What ten years of restatement trends tell us about the state of financial reporting

Many audit firms voluntarily report firm-level metrics publicly through their audit quality and transparency reports. These include many different metrics, such as learning and development offered to auditors, technology used by audit teams, and audit hours provided by specialists, to name a few.

One metric that audit firms regularly include in their audit quality reports is the number of issuer audit client financial statements that were not restated. This is because restatement activity is frequently used as an outcome-based measure of financial reporting quality. Further, a broader dataset of restatement activity can provide a better picture of financial reporting quality.

To that end, the Center for Audit Quality conducted an analysis of restatements announced from 2013 – 2022. Here are a few takeaways from that analysis, and what they tell us about the state of financial reporting.

1. Restatements continue to decline

Restatements have declined steadily during the period 2013-2022 with the biggest decline observed in 4.02 restatements (colloquially referred to as “Big R” restatements and attributable to errors determined to be material to previously issued financial statements such that those statements are deemed unreliable).

Certain actions by accounting standard-setters and regulatory bodies provide some context for the decline in restatements. These include several standards issued by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) aimed at simplifying and clarifying information in the financial statement. This also includes regulatory events, such as the Committee of Sponsoring Organizations of the Treadway Commission (COSO) updating its internal control framework, which established a higher threshold for achieving internal control effectiveness. The decline in restatements  demonstrates that public companies and their external auditors quickly adapted to new financial reporting rules and standards.

The SPAC effect: The decline described excludes a spike in restatements in 2021 related to special purpose acquisition companies (SPACs). The restatement spike is not irrelevant, but it is narrow and of a technical nature related to accounting for certain warrant transactions. Upon excluding that spike that is arguably not indicative of any systematic deterioration in financial reporting or audit quality, we see that restatements have declined significantly, with an uptick observed in 2022. While it is too early to extrapolate from the data what may have caused the uptick, there is a possibility that it can be related to the burst of SPAC activity in 2021 and 2022. In addition, the impact of the COVID-19 pandemic on financial statements remains to be seen, but public companies have already reported specific accounting challenges during this time period.

2. Certain accounting issues commonly triggered restatements, while restatements attributed to fraud were uncommon

Expenses, specifically the misapplication of reporting rules for accruals, reserves and estimates, were cited most frequently in restatement announcements. This was followed by financing activities and revenue-related accounting errors.   

Fraud did not often contribute to a restatement, with approximately 3% of restatements attributable to fraud. However, fraud was consistently higher for 4.02 restatements than the rest of the sample.

3. Companies that issued restatements tended to be smaller, and were more commonly in finance, healthcare or technology

Public companies that issued restatements tended to be smaller (<$13B in assets), with companies announcing more severe 4.02 statements even smaller (<$2.3B in assets). Over half of the organizations that issued restatements (57%) were listed on either the NYSE or NASDAQ, though notably, 30% of the organizations with restatement events were delisted over the course of the sample period.

Certain industries also experienced a higher number of restatements. These are industries that deal in more complex financial reporting, such as financial, banks & insurance, healthcare and pharmaceuticals, and computer & software.

The data also shows that restatements correlated with their organization’s bottom line. Public companies that issued a restatement were less likely to be profitable for the next three years.

4. ICFR reports did not predict restatements

Internal control over financial reporting (ICFR) also has an impact on the likelihood of a restatement being issued. Unsurprisingly, public companies where internal control assessments identified weaknesses were more likely to issue restatements than those with effective controls.

This may in part explain why smaller organizations, which may encounter ICFR and other resource constraints, are more likely to issue restatements. However, accounting issues cited in internal control reports were unlikely to predict a subsequent restatement, suggesting that material weakness disclosures in ICFR were not usually predictive of restatements.

The data also suggests that company controls are working to catch errors. This is demonstrated by the length of the restated period, which declined to a low of slightly over one year (1.05 years). Additionally, the percentage of restatements affecting only unaudited interim results increased over the sample period, with the highest percentage in 2022 at 46%, which underlines the importance of auditor involvement.

5. CAMs may not provide information about restatement risk

Critical audit matters (CAMs) are those matters communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment. By expanding the audit report to include CAMs, the PCAOB hoped to increase its relevance to financial statement users. Investors may use CAMs to better understand reporting risk.

However, the data from our analysis suggests that it may be difficult to ascertain restatement risk from CAMs.  While the average number of CAMs was slightly higher for 4.02 restatement issuers in every applicable year, perhaps the more interesting takeaway is the trend in the percent difference observed during the period 2019-2022. For the first 3 years, the magnitude of the difference grew year over year. Then, in 2022, that difference declines such that the average number of CAMs is essentially the same for 4.02 restatement issuers and non-restatement issuers.

This suggests that future research may need to be conducted on this topic to better understand if CAMs are a sufficient measure of reporting risk.

Download the full report for the full analysis on restatements: Financial Restatement Trends in the United States: 2013 – 2022.