Investor advocates are wary of a regulatory proposal that could decrease the number of times companies restate their financial results.
Barbara Roper, director of investor protection for the Consumer Federation of America, contends that the suggested changes to the Securities and Exchange Commission’s nearly 10-year-old materiality guidance — which companies rely on to calculate an error’s effect on financial statements — will likely reduce transparency and encourage “shoddy practices” by unscrupulous companies.
Adds Elizabeth Mooney, analyst for the Capital Group Cos., investors count on restatements to get a true sense of a company’s financial health, notice trends, and create realistic projections of earnings and cash flows. “Disclosure is a concern, and investors want to be their own decision-makers of which errors are unimportant in their investment theses,” she said at a Thursday meeting of the SEC’s Advisory Committee on Improvements to Financial Reporting (CIFR). She asked that the regulator not change its 1999 staff document for materiality standards, known as SAB 99.
In its midpoint report to the SEC published last month, the CIFR called for better materiality guidelines. The committee believes restatements should be triggered only by errors that were considered material when financial statements were filed, though companies should weigh the needs of current investors in deciding whether to restate.
As it is now, in addition to referencing SAB 99 to gauge an error’s materiality, companies use another SEC staff document, SAB 108, for deciding whether to adjust previously issued misstatements once they find mistakes. Companies’ reading of that guidance has resulted in unnecessary corrected financial statements to fix immaterial errors, according to the CIFR, because when added up, the errors over time seem to have a material effect on the current financial statements.
The CIFR also suggests that some seemingly large errors are not worth fixing when taking into account the time and expense of undergoing a restatement process. The growing number of restatements in recent years could be reduced if companies focused on the needs of a so-called reasonable investor. “It is possible that an error that results in a misclassification on the income statement (without a change in net income) may not be deemed material, while an error of the same magnitude that impacts net income may be deemed material based on the effect of the error on the total mix of information available to a reasonable investor,” the CIFR wrote in its most recent report.
Members of the CIFR — who include current and former CFOs, professors, securities lawyers, investor advocates, and audit-firm executives — believe the growing number of restatements has contributed to the complexity in the U.S. financial-reporting system. Ten percent of public companies restated their financials in 2006, but less than 25 of restatements are actually material to a company’s financial standing, according to the members.
Under the current approach to restatements — which some CIFR members consider to be overly conservative — companies in the middle of a large restatement process go through a “dark period” that could last up to two years when no regulatory filings are made while their internal accountants and auditors pore over mistakes. Sometimes, according to the CIFR, that work isn’t necessary, if the errors were not material under the committee’s standards.
The committee members carefully explained during the Thursday meeting that while they hope to reduce the number of unnecessary restatements, they believe all financial errors should be fixed. They said they may make changes to their recommendations to make the intent clearer.
Still up for debate is how and when each mistake should be corrected. For example, CIFR chairman Robert Pozen, who also chairs MFS Investment Management, said companies could address some immaterial errors simply by issuing an 8-K that states the mistake and explains why they’re not going to restate their results.
