Audit Analytics has just posted its 2021 annual review of financial restatements, which this year covered a 21-year period. The review showed a 289% increase in the number of restatements to 1470, the highest level of restatements since 2006. You may have guessed that the increase was attributable to restatements by SPACs. Excluding SPACs, the numbers actually reflected a 10% decrease in the number of restatements year over year. SPACs also account-largely but not entirely-for a large increase in the proportion of reissuance ("Big R") restatements. Audit Analytics found that 62% of restatements were reissuance restatements, the biggest proportion since 2005. But even excluding SPAC restatements, 24% of 2021 restatements were reissuances, an increase from 2020 of three percentage points.
SideBar
What's the difference between a "Big R" and "little r" restatement? In this Statement from December 2021, Acting Chief Accountant Paul Munter said that "if an error is identified in the financial statements, management must determine whether the error is material, which is based on what is important to the user. If that analysis indicates that previously issued financial statements are materially misstated, those financial statements would need to be restated and reissued." In that event, companies are required to file a Form 8-K indicating that the previous financial statements should not be relied upon. "By comparison," Munter continued, "if the error is not material to previously issued financial statements, but correcting the error in the current period would be material to the current period, an entity is not precluded from correcting the error in the current period comparative financial statements by restating the prior period information and disclosing the error, which is commonly referred to as a 'little r' restatement." In essence, in a "little r" revision, companies can correct the error in revisions to the comparative financial statements and disclose the error in the current period. (In some cases, companies can correct the error in the current-period financial statements if it is immaterial. According to Audit Analytics, these are "out-of-period adjustments" and are "not restatements because previous financial statements are not affected.") Munter cautioned that "under existing accounting guidance assessing whether an error is material to prior periods is not a mechanical exercise, nor is it based solely on a quantitative analysis. Rather, management must judiciously evaluate the total mix of information, taking into consideration both quantitative and qualitative factors to determine whether an error is material to investors and other users."
In late 2021 and early 2022, SEC staff admonished companies and auditors about misuse of "little r" revision restatements. In January, Lindsay McCord, Corp Fin Chief Accountant, raised a question: were companies being properly "objective" in assessing whether a restatement should be a "Big R" or "little r" restatement? McCord stressed that, while it's not inevitable, it's very difficult to conclude that an error is immaterial when it is quantitatively large. In that context, the SEC often ends up disagreeing with management's position and requiring a "Big R" restatement. On the other hand, the errors could be quantitatively small but material from a qualitative perspective. According to Bloomberg, at the December 2021 AICPA Conference on Current SEC and PCAOB Developments, Munter asked whether restatement analyses were "'being done from an objective perspective? Or are the analyses starting with, potentially, a bit of a bias and trying to develop arguments for why something is not a 'Big R' restatement? I would encourage folks to start out with an objective evaluation.' Munter encouraged auditors and companies to review SEC staff guidance on materiality, as outlined in SAB 99, to consider when an accounting error is material enough to require a formal restatement. Recent conversations with companies and auditors about materiality have involved arguments from them that an error may be numerically material but not important to investors. 'And I'm not saying that couldn't be the outcome,' Munter told the conference. 'But what I am saying is that's not the way that the SAB 99 is written. So I think the analysis requires a more objective evaluation of the totality of the fact pattern.'"
In 2021, SEC guidance addressing SPAC accounting for warrants and classification of redeemable equity resulted in significant increases in the number of restatements, especially reissuance restatements. According to Audit Analytics, of restatements by SPACs or companies acquired by SPACs, 35% related to redeemable shares (over 500 companies) and 42% related to warrants (over 600 companies). As a result of the many new SPAC registrants, the number of SPAC restatements pushed the "percentage of unique companies that disclosed a restatement to 12.7%, slightly trailing the 13.6% high point observed during 2006."
SideBar
In April 2021, Munter and then-Acting Corp Fin Director John Coates released this Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies ("SPACs"). The primary issue identified in the Statement was whether the warrants issued in connection with de-SPAC transactions should be classified as equity or liability, which depends largely on the specific terms of the warrant and the entity's specific facts and circumstances. If warrants were classified as a liability, according to the Statement, they should be "measured at fair value, with changes in fair value reported each period in earnings." If the company and its auditors determined that, in light of this Statement, there was an error regarding the classification of warrants in previously filed financials, the company had to consider the materiality of the error in assessing whether it needed to restate its financials-which could involve amending one or more periodic reports-and file an 8-K. In addition, the Statement observed, the company needed to consider whether it had to upgrade its ICFR and disclosure controls and procedures and amend its prior disclosures on the evaluation of ICFR and disclosure controls. (See this PubCo post.)
Then in November, Bloomberg reported that the SEC was requiring many SPACs to "Big R" restate their financial statements because they tripped over the classification of certain shares they offered to investors. Auditors with whom Bloomberg spoke said that the SPAC accounting snafu related to incorrect categorization of Class A shares-which are typically redeemable-as "permanent equity instead of temporary equity." One auditor described the issue as "pervasive[:] everyone's dealing with it because everyone did it wrong." SPACs typically issue non-redeemable founders' shares and redeemable Class A shares as part of their capital structures. The redemption feature in the Class A shares provides part of the appeal of SPACs for many investors: if they aren't satisfied with the de-SPAC merger transaction, they can simply redeem their shares for cash. However, under ASC 480, "if an equity instrument is redeemable and this redemption feature is outside the control of the company, that instrument can't be considered permanent," advised another auditor, whose firm, he insisted, consistently applied the proper accounting treatment. Apparently, "most audit firms considered the errors small enough to be fixable with a revision, a minor correction that gets disclosed in the next period's financial statement," the article reported. However, according to one auditor cited in the article, "the SEC came back and made it clear that they believe it's a big R." (See this PubCo post.) According to this Bloomberg article, Munter said that investors "care about the distinction between equity that is considered permanent versus equity that is temporary.. In some situations, SPACs ended up with no permanent equity when they corrected their accounting. And if SPACs drop below a certain equity threshold, they may not be able to list on certain exchanges, he said." He found it hard to understand how, in that circumstance, a "little r" was "responsive to the information needs of investors."
Audit Analytics observes that, while recently, the proportion of restatements filed by foreign private issuers had been increasing, in 2021, this trend reversed, in part, because of the substantial proportion of restatements by domestic SPACs.
Audit Analytics also looked at the impact of restatements on reported net income. For 2021, 26% of restatements had a negative impact on net income; however, excluding SPACs, 32% of restatements had a negative impact on net income.
In terms of "severity" of the restatement, in 2021, there were 1.85 issues per restatement on average (1.4 excluding SPACs), compared with an average of 1.52 last year. In addition, 33% of restatements (61% excluding SPACs) involved an annual report (which include audited financial statements), compared with 58% in 2020. In 2021, the average restatement period was about 300 days (about 500 days excluding SPACs). The disclosure window (the time between announcement and filing) was about 10 days in 2021 (about 30 days excluding SPACs).
Among domestic companies in 2021, 73.1% were non-accelerated filers, 4.5% were accelerated filers and 10.2% were large accelerated filers. The top accounting issues in restatements, excluding SPACs, were debt and equity securities (19.1%), revenue recognition (12%), liabilities and accruals (11.7%), expenses (10.9%) and taxes (8.8%). Including SPACs, debt and equity securities were issues among 80.4%.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
