How will the SEC’s renewed focus on financial reporting affect restatements?

Jul 07, 2022
Financial investigations Financial management SEC matters Financial consulting

SEC enforcement to focus on financial reporting for public companies

In a series of recent speeches, members of the Securities and Exchange Commission staff—as well as the chairman himself—have signaled a renewed focus on financial reporting errors made by public registrants, including key changes in how enforcement will approach potentially problematic financial reporting.

Financial statement restatements

According to a recent study by Audit Analytics, public registrants filed 1,470 financial statement restatements in 2021, a 289% increase over 2020. Notably, approximately 77% of the 2021 restatements involved accounting errors by special purpose acquisition companies (SPACs), primarily related to the accounting for redeemable shares and warrant liabilities. These restatements resulted in part from an SEC staff statement in April 2021 urging SPACs to revisit their accounting in these two areas.

Audit Analytics also reported that, excluding the “one-time” SPAC accounting errors, roughly 340 restatements were filed in 2021, an approximately 80% decrease from their peak in 2006 and continuing a long-term downward trend. Interestingly, the number of restatements done by revising previously reported financial results in a current filing (commonly referred to as “little r” restatements) increased from approximately 35% of all restatements in 2005 to over 75% in 2021 (excluding the one-time SPAC restatements), with a corresponding drop in reissuance restatements (commonly referred to as “Big R” restatements).

This long-term shift toward little r restatements is noteworthy. While each restatement involves its own unique facts and circumstances, generally Big R restatements have many more significant consequences. By filing a Big R restatement, a registrant signals it has concluded that one or more of its previously filed financial statements contain material errors. This increases litigation risk, and is more likely to draw the attention of investors and regulators.

A Big R restatement also may result in the clawback of executive compensation—and compared to a little r restatement, can result in reputational harm and a negative impact on share price. In a March 2022 speech, acting SEC Chief Accountant Paul Munter noted that “some materiality analyses appear to be biased toward supporting an outcome that an error is not material to previously issued financial statements, resulting in ‘little r’ revision restatements.”

In this regard, Munter made certain observations about materiality analyses conducted by registrants when assessing a potential restatement, including:

  • SEC Staff Accounting Bulletin No. 99, Materiality, includes several qualitative factors for assessing whether a quantitatively small error may be material. It would be inappropriate to simply analyze these factors in reverse when determining whether a quantitatively large error may be immaterial. Instead, registrants should conduct a “holistic and objective assessment” of factors that are most relevant to a reasonable investor.
  • A position that certain elements or line items in previously issued financial statements prepared in accordance with generally accepted accounting principles (GAAP) or international financial reporting standards are not relevant to investors would generally not be persuasive.
  • Errors’ effects on key non-GAAP measures considered important to investors should be assessed in addition to, not instead of, their effects on GAAP measures.
  • An error should not be considered immaterial to previously issued financial statements simply because it was made by numerous other registrants or otherwise represented a widely held view.
  • An error that is material in and of itself should not be considered immaterial because it is offset by one or more other errors.

SEC enforcement

Consistent with the drop in restatements, a study by Cornerstone Research noted that SEC accounting and auditing enforcement actions declined 32% in 2021 from the prior year, and 41% when compared to the five-year average from 2016 through 2020. However, in perhaps a sign of things to come, Cornerstone also noted swifter enforcement activity under new SEC Chairman Gensler compared to the early days of the prior administration.

In a November 2021 speech at the Securities Enforcement Forum, Gensler highlighted several areas where he expects changes in the SEC’s approach to enforcement. One is an emphasis on self-reporting and cooperation by registrants. Gensler expressed skepticism about what has been considered cooperation in the past, noting that he expects registrants to do “more than the bare minimum, like conducting a self-serving independent investigation.” He indicated that he expects cooperating registrants to, among other things, help the SEC move more quickly and, if appropriate, identify additional misconduct.

Gensler also spoke about a “focus on bringing matters to resolution swiftly.” To that end, he indicated that to prevent defense counsel from “burn(ing) the clock,” he had asked SEC staff to cut back on the number of meetings it grants to discuss issues raised in Wells submissions. Such a development would be expected to accelerate the timeline of enforcement actions brought by the SEC.

The SEC’s enforcement staff are extraordinarily talented and possess great experience and judgment. I want to empower them
Gurbir Grewal, Director, SEC Division of Enforcement, October 2021

In remarks at the 2021 SEC Speaks conference, Division of Enforcement Director Gurbir Grewal similarly emphasized a streamlining of the Wells submission process. In the past, the director or deputy director of enforcement has customarily attended Wells meetings with registrants. Grewal indicated that for Wells submissions that don’t raise novel legal or factual questions, it would be more efficient for an associate director or unit chief to attend the meeting. This is a significant change, as historically the Wells submission process has provided a registrant the opportunity to make its case to senior members of the SEC staff.

Going forward

The change in administration in Washington, with the corresponding turnover in the administration at the SEC, brings potential for new priorities in regulation and enforcement activity that will influence the financial reporting landscape. Based on recent speeches and activities, the SEC appears prepared to  renew its focus on enforcing financial reporting rules for public company registrants in the coming months and years.

We encourage registrants and their audit committees to pay particular attention when conducting materiality analyses related to prior-period errors, and to actively engage with their outside auditors and counsel. Further, if prior-period errors require restatement of previously issued financial statements, diligent consideration should be given to the timing and extent of communications with SEC staff concerning both the nature of those errors and the company’s actions and plans with regard to determining their cause and taking remedial measures to help prevent similar errors in the future.

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