Since financial restatements are pretty rare, your first inclination when faced with one could be panic. It’s an understandable reaction when restatements are often associated with occurrences of fraud (Enron’s and WorldCom’s infamous restatements come to mind). But not all restatements are caused by an unscrupulous executive’s desire to meet earnings expectations, increase stock prices or earn incentive compensation. Sometimes errors occur due to honest mistakes or misapplication of accounting guidance.
After all, accounting rules are complex (implementing the new standards for revenue recognition and lease accounting have been huge undertakings). Financing arrangements can be complicated, and determining the correct authoritative guidance can be tricky. And it’s subject to interpretation—and errors. If you suspect you may need a restatement, here’s how to get through your company through the restatement process, from figuring out if a restatement is necessary to determining how the problem happened, and correcting it.
1. Keep Calm
If you find you have an error in your prior period financial statements, don’t freak out. We get it—you probably don’t have a history of dealing with this type of issue, and remediating financial reporting issues can be a complex process. This would be a good time to reach out to experts who have taken companies through it and can help you. Don’t underestimate the work that’s ahead.
Don’t let your organization get distracted by the restatement process. It’s important for the company to stay the course, so you’ll want to minimize the disruption to other departments as much as possible. In our experience, the companies that come out of a restatement successfully are the ones that continue to focus on their core operations and revenue growth. Investors could see the underlying business was strong. As for the finance organization, you’ll likely need extra help to handle the day-to-day accounting so that nothing falls behind. Don’t underestimate the workload involved in this process!
2. Investigate the Error
When an error is discovered in a previously issued financial statement, it needs a close look. Assess whether it is material—this assessment should include both quantitative and qualitative factors (e.g., even a small error could mask the full picture of what’s going in the business, such as trends in revenue or earnings or the company’s ability to meet its debt covenants). If you determine the error is material to the prior period, you are looking at a restatement, and you will need to notify your investors in an 8-K which of your previously issued reports should not be relied upon.
How and what you communicate is important—you want to provide the necessary information without causing your investors to question whether your future financials will be reliable. As you get through the process and understand more fully what caused the error, your investors will make decisions about the seriousness of the error, how much of an impact it is likely to have, and whether this was an innocent mistake or something more sinister.
3. Dig Deeper
Your investigation should assess why the error occurred—was this an intentional misrepresentation of the financial statements in order to meet revenue expectations, boost the stock price or meet executive bonus plans? Is the error limited to a single transaction, or is it more pervasive? Was an individual performing tasks they were not qualified to do? Was the company relying on inaccurate underlying data to record transactions?
Your course of action will depend on what your root cause investigation reveals. You may need to look at all transactions handled by a specific individual or all areas involving significant judgments. Or if this issue was related to inaccurate data, you will be looking at data sources and reconciliation processes across the board to ensure that all other data sources are complete and accurate. In any event, you will need to review all areas of potential risk, not just the transaction in question.
4. Create a Plan, and Put the Right Team in Place
With a lot to review and the need to be meticulous, a project plan will help lead the way. This plan should clearly identify roles and responsibilities, including a strong project manager to lead the team. This person will need to manage expectations of all key stakeholders (internal and external) throughout the process. You likely will need people with strong technical accounting skills to review your significant transactions and ensure they were recorded properly, have the appropriate supporting documentation and are ready to stand up to the (new) scrutiny of your external auditor. This may be time to lean on very experienced finance pros who understand the restatement process and whose presence could assure your auditor that it will be taken care of properly. The preparation of adjusting journal entries to fix the accounting errors in prior periods, and tracking and managing the adjustments, can be a job in itself.
5. Be Prepared for External Auditor Scrutiny Throughout the Process
During the entire time, your external auditors will be playing a big role in this process—they will be reviewing the error, coming up with their own root cause analysis, and re-looking at all the risk areas to ensure there are no additional errors lurking. To be responsive to their queries, it’s a good idea to appoint someone to facilitate dealing with the external audit team. You’ll be expected to turn around information as quickly as possible. Remember your auditors are under pressure too—they may be perceived to have missed the error as well.
6. Review Internal Controls
With any restatement, there is a presumption of a material weakness in one or more controls. You’ll need to review your internal controls and determine which controls were not properly designed or not properly executed, and how you are remediating that deficiency. This is very important to helping restore credibility with your investors so that they’ll have confidence the error won’t repeat in the future.
7. Finally, Make the Restatement
The restated interim and annual financial statements need to be drafted, with a footnote disclosure about the error correction—the nature of the error, how it occurred, how it was corrected and whether there is likely to be any future ramifications. You should also be prepared to respond to SEC comments and questions. Having someone with expertise in this area will be invaluable to your efforts.
Mistakes happen. Even after you take care to close your books accurately, record transactions in accordance with GAAP, research complex transactions and document your basis in GAAP—and even after your external auditors comb through it all and agree with your accounting—you could still find yourself facing the need for a potential restatement. Once the error is realized, it’s important to act swiftly and carefully to get the proper information out there. Finance pros who have helped companies through this same process can help you focus on all the steps in this list. They know exactly what’s needed to remediate an error, fix the previously issued financial statements and help you put processes in place to prevent history from repeating itself.