Disclosure of financial reporting errors is vital to maintaining investors’ trust in the capital markets. Yet, in recent years the number of misstatements corrected in restatements of financial reports has declined dramatically, and misstatements are now more likely to be corrected in less formal revisions of those reports. Based on materiality guidance, prior years’ financial statements of firms with material misstatements are required to be restated on an 8-K filing.[1] In contrast, revisions, sometimes referred to as “little r” restatements, are considered to be immaterial to prior period financial statements and do not require an 8-K filing. In view of the negative consequences of restatements, such as negative stock market reaction and potential clawback of compensation, managers have incentives to strategically disclose misstatements as revisions in order to avoid reporting restatements.[2] In my study, I examine (1) whether firms record material misstatements as revisions, (2) whether the market recognizes the nature of material revisions, and (3) whether managers are opportunistically using their discretion to assess misstatements as immaterial (i.e., report revisions) when they are subject to compensation clawbacks.

Since the decision to revise or restate hinges on a firm’s assessment of the materiality of the misstatement, I first examine whether revisions meet the existing materiality guidance. The Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) provide guidance on assessing the materiality of an item, emphasizing the need to consider both the magnitude of the misstatement compared with relevant benchmarks (e.g., 5 percent of net income) as well as the other facts and circumstances of the misstatement that could influence financial statement users’ decisions (e.g., whether the misstatement enables the firm to meet or beat equity analysts’ earnings forecasts).[3] Interestingly, I find that 45 percent of the revisions in my sample meet at least one of the materiality criteria or exceed at least one of the de-facto materiality thresholds. Thus, it appears that managers are frequently using materiality discretion to correct material misstatements using revisions rather than restatements.

The fact that a significant number of firms report material misstatements as revisions naturally raises the question: Does the stock market perceive these revisions to be material? I examine the stock market response to the disclosure of revisions and find that material revisions (i.e., revisions meeting at least one materiality criterion) elicit a stronger negative market response compared with revisions which do not meet the materiality criteria (i.e., immaterial revisions).

In the month of the revision announcement, cumulative abnormal returns are significantly negative for material revisions and significantly more negative relative to immaterial revisions. Interestingly, when using a shorter three-day window, I find no significant difference in the cumulative abnormal returns between the material and immaterial revisions. Thus, although the market does recognize the materiality of the revision, it does so with a delay. In addition, I compare the market response to the disclosure of material revisions and material restatements to test whether the market perceives material restatements to be more severe relative to material revisions. After controlling for the materiality criteria, I find that the cumulative abnormal return (CAR) of revising firms is not significantly different from the restating firms’ CAR, suggesting that firms’ materiality determination (i.e., as revealed through its reporting of a revision [immaterial] or restatement [material]) has little relevance for investors.

Next, I examine whether the correction of misstatements using revisions is consistent with managers’ opportunistic avoidance of restatements. More specifically, I focus on one incentive which is likely to strongly influence managers’ misstatement reporting decisions, restatement clawback provisions. Firms that have adopted those provisions can recoup compensation from managers if the firm reports a “material” restatement. However, since revisions are deemed “immaterial” by firms, revisions do not trigger the clawback provisions.

Consistent with the opportunistic reporting of revisions to avoid the potential repayment of compensation, I find that managers who are subject to clawback provisions are significantly more likely to revise rather than to restate compared with managers who are not subject to clawbacks. Specifically, in my sample firms with clawback provisions are over 2.5 times more likely to report material misstatements as revisions compared with firms without clawback provisions (70.1 percent and 26.8 percent respectively).

I further examine whether the effect of clawback provisions on correcting misstatements using revisions is even stronger when management has more discretion over the misstatement reporting decision and when managers are more sensitive to the impact of the clawback provision. Since highly material revisions are more likely to face scrutiny by regulators (Acito, Burks, and Johnson, 2019) and auditors, managers are afforded more discretion over the misstatement disclosure choice when the misstatement is not highly material. Consistent with managers exploiting discretion afforded by less material misstatements, my results show that the positive association between clawback provisions and revisions is stronger for material misstatements that meet fewer materiality criteria. In addition, the impact of clawback provisions on reporting misstatements as revisions is even stronger when the CEO’s compensation is more sensitive to the impacts of the clawback provision (i.e., CEO’s compensation has a higher proportion of incentive based pay).

My results highlight the importance of explicit consideration of misstatement materiality by showing that evaluating material versus immaterial revisions separately can lead to new inferences. I find that material revisions elicit a significant negative market response, indicating that the market may not believe that management is reporting all revisions correctly. Additionally, after controlling for materiality criteria, the difference in cumulative abnormal return (CAR) between material revisions and material restatements disappears, casting further doubt that these “material” revisions were reported correctly.

In addition, my results show that managers opportunistically report revisions in order to avoid reporting restatements. Specifically, I show that in the presence of clawback provisions managers are more likely to use discretion afforded by the materiality rules to correct misstatements through revisions instead of restatements. This new evidence documents an unintended consequence of clawbacks, namely that clawback provisions deter the filing of restatements upon a misstatement discovery.

Lastly, my study has important implications for regulators and standards setters, especially in relation to the FASB’s recent project on materiality. In 2015, the FASB released two exposure drafts aiming to clarify when an item is material, including a new definition of materiality.[4] Amid criticism that the proposal allowed for increased discretion and thus less transparent information for market participants, in 2018 the FASB scaled back the proposed changes and returned to an earlier definition of materiality.[5] My study substantiates the critics’ concerns and suggests that increases in discretion within the materiality rules could lead to more firms using materiality discretion opportunistically.   

ENDNOTES

[1] See Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topics 250 and 105 and Securities and Exchange Commission (SEC) 2004: “Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date.”

[2] For example, see Palmrose, Richardson, and Scholz (2004), Palmrose and Scholz (2004), and Pyzoha (2015).

[3] For example, the SEC’s Staff Accounting Bulletin (SAB) No. 99 lists several criteria for determining whether small magnitude misstatements are material, including whether the prior period error 1) reverses an earnings trend, 2) involves misconduct, 3) causes a debt covenant violation, 4) changes the earnings sign, 5) enables a firm to meet or beat analysts’ earnings forecasts,  6) affects a key portion of the firm’s business or operations, 7) is capable of precise measurement, 8) impacts regulatory compliance, or 9) impacts managements’ compensation.

[4] One of the exposure drafts contained proposed amendments to the FASB’s Conceptual Statement No. 8, Chapter 3 “Qualitative Characteristics of Useful Information” and the other was a proposed Accounting Standards Update, ASU Topic 235: “Assessing Whether Disclosures are Material.”

[5] Examples of the proposal’s criticism include: “FASB Proposes to Curb What Companies Must Disclose” (New York Times, 2016):http://www.nytimes.com/2016/01/03/business/fasb-proposes-to-curb-what-companies-must-disclose.html?_r=1, SEC Investor Advisory Comment Letter (No. 51 for Project 2015-300, No. 78 for Project 2015-310): https://www.sec.gov/spotlight/investor-advisory-committee-2012/iac-letter-fasb-materiality-012116.pdf. “The Raw Nerve of Materiality” (CFO, 2016): http://ww2.cfo.com/gaap-ifrs/2016/05/raw-nerve-materiality/.

REFERENCES

Acito, Burks, J. and Johnson, B., 2019. The Materiality of Accounting Errors: Evidence from SEC Comment Letters. Contemporary Accounting Research, 36(2), pp. 839-868.

Palmrose, Z.V., Richardson, V.J. and Scholz, S., 2004. Determinants of market reactions to restatement announcements. Journal of Accounting and Economics, 37(1), pp. 59-89.

Palmrose, Z.V. and Scholz, S., 2004. The Circumstances and Legal Consequences of Non-GAAP Reporting: Evidence from Restatements. Contemporary Accounting Research, 21(1), pp.139–180.

Pyzoha, J.S., 2015. Why do restatements decrease in a clawback environment? An investigation into financial reporting executives’ decision-making during the restatement process. Accounting Review, 90(6), pp.2515–2536.

This post comes to us from Professor Rachel Thompson at the University of Texas, El Paso. It is based on her recent article, “Reporting Misstatements as Revisions: An Evaluation of Managers’ Use of Materiality Discretion,” available here.