An SEC Statement on Restatements

The top accountant at the Securities and Exchange Commission wants corporate executives and audit committees to do better at evaluating when financial restatements are necessary, saying that too many tilt their analysis toward the conclusion that, nope, that error we had last quarter doesn’t need to be restated after all. 

Paul Munter, the SEC’s acting chief accountant, published his rather unusual statement last week. Munter framed it as a refresher course on how to evaluate the materiality of errors in previously issued financial statements, but he minced no words: “We have observed that some materiality analyses appear to be biased toward supporting an outcome that an error is not material to previously issued financial statements.” 

Those biased materiality assessments, Munter said, need to stop.


His message is worth reading for anyone involved in corporate securities filings or internal control in financial reporting, as well as to the CEOs and CFOs signing their names to the accuracy of the 10-Q. And while Munter does not speak for the SEC overall, I’m hard-pressed to believe he would make a statement like this without the blessing of SEC chairman Gary Gensler. So let’s give Munter’s words a close read. The agency is trying to tell us something. 

First, a recap of when and how restatements are supposed to be made. When a company discovers an error in previously issued financial statements, and the error is material to those past statements — yes, you need to do a full restatement of the affected periods. This is commonly known as a “Big R” restatement because these restatements are a big mess. 

Munter was concerned about errors that aren’t material to those prior statements, but either correcting the error or leaving the error uncorrected would be material to the current period’s financial statements. When this happens (and it happens fairly often), a company must still correct the error, but it can do so simply by correcting the prior period’s numbers in your current filing and disclosing the error. 

This second category is known as a “Little R” restatement. These restatements are what drew Munter’s ire.

Restatements and Materiality

Munter’s central complaint was that too often, registrants use flawed processes to assess the materiality of an error and end up deciding the company can make do with a Little R restatement, when the company should have made a formal Big R restatement. So he walked through some of the problematic assessments his office has seen, and reminded everyone that materiality assessments need to be objective.

The tricky issue here is that a company needs to assess both quantitative factors (how large the error is in absolute dollars) and qualitative factors: the more intangible factors that would make an error important to investors even if the dollar amount involved is small. Munter was emphatic that every materiality assessment needs to consider both types of factors — and on an error-by-error basis, too, rather than some automatic formula based on amounts. His words:

A materiality analysis is not a mechanical exercise, nor should it be based solely on a quantitative analysis. Rather, registrants, auditors, and audit committees need to thoroughly and objectively evaluate the total mix of information. Such an evaluation should take into consideration all relevant facts and circumstances surrounding the error, including both quantitative and qualitative factors, to determine whether an error is material to investors.

Most CFOs, auditors, and internal control professionals would agree with that point on a theoretical level. So what is Munter seeing companies do wrong in practice, that he felt compelled to publish this statement? 

It’s about the balance of those quantitative and qualitative factors, he said. A company might suffer an error that is small in quantitative terms, but the qualitative factors are compelling enough that the error should still be considered material anyway. But… 

We are often involved in discussions where the reverse is argued — that is, a quantitatively significant error is nevertheless immaterial because of qualitative considerations. We believe, however, that as the quantitative magnitude of the error increases, it becomes increasingly difficult for qualitative factors to overcome the quantitative significance of the error.

That’s the real issue here. Too often, management teams are allowing bias to creep into their materiality analysis, and they come up with all sorts of qualitative factors to justify a Little R restatement, even when the quantitative factors would demand a Big R restatement. 

fcpaFor example, Munter said, his office has seen materiality assessments arguing that an error wasn’t material to previously issued financial statements because the error was also made by other registrants, “and therefore reflects a widely held view rather than an intention to misstate.” (That is exactly what SPACs argued last year, when legions of them had to restate prior financials because they all had misapplied accounting rules related to warrants and equity.)

No dice, Munter said. Lack of intention to misstate might mean an error isn’t material, but it doesn’t automatically mean the error isn’t material. He offered several other examples along similar lines, all suggesting that companies are twisting accounting and auditing standards the wrong way to help them avoid issuing a Big R restatement. 

What Does All This Mean?

One valid question to ask is who in the corporate governance and internal control world should care about this stuff, and why? We can walk through a few answers. 

First, audit committees and external audit firms will need to care, because conversations about errors and financial restatements can get pretty intense. Munter is telling audit committees that they need to assure an objective analysis of errors’ materiality, and telling audit firms that they need to do better at calling out flawed analysis when they see it. 

Second, internal audit and SOX compliance teams need to consider what Munter is telling you about internal control over financial reporting. A material error pretty much assures the existence of a material weakness in ICFR — but again, you can’t run that logic in reverse; the absence of a material error does not mean the absence of a material weakness. A material weakness can exist without the existence of a material error. So, as Munter said, “Management’s assessment of the effectiveness of ICFR should therefore be focused on a holistic, objective analysis of what could happen in the context of current and evolving financial reporting risks.”

Lastly, I can’t help but wonder what Munter’s statement might mean for materiality assessments for other, non-financial risks that might go into the 10-Q. 

To be clear, Munter is an accountant and he only spoke about financial errors. But his broad point about qualitative versus quantitative factors — that companies stretch the qualitative factors beyond reasonable interpretation, to justify deeming an issue not material — is just as valid for other risks. You could easily imagine examples related to cybersecurity, Russia exposure, climate change. 

And that idea brings me back to another statement we saw last week from SEC commissioner Allison Herren Lee, musing about how corporate lawyers should be held more accountable for bad advice they give about, you guessed it, material risks that should be disclosed to investors. 

Food for thought as you recheck your arithmetic before first-quarter closes in three weeks.

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