Lawyers Address Correcting Accounting Errors

So what should you do when your company hears there might be a potential accounting problem?

Things to address, said John White, a partner at Cravath, Swaine & Moore LLP in New York, are: what’s the problem, how to fix it, why and how it happened.

White’s comments were part of a Practising Law Institute panel discussion Nov. 2, which spotlighted accounting and financial reporting issues. 

Accounting Error vs Change in Estimate.

A company first has to figure out whether it has an accounting error or a change in estimate, White said.

The error “could be a mathematical mistake, it can be a mistake in the application of generally accepted accounting principles (GAAP), it can be a misuse of facts that existed at the time the financial statements were prepared,” said White. “All those things can just be plain old accounting errors,” he said.

Accounting errors are different from where the company has a change in estimate based on subsequent facts.

There are three different ways an error can be fixed:

  • with a restatement of the prior financial statements (big “R” restatement);

  •  with a revision of the prior financial statements (little “r” restatement); or,

  •  correct it in the current period, with an out-of-period correction.

Big “R” Restatement.

To figure out whether the company is in the category of the big “R” restatement, look and see whether the errors identified are material compared to previously issued financial statements, according to the discussions.

If they are material compared to previously-issued financial statements that would trigger the 8-K 402 restatement. Meaning, if the company concludes that it can’t rely on previously issued financial statements because there was a material error, then an 8-K has to be issued and the company has to promptly move to correct those errors.

“You might do that by amending the prior 10-K or if you’re about ready to file your next 10-K you might just correct them in the next 10-K--you do have to correct them promptly,” said White.

Little “r” Restatements.

Little “r” restatements are situations where the company has an error, the company concludes it is not material to previously issued financial statements, but realizes it would be material to correct it in the current period because the amount would be large in the current period.

 “You would not be correcting that error in the current period, you would revise your prior financial statements to correct these errors which were immaterial in the prior periods, but would have been material in the current period,” said White. 

Companies should also think about their internal control over financial reporting (ICFR) opinion and their disclosure controls and procedures (DCP) opinion, he said.

Simply Correct Error.

The third category is where the error can be corrected in the current period without being material. If that is the case the company should simply correct the error--run it through the income statement in the current period.

“You will have the question about whether you have to disclose that” said White, and there are various ways to analyze and get to what the right answer is for what you need to disclose.

When that disclosure is done, the company needs to again reassess its internal controls and its DCP to see whether it has a material weakness there.

Materiality Analysis.

One point, raised by Allan Beller, New York-based Cleary Gottlieb Steen & Hamilton LLP’s senior counsel, is that talking about making judgements as to materiality means doing the full Staff Accounting Bulletin (SAB) 99 analysis.

Companies have to go back and do a full SAB 99 materiality analysis on both the prior periods and the current period, Beller and White both agreed. 

Because if a company does a revision, it can expect a comment that will ask “how did you conclude this was not material?”  Saying the number is too small is not going to cut it without the full SAB 99 back up, they said.

Continue the discussion on Financial Restatement at  Bloomberg BNA Accounting LinkedIn.