Financial restatements: Why can’t management get it right the first time?

Fraud isn’t the only reason behind financial restatements. Sometimes they’re caused by unintentional errors or omissions, especially as companies record complex transactions or implement new accounting and tax rules.

Error-prone transactions

When a company restates its financial results, investors and lenders may jump to the conclusion that management is cooking the books. But sometimes a restatement happens because management lacks a clear understanding of U.S. Generally Accepted Accounting Principles (GAAP).

Restatements generally coincide with more complicated accounting rules or management’s handling of an unusual, one-time transaction. Historically, the leading causes of restatements include:

  • Recognizing revenue from contracts,
  • Reporting related-party transactions,
  • Classifying cash flows as investing, financing and operating on the statement of cash flows,
  • Reporting compensation expense from share-based payments,
  • Issuing common or preferred stock,
  • Accounting for business combinations, and
  • Estimating goodwill impairment.

Mistakes and omissions are typically found when the company’s financial statements undergo a higher level of scrutiny. For example, restatements may be necessary when you upgrade your level of assurance from a compilation to a review or from a review to an audit. A new controller or audit firm also may identify the need for a restatement.

Major changes coming

Recent changes to the accounting rules and the new tax law might increase the number of companies issuing restatements in the coming years. Specifically, the Financial Accounting Standards Board has issued two major changes to GAAP that will affect many manufacturers in the next few years:

  1. Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, effective in 2018 for public companies and in 2019 for private ones, and
  2. ASU No. 2016-02, Leases, effective in 2019 for public companies and in 2020 for private businesses.

The updates may cause some errors that require restatements, especially if management waits until the last minute to implement the changes. In addition, the Tax Cuts and Jobs Act contains numerous provisions — including lower tax rates, new and eliminated deductions, and foreign tax changes — that will affect the amount of tax-related assets and liabilities companies report on their financials.

The impact of the new law may be difficult to quantify, but companies that follow GAAP must report the effect of a new tax law in the quarter it’s enacted. By the end of 2018, some companies may need to revise their initial estimates.

We can help

Restatements can complicate financial reporting and possibly raise a red flag with stakeholders. As your company implements the recent changes to the accounting and tax rules, an Elliott Davis advisor would love to help.