea that companies will fix misstatements without being completely forthcoming or timely with the changes — however minor — generally has not sat well with investor advocates or regulators in the past. At the same time, overly conservative companies have been criticized for filing too many restatements that could be considered immaterial — which, some observers argue, needlessly keeps investors “in the dark” when companies work on fixing old financial filings while halting work on current results.

In 2006, two years after the SEC began requiring its registrants to file an 8-K within four days of deciding that investors “can no longer rely upon” previously issued financial statements, the U.S. Government Accountability Office called on the commission to clarify its rules. The GAO had found that between 2004 and 2005, about 30% of companies that restated “did not appear to file the proper disclosure.”

Instead, those companies either did not disclose the restatement or used a 10-K or 10-Q as their first avenue for sharing the adjustments. These findings raised concerns over “the ongoing transparency and consistency of public disclosures,” the GAO said. The agency wanted the SEC to spell out in its 8-K instructions that companies should always file the form for every restatement, even if they plan to share the change in a quarterly or annual filing.

By January 2008, John White, then director of the SEC’s Corporation Finance Division, said new rulemaking on the issue would be forthcoming, even though the commission believed its staff guidance “made clear that we believe that the disclosure is required in a separate Form 8-K filing.” However, Audit Analytics found that the discrepancy between what the SEC expected and what companies were doing continued throughout the year. For 2008, companies that restated were more likely not to issue a related 8-K if the effect was a small decline in their net income. One quarter of the nearly 200 restatements that affected net income were not accompanied by 8-Ks. The firm conducted its analysis to explore the financial impact of stealth restatements, explains Donald Whalen, Audit Analytics’s director of research.

After the number of restatements skyrocketed earlier this decade — peaking at 1,299 in 2006 — business advocates and advisers to regulators claimed that the flurry of adjusted filings could be needlessly confusing for investors. More than a year ago, the SEC’s Advisory Committee on Improvements to Financial Reporting suggested that the regulator slightly change its guidance to reduce the number of unnecessary restatements.

At the same time, the committee — which worked closely with the SEC before issuing its final report last summer — called on the commission to require that companies disclose all their accounting errors and clarify that stealth restatements aren’t allowed. “No one gets a chance to hide an error — we need to make this loud and clear,” says J. Michael Cook, former CEO and chairman of Deloitte & Touche LLP and one of the CIFR members during the committee’s deliberations.