Qualitative Characteristics of Financial Reporting Errors Deemed Immaterial by
Managers
Preeti Choudhary*
Georgetown University
[email protected]
Kenneth Merkley
Cornell University
[email protected]
Katherine Schipper
Duke University
[email protected]
First draft: January 2016
This version: March 2016
* Corresponding Author. Professor Choudhary acknowledges the financial support of the
McDonough School of Business at Georgetown University, and wrote this paper prior to joining
the PCAOB. The views expressed in this paper are her personal views and do not necessarily
reflect the views of the Board as a whole or members of its staff or Board. The PCAOB as a
matter of policy disclaims responsibility for any private publication or statement by any of its
Economic Research Fellows and employees. We appreciate helpful comments from workshop
participants at the PCAOB, the University of Arizona, the University of Connecticut, and the
London Business School.
Qualitative Characteristics of Financial Reporting Errors Deemed Immaterial by
Managers
Abstract:
We provide evidence on two qualitative characteristics of financial reporting errors deemed
immaterial by management (immaterial errors) and benchmark these characteristics against those
of material errors corrected by restatements. With regard to relevance for equity valuation, our
results suggest that investors find immaterial errors relevant, in particular those that are more
severe, with valuation effects smaller than those associated with restatements disclosed in form
8-K. With regard to predictive ability for reporting quality, we find immaterial errors are
informative about financial reporting reliability because they indicate increased propensities for
future material errors, immaterial errors, and material weakness assessments. The predictive
ability of immaterial errors for reporting quality is not qualitatively different from that of
material errors. Viewed in the context of previous research on material errors, our results support
the notion that immaterial errors are informative about reporting quality. Our analysis informs
recent debates about materiality assessments from an investor perspective.
1. Introduction
We investigate the outcome of the required application of the concept of materiality in
financial reporting by analyzing accounting errors, including those deemed material and those
deemed immaterial by management. We distinguish the two types of errors based on differences
in the ways material vs immaterial errors are described and corrected. We assess the outcome of
these management judgments by providing evidence on two qualitative characteristics of
financial reporting errors judged by management to be immaterial.1 First, taking as our
benchmark investor responses to material error corrections, we assess relevance for equity
valuation by measuring whether equity investors respond to immaterial error corrections despite
their designation. This evidence is intended to shed light on whether preparer materiality
assessments align with those of investors. Second, we investigate whether immaterial errors
have predictive ability, a component of relevance in the conceptual framework of the Financial
Accounting Standards Board (FASB).2 Specifically, we test whether immaterial error
corrections provide forward-looking information about the reliability of the firm’s financial
reporting system, as captured by predictive ability of current period error corrections for future
errors and material weaknesses in internal controls.
In the U.S. the legal definition of materiality is qualitative, in that information is material
if “there is a substantial likelihood that the omitted or misstated item would have been viewed by
a reasonable resource provider as having significantly altered the total mix of information.” 3 The
application of this qualitative definition in a financial reporting context typically begins with a
quantitative threshold, in the sense that reporting errors whose magnitude exceeds a specified
amount are deemed material; otherwise, the error is deemed immaterial unless a qualitative
analysis determines otherwise. That is, in evaluating an error’s materiality, preparers are
required to evaluate the nature of the error and its surrounding circumstances to determine
1
Following authoritative guidance (ASC-250), errors are defined as misapplications of GAAP including misuse of
facts at the time financial information is prepared. Errors can be intentional or unintentional; in general it is not
possible to distinguish these two types of errors by examining the nature (for example, the effect on income) of the
errors themselves. We focus on management’s determination as to error materiality, not the related but distinct
determination required of the external auditor. We use the term “material error” to describe a financial reporting
error deemed material by management and corrected by restatement and “immaterial error” to describe an error
deemed immaterial by management.
2
Para. QC6-QC11 of Statement of Financial Accounting Concepts No. 8.
3
Para. QC11 of the FASB’s September 2015 Exposure Draft to amend Concepts Statement No. 8; refer also to
footnote 4.
1
whether a reasonable investor would find the information important, in the sense of significantly
altering the mix of available information. Authoritative guidance identifies factors that preparers
should consider because those factors may influence investor assessments about whether a given
information item, including an error correction, would alter the mix of information (e.g. SEC
Staff Accounting Bulletin (SAB) No. 99, Materiality, issued in 1999). That said, professional
judgment is required to designate errors as material versus immaterial. We investigate the
outcome of these judgments, by analyzing two qualitative characteristics of errors determined by
management to be immaterial: relevance for equity values and predictive ability. We measure
equity value relevance by reference to investor perceptions, as captured by market reactions to
disclosure of immaterial error corrections, and we measure predictive ability by reference to the
ability of immaterial errors to forecast indicators of poor future reporting quality.
In assessing the properties of immaterial financial reporting errors, we aim to provide
evidence on the concept of materiality as an underpinning of financial reporting and auditing.
The application of this concept is pervasive; for example, the FASB states in ASC Topic 105,
Generally Accepted Accounting Principles, that the provisions of its standards need not be
applied (by preparers) to immaterial items. To clarify the concept of materiality for preparers and
users of financial statements, in September 2015 the FASB proposed both amending the
discussion of materiality in the Conceptual Framework and providing standards-level guidance
to financial statement preparers in assessing materiality in the notes to financial statements. 4
Outside the U.S. reporting environment, revised U.K. and Ireland audit reports beginning in 2013
provide specific information about how auditors assess quantitative materiality thresholds. This
newly provided information has generated interest among market participants who have diverse
views on materiality and also among academic researchers.5
4
A proposed ASU to Topic 235, Notes to Financial Statements: Assessing Whether Disclosures are Material, would
specify, among other things, that materiality is a legal concept and the omission of immaterial disclosures is not an
accounting error. A proposed amendment to Chapter 3 of Concepts Statement No. 8, Conceptual Framework for
Financial Reporting, would state specifically that materiality is a legal concept, and cite to the Supreme Court
decisions TSC Industries, Inc. v. Northway Inc., 426 U.S. 438 (1976) and Basic Inc. v. Levinson, 485 U. S. 224
(1988). The proposed amendment states specifically that the FASB does not define materiality (para. BC18B),
meaning that the FASB would also not define the terms in the legal definition such as “reasonable resource
provider” or “significantly altered the mix of information.”
5
The UK/Ireland guidance for auditors is International Standard on Auditing (UK and Ireland) 700, The
Independent Auditor’s Report on Financial Statements, (ISA 700) Financial Reporting Council, 2013. Investor
interest in these reports is illustrated in a Citi Research Report, UK Auditor’s Reports, September 24, 2015, which
analyzes 97 of the FTSE 100 auditor reports, including a detailed discussion of differences in quantitative
2
Our analyses of immaterial errors are based on a broad sample of 2,385 reporting errors
that are deemed immaterial by management of firms applying U.S. GAAP between October
2008 and December 2014 and that are included in the Audit Analytics database. During this
period, there is an increasing propensity to disclose immaterial errors and a decreasing
propensity to disclose material errors (restatements). For example, during this sample period, the
frequency of immaterial errors doubles from 4% to 9%, while the corresponding frequency for
material errors declines by 50% from 3.2% to 1.5%. Our analysis aims to shed light on the
properties of immaterial financial reporting errors and their implications for reporting quality.
We find that, compared to material errors, immaterial errors tend to be disclosed through
less salient channels (periodic filings such as form 10-Q or form 10-K as opposed to press
releases or Form 8-K filings) and gain less attention from the SEC, the firm’s board of directors,
and auditors. Immaterial errors are, not surprisingly, smaller on average than material errors; the
mean immaterial error is approximately 20% the size of a material error, computed as the ratio of
the income effect of the error scaled by absolute pretax income. Despite this difference in mean
magnitudes, there is overlap in the distributions of errors deemed material versus immaterial, as
depicted in Figure 3, suggesting that managers’ consideration of qualitative factors leads to
variation in materiality designations. Further, despite their smaller average magnitudes and lessprominent disclosures, immaterial error corrections are often associated with negative price
responses. While the price reactions to immaterial errors are on average much smaller in
magnitude than the reactions to material errors (documented in our results as well as in previous
research), they are reliably non-zero. Additional analyses show the price reactions for immaterial
errors are stronger when those errors are more severe and when the corrections are disclosed in
non-routine filings as opposed to periodic filings (e.g. 10-K, 10-Q). We interpret the weight of
the evidence as supporting the view that investors do not disregard error corrections designated
by management as immaterial. This inference suggests a possible misalignment between
preparer and auditor assessments of what alters the mix of information and investor assessments.
We explore a plausible potential source of this possible misalignment, specifically,
whether immaterial errors alter the mix of information by providing a forward-looking signal of
materiality thresholds and their application. Academic research on the capital market and financial reporting
consequences of the new auditor reports includes, for example, Gutierrez, Minutta-Meza, Tatum and Vulcheve
(2016), Lennox, Schmidt and Thompson (2015), and Reid, Carcello, Li and Neil (2015a, 2015b).
3
the (un)reliability of financial reporting systems. Neither quantitative materiality thresholds, such
as 5% of assets or income, nor the qualitative materiality factors in authoritative guidance
specify informativeness about reporting reliability (or likelihood of error recurrence) as a
consideration in reaching materiality determinations. We conjecture that equity investors might
view immaterial errors as indications of weak internal controls or poor reporting quality
generally, while preparers do not consider this factor in their materiality assessments because it
is not part of the guidance they are required to follow. In evaluating this possibility, we find that,
after controlling for material errors, immaterial errors are associated with poor future financial
reporting quality as captured by higher propensities of future material errors, immaterial errors,
and material weaknesses. We interpret this finding as pointing to a possible reason for
misalignment between investors in interpreting immaterial errors and preparers in determining
that errors are immaterial: investors are considering a factor that does not enter the preparers’
determination. The finding is inconsistent with the view that immaterial errors are promptly
corrected, and their underlying causes are promptly addressed, in a manner that increases
reporting quality in the sense of reducing the likelihood of future financial reporting problems.
We contribute to research on reporting quality, specifically, research on financial
reporting errors. Taking the perspective that financial reporting errors, whether material or
immaterial, have the potential to convey decision-useful information to equity investors, we
study immaterial errors that firms disclose pursuant to ASC 250-10 to provide evidence on
whether these errors are meaningful or informative. Our focus on immaterial errors contrasts
with and complements previous analyses of material errors, including classifications intended to
capture the prominence or salience of information presented about the material error correction
(e.g. Hribar and Jenkins 2004; Palmrose and Scholz 2004; Palmrose, Richardson, Scholz 2004;
Efendi et al 2007; Hennes, Leone, and Miller 2008; Plumlee and Yohn 2010; Kravet and Shevlin
2010; Ettredge et al. 2011; Badertscher and Burks 2011; Myers, Scholz and Sharp 2013).
Prior research that studies immaterial errors focuses on firm characteristics that
determine such errors in the form of revisions (e.g., DeFond and Jiambalvo 1991; Tan and
Young 2014), or uses them to evaluate the determinants of materiality judgments including
auditor/preparer incentives, qualitative and quantitative factors (e.g., Acito, Burks, Johnson
2009; Keune and Johnston 2012). That is, previous research on immaterial errors tends to focus
on determinants, not outcomes, taking the qualitative characteristics of errors as given. Our
4
analyses contribute beyond these prior investigations of immaterial errors in three ways. First,
we provide evidence on two qualitative characteristics that capture outcomes of immaterial
errors, relevance for equity valuation and predictive ability. Second, we separately consider two
types of immaterial errors, those corrected as revisions and those corrected as out-of-period
adjustments; our results suggest qualitative differences in between these two types of errors.
Third, we provide explicit comparisons using material errors to benchmark our results.
The rest of this paper proceeds as follows. Sections 2 provides background information
on materiality and immaterial versus material errors in financial reporting. Sections 3, 4 and 5
review the relevant literature, develop our hypotheses and report empirical results, respectively.
Section 6 concludes.
2. Background information
2.1 Immaterial errors versus material errors and their correction
Figure 1 shows schematically the determination of whether a financial reporting error is
immaterial, the way the error and its correction are disclosed, and the distinction between two
types of immaterial errors. The starting point is the identification of a financial reporting error,
defined as inaccuracies in recognition, measurement, presentation, or disclosure in financial
statements resulting from mathematical mistakes, mistakes in the application of generally
accepted accounting principles (GAAP), or oversight or misuse of facts that existed at the time
the financial statements were prepared (ASC 250-10).6 For our purposes, it is important to
distinguish a reporting error from an after-the-fact inaccuracy due to the difference between an
ex ante estimate and an ex post outcome. The distinction matters because a difference between
an estimate and an outcome does not arise from a mistake or a misuse of facts; rather, it arises
from the uncertainty inherent in financial reporting. Management would be expected to respond
to a difference between an estimate and an outcome by changing the estimate prospectively.
Once an item is determined to be an error as opposed to a circumstance that might require
a prospective change in estimate or judgment, management must determine if the error is
material or immaterial. If the error is deemed material, the preparer follows the guidance for
recording and disclosing restatements. If the error is deemed immaterial to the financial
6
For example, a change from an accounting principle that is not generally accepted to one that is generally accepted
is a correction of an error.
5
statement period in which it occurred, the preparer follows the guidance for recording and
disclosing immaterial errors. This determination requires professional judgment on the part of
the preparer, to make the initial decision, and then by the auditor as part of the assurance process.
We focus on management’s determination of materiality, and consider three types of errors:
material errors corrected by restatement, immaterial errors corrected by revision, and immaterial
errors corrected by an out-of-period adjustment.
An error that is judged to be material to the financial reports for the period(s) in which it
occurred requires a statement of non-reliance (i.e., Item 4.02 in 8-K filing) for the prior periodic
report(s) containing the material error and a restatement (i.e., revised financial statements)
disclosed either in an amended filing or a future filling.7 Both a statement of non-reliance and
revised financial statements are required even if the errors are deemed immaterial to the period in
which they are identified. In addition, a revised audit opinion is required with discussion in the
auditor’s report of the error. We refer to these as material errors or restatements; in practice they
are commonly referred to as “Big R” restatements. Appendix A, Section 1 provides examples.
These examples illustrate that material error corrections (restatements) are accompanied by
detailed disclosures, revised financial statements, and explanations.
We classify errors that do not meet the combined quantitative and qualitative threshold to
be deemed material errors as immaterial errors, judged by management to be not-material in
accordance with authoritative guidance. That is, we assume preparers and auditors have
faithfully and objectively applied the requirements of authoritative guidance to assess the
materiality of errors, and the method of disclosing/correcting the error faithfully represents the
outcome of that assessment. Per SAB 108, issued September 13, 2006, management is expected
to correct immaterial errors and not allow them to remain on the balance sheet indefinitely.8 In a
December 2008 speech, the associate Chief Accountant of the SEC indicated that if the effect of
a correction would not materially affect the previously-issued financial statements, those
Form 8-K current report General Instructions, Item 4.02 must be filed if (a) the registrant’s board of directors….
concludes that any previously issues financial statements, covering one or more years or interim periods for which
the registrant is required to provide financial statements… should no longer be relied upon because of an error in
such financial statements (Rule 33-8400).
8
We note that the disclosure of accounting errors differs from the disclosure of some other forms of financial
reporting information in that it is mandatory that immaterial errors be corrected and disclosed following SAB 108.
In other cases, managers must disclose information deemed material, but the disclosure of immaterial information
can be voluntary (Heitzman, Wasley, and Zimmerman 2010).
7
6
financial statements may be relied upon, and the corrections may be made in future filings (i.e.,
without amending prior filings or issuing an Item 4.02 8-K disclosure).9
The correction of an immaterial error depends on the nature of the error. First, a revision
(sometimes called a prior period adjustment or “little r” restatement) is a correction of an error or
a series of errors whose nature is such that (1) the error is immaterial to each individual financial
reporting period in which the error occurred using both a period-by-period and cumulative
analysis of the financial statement effects of the error, but (2) collectively the error(s) may be
sufficient to distort current period income if all the errors are corrected in the period
discovered.10 For example, errors can occur in multiple periodic filings and accumulate such that
a current-period correction would distort current-period income (ASC 250-10-45-24; PWC
Interpretive Guidance 2013; SEC speech by Mark Maher 12/8/2008). These immaterial errors are
recorded as revisions, specifically, by revising comparative financial statements included in the
current period financial report. The adjustment to correct the past-period(s) error is made to
opening balances of retained earnings; an error that would affect current period income would
flow through the income statement. These errors do not require Item 4.02 statement of nonreliance disclosures because the financial statements containing the errors are not materially
misstated, and thus, can be relied upon. Appendix A, Section 2 provides some examples of
revision disclosures. Qualitatively, revision disclosures tend to be less detailed and shorter
relative to material error disclosures.
Second, an out-of-period adjustment refers to an immaterial error that is corrected by
adjusting the current period financial statements for the prior period error.11 That is, the error(s)
occurred in some prior period(s) and the entire correction is recognized in financial statement
amounts in the current period, meaning the current period income statement contains the entire
correction of a previous-period error. As result, at least two accounting periods contain
9
http://www.sec.gov/news/speech/2008/spch120808mm.htm
The term revisions does not appear specifically in authoritative guidance but is commonly used in practice as
evidenced by interpretive guidance from large audit firms. This interpretive guidance cites the SEC speech made by
Associate Chief Accountant Mark Maher in December 2008, sometimes referred to as “standard setting by speech.”
Practitioners also sometimes refer to these immaterial error corrections (pejoratively) as stealth restatements. The
use of the term stealth restatements in the academic literature does not refer to revisions as we use that term. We
describe the uses of the term stealth restatements in Section 3.0.
11
While the term “out-of-period adjustment” is not used in authoritative guidance it is commonly used in practice as
evidenced by interpretive guidance from large audit firms (May et al. 2013; Ernst and Young 2014). As illustrated in
Appendix A, Section 3, firms often use this term in their disclosures.
10
7
distortions from true periodic performance, the current period to which the correction is applied
and the prior period(s) where the error occurred. Examples of out-of-period adjustment
disclosures appear in Appendix A, Section 3.
Based on this discussion of the nature of material and immaterial errors and following
prior research, we infer that a financial reporting error corrected by restatement would be
material to financial statement users; we discuss related research in Section 3. Among errors
deemed immaterial by management, and focusing only on magnitudes of errors with no
consideration of qualitative factors, we infer that revisions would be smaller than material errors
but larger than out-of-period adjustments (alternatively, closer to the materiality threshold),
because correcting revisions entirely in the current period financial reports would distort the
ability of current period reporting to represent current period profits. Consequently, when we
focus on magnitudes only, we infer that out-of-period adjustments would be the smallest, or,
alternatively, farther from the materiality threshold than revisions. However, a focus on
magnitudes is incomplete, because authoritative guidance for materiality judgments contains
qualitative factors, meaning that error magnitude is not determinative of materiality. Taking the
perspective that materiality determinations are based on combined quantitative and qualitative
factors, we investigate how financial statement users process corrections of errors that
management deems immaterial, whether this processing varies between revisions and out-ofperiod adjustments, and whether either type or both types of immaterial errors have predictive
ability for future reporting quality.
2.2 Materiality in financial reporting
Applying the notion of materiality in a financial reporting setting requires professional
judgment. In practice, it is common to begin materiality assessments by applying quantitative
thresholds such as 5% of pre-tax income (e.g., Messier, Mortinov-Bennie and Eilifsen 2005).
SEC Staff Accounting Bulletin (SAB) 108 provides additional guidance that both the iron curtain
(income statement) and the rollover (balance sheet) approaches should be used to assess the
materiality of an error. Prior to SAB 108, preparers and auditors could choose between the two
methods (e.g., Nelson et al. 2005; Keune and Johnstone 2009). The rollover method focuses on
the materiality of current-year errors and the effect of correcting prior-year errors on current
period income (Keune and Johnstone 2012). The iron curtain method evaluates the materiality of
8
the error by recording income statement errors from prior periods as an adjustment to retained
earnings; in other words it requires a quantitative evaluation of the cumulative effect of the error
(i.e. year-to-date) on current period financial statements. For example, if an error of $30 affects
reported income of $1,000 in each of two periods, the rollover approach quantifies the error as
3% of income in each period and the iron curtain approach quantifies the error as 3% in period 1
and 6% in period 2 (PWC Interpretive Guidance 2013).
As a matter of principle or practice, materiality can be specified, at least as a starting
point, as a quantitative threshold, for example, an error expressed as a percentage of income or
assets would exceed (material) or not exceed (immaterial) a specified numerical threshold. The
use of a numerical threshold “as an initial step in assessing materiality” is described as
appropriate in SEC Staff Accounting Bulletin (SAB) 99. However, SAB 99 also clarifies that
the legal notion of materiality for financial reporting extends beyond quantitative thresholds,
requiring an assessment of relevant circumstances or qualitative factors. Qualitative factors to be
considered per SAB 99 include but are not limited to: whether the item being measured is
capable of precise measurement; how an item being evaluated for materiality affects earnings
trends, or meeting analyst expectations, or a change from reporting a loss to reporting income (or
vice versa); whether the item affects compliance with regulatory requirements or loan covenants;
whether the item would increase management compensation by, for example, meeting a bonus
requirement; whether the item conceals an unlawful transaction; whether the item is a result of
intentional earnings manipulation. Based on these qualitative factors, an error that is small as a
percentage of income or assets could be material.
3.0 Previous research on materiality in financial reporting
A substantial body of accounting research analyzes material errors, meaning those that
are disclosed in form 8-K and corrected in a restatement. Some of the first work in this area
studied determinants and consequences of material errors identified in interim reports (Kinney
and McDaniel 1989). Subsequent studies examine additional determinants and consequences of
material errors and how the consequences differ based on various firm and error characteristics
(e.g., Hribar and Jenkins 2004; Palmrose and Scholz 2004; Palmrose, Richardson, Scholz 2004;
Efendi et al 2007; Hennes, Leone, and Miller 2008; Plumlee and Yohn 2010; Kravet and Shevlin
2010; Ettredge et al. 2011; Badertscher and Burks 2011; Myers, Scholz and Sharp 2013).
9
Previous analyses of error corrections and particularly restatements sometimes use the
term “stealth restatements.” We do not use this term, because we believe it has a number of
possible meanings depending on the context. First, as indicated in note 9, practitioners
sometimes refer to immaterial errors corrected by revisions as “stealth restatements” suggesting
that because those errors are not disclosed in the same way as material errors investors could
overlook them. Second, we find the term “stealth restatements” in a 2006 report by Glass Lewis
& Co., LLP that identified certain firms that disclosed material errors only in regular filings (i.e.,
10-K, 10-Q) or not at all.12 We interpret the term “stealth restatement” as used by Glass Lewis as
referring to errors where their judgment of materiality differs from the judgment reached by
management and/or material errors that are disclosed inappropriately (possibly intentionally).
Based on our interpretation, this usage of the term stealth restatement appears to comingle the
way the error is disclosed, that is, whether the information presented is or is not viewed as salient
or prominent, with the determination as to whether an error is material, that is, a misapplication
of the materiality concept.
Finally, some researchers use the term “stealth restatements” to refer to material error
corrections (restatements) that are disclosed with varying degrees of prominence that might
affect the attention investors pay to the error. This use of the term focuses on the salience of how
a restatement is presented, not the judgment that led to the error being deemed material. For
example, Files, Swanson and Tse (2009) label “stealth restatements” as Big R restatements
(material error corrections) with less prominent disclosures (across headline, body of press
release, and footnote reference in press release) and find evidence of larger market reactions to
more prominent restatement disclosures. Myers et al. (2013) define and study stealth
restatements as Big R restatements that do not have a corresponding 8-K disclosure.13 They
document less negative market reactions to Big R restatements absent 8-K disclosures. These
academic studies using the term stealth restatement, which analyze how information about
material error corrections is presented, do not overlap with our analysis.
12
In other words, Glass Lewis identified companies as not complying with requirement to issue 8-K/press release
announcements as clarified by the SEC in August 2004 for all material error corrections (Rule 33-8400).
13
Some of their sample pre-dates the Item 4.02 disclosure (effective in 2004) such that their sample comingles both
Big “R” restatements without voluntary 8-K/press release disclosures and little r restatements (revisions) that are not
material errors. Their definition of “stealth restatements” is restatements with low transparency.
10
To summarize, previous analyses by accounting researchers and others have focused on
material errors of varying types, including classifications intended to capture the prominence or
salience of information presented about the material error correction. In contrast, we study
immaterial errors that firms disclose pursuant to ASC 250-10 to provide evidence on whether
these errors are also meaningful or informative, despite their assessment as immaterial.
Specifically, we investigate whether investors respond to immaterial errors, and whether
immaterial errors have predictive ability for future reporting quality; in these analyses we
consider the properties of material errors only as a benchmark for comparison. Based on
previous research, we also distinguish in some analyses between immaterial errors disclosed in a
routine periodic filing (form 10-Q or 10-K) and immaterial errors disclosed in a non-routine
filing, for example, in a form 8-K.14
In contrast to the broad literature on material errors corrected by restatements, there are
few studies of immaterial errors. The existing research has considered one type of immaterial
error, a revision or little r restatement, and has provided evidence on determinants (e.g., DeFond
and Jiambalvo 1991). Tan and Young (2014) extend this determinants analysis to a more recent
time period characterized by a greater frequency of these types of errors. Related work by Keune
and Johnston (2009) provides descriptive evidence of revisions following SAB 108 which
changed materiality guidance.15 Finally, some recent studies compare restatements and revisions
to shed light on materiality judgments and factors that influence those judgments (e.g., Acito,
Burks, Johnson 2009; Keune and Johnston 2012).
Previous research on immaterial errors has thus analyzed one type of immaterial error
(revisions), primarily from the perspective of providing evidence on the determinants of this
outcome of management judgment. Our research differs in three ways. First, we are primarily
concerned with qualitative characteristics of immaterial errors, including relevance as measured
by equity market responses to disclosures of immaterial error corrections and predictive ability
of immaterial errors. Second, we separately analyze two types of immaterial errors: revisions
(error corrections recorded as an adjustment to retained earnings) and out-of-period adjustments
14
As illustrated in Figure 1, immaterial errors are not required to be disclosed using form 8-K, meaning that a
decision to do so would reflect a disclosure choice by management.
15
SAB 108 adjustments would be reported similar to “little r” restatements, except they do not require revised prior
period comparative financials because the triggering event for the correction is a change in guidance for applying
quantitative materiality thresholds.
11
(error corrections recorded in current period income and therefore expected to be the least
material). Analyzing both revisions and out-of-period adjustments allows us to provide a more
complete understanding of the characteristics of immaterial errors, including whether the
distinction between them is meaningful. Third, we provide explicit comparisons using material
error corrections as a benchmark, allowing us to calibrate the magnitude of our results. That is,
we compare the equity value relevance and predictive ability of immaterial errors to the
relevance and predictive ability of material errors as a benchmark.
4.0 Empirical predictions and tests
While management is responsible for preparing the financial statements and making all
necessary materiality determinations, ultimately the designation of an error as material or
immaterial is determined jointly by management and the auditor. The outcome of this
determination—whether an error is or is not material—in turn determines how the error is
corrected and how the correction is disclosed. In reaching their materiality conclusions, both
preparers and auditors apply authoritative guidance that requires interpretations and judgment.
That is, the guidance does not provide bright lines to assess materiality, nor does it permit
materiality assessments based only on calibrations against quantitative thresholds such as 5% of
pre-tax income. The legal definition of materiality is entirely qualitative: “whether there is a
substantial likelihood that a reasonable investor would consider this information important (SAB
99).” In other words, “the misstatement is material if it …. is probable that the judgment of a
reasonable person relying upon the report would have been changed or influenced by the
inclusion or correction of the item” (FASB Concept Statement 2, glossary). Based on this
reasoning, equity investors would be expected to ignore immaterial errors and respond to
material errors.
Alternatively, investors may view financial reporting errors of any magnitude as
indicative of inherent financial reporting or internal control problems. In this case, investors
would be expected to respond to news of immaterial reporting errors less because of the errors
themselves and more because of what the errors suggest about financial reporting reliability and
therefore the quality of reported information. This reasoning stems from the nature of errors.
They are inaccuracies in financial reporting that result from the misapplication of GAAP or the
misuse of facts; they do not arise because actual outcomes differ from expectations based on
12
management’s judgements and estimates. Ex post inaccurate judgments, estimates and
assumptions would lead to changes in prospective accrual estimations and are not financial
reporting errors. An example of such a change in estimate would be the prospective accounting
for a change in estimated asset service lives or salvage values.
We use market reactions to error announcements to assess whether investors appear to
believe there is information in an immaterial error announcements that is relevant to pricing
securities. Our use of stock price returns to capture investor revisions of firm valuations is
consistent with the use of stock returns in class action lawsuits (e.g., Kellogg 1984). If investors
agree with the designation of the error as immaterial, then on average, we will not observe any
market reaction to immaterial error disclosures. On the other hand, a discernible market reaction
to errors that are deemed immaterial suggests that investors view the error corrections as
pertinent to their valuation assessments. This alternative suggests that error corrections, even
corrections of errors deemed immaterial by preparers, provide adverse information, possibly
about the reliability of the financial reporting system and, therefore, the quality of reported
information. Our first set of empirical tests focuses on these alternatives by analyzing the share
price response to corrections of immaterial error announcements and comparing that response to
the price response to restatements. We present results on size-adjusted returns associated with the
disclosure of errors and also examine how variation in the severity of the errors relates to the
price responses. If all immaterial errors are viewed as uninformative by investors, we would
expect variation of the severity of the error within the immaterial error category to be unrelated
to price responses. However, if investors view the severity of immaterial errors as providing
decision-useful information we would expect more severe errors to be associated with more
significant price responses.
Our second set of empirical tests takes the perspective that immaterial errors may be
viewed as indicators of poor reporting quality, specifically, that immaterial errors predict a lack
of reliability of the financial reporting system. We believe there are at least three possible
scenarios. 16 First, if immaterial reporting errors are isolated occurrences, idiosyncratic to specific
and nonrecurring facts and circumstances, the errors would occur randomly and would not
16
We recognize that immaterial errors could result from intentional misapplications of the materiality guidance in
which managers willfully classify material errors as immaterial errors. We do not consider this scenario in our
analyses.
13
provide any indication of the quality of the financial reporting system. This reasoning implies
there would be no relation between immaterial errors and (future) poor financial reporting
quality. Second, immaterial errors might indicate improved future financial reporting quality if
managers use immaterial errors as a warning signal of systematic problems which they promptly
correct by personnel changes and system improvements. Given the negative consequences of
material errors documented by prior research, managers might find it beneficial to exert effort to
detect errors sooner, correct them, and take steps to improve the reporting system. This reasoning
would imply a negative relation between immaterial errors and (future) poor financial reporting
quality. Finally, if immaterial errors indicate the (poor) quality of the underlying financial
reporting system either because their causes remain unaddressed or because these errors
represent pervasive financial reporting problems, then we may observe that immaterial errors
have predictive ability for the reliability of the financial reporting system or a positive relation
between immaterial errors and (future) poor financial reporting quality. We measure reliability as
the incidence of future reporting errors, and our second set of tests provides evidence on the
predictive ability of immaterial errors for future material and immaterial errors and for future
internal control weaknesses.
5.0 Data and Analysis
5.1 Descriptive statistics
We begin our analysis with the Audit Analytics databases on restatements and immaterial
error corrections including (when available) both revisions and out-of-period adjustments.
Figure 2 depicts the frequency of these types of errors between 2004 (when 8-K Item 4.02
disclosures became effective) and 2014 as a percentage of all firm observations in each year. The
top graph depicts restatements and immaterial error corrections between 2004 and 2014. The
bottom graph depicts restatements, revisions and out-of-period adjustments separately. Both
graphs include out-of-period adjustments when these data are available in Audit Analytics (fiscal
years ending on or after October 2008).
Both graphs display a visually striking pattern of declining frequencies in material errors
over the sample period and increasing frequencies in immaterial errors, in particular revisions,
since 2008. Although the trend is less dramatic relative to the trend for revisions, out-of-period
adjustments also appear (visually) to increase over the period October 2008-December 2014. We
14
believe there are at least three non-mutually-exclusive explanations for this pattern. First, greater
diligence in internal control assessments mandated by the Sarbanes-Oxley Act of 2002,
combined with Public Company Accounting Oversight Board (PCAOB) enforcement activities
could have increased the likelihood that immaterial errors are detected during the latter portion of
the sample period (e.g., DeFond and Lennox 2015). Second, awareness of the negative
consequences of restatements could induce managers to exert greater effort to detect and correct
errors sooner, when they are presumably smaller and therefore correctable by a revision or outof-period adjustment as opposed to restatement. Third, preparers and auditors may be responding
to SAB 108, issued in 2006, that clarifies immaterial errors must be corrected, and to the
December 2008 speech described in Section 2 and referenced in footnotes 8 and 9 suggesting
that an immaterial error should be corrected by revision if the error correction materially affects
current period net income.17 Regardless of the cause, or combination of causes, the over-time
pattern is an increase in immaterial errors, particularly revisions, and a decrease in material
errors in the Audit Analytics database since approximately 2008.
As described in Table 1, our initial sample of error events includes 6,103 financial
reporting errors from the Audit Analytics database during October 15, 2008 to December 31,
2014.18 We eliminate 1,653 observations without Compustat links and 1,470 observations
without CRSP links, event period returns, and related price information. The resulting sample of
2,980 error events (2,837 distinct firm year observations) includes 622 “Big R” errors (material
errors corrected by restatements), 1,324 “little r” errors (immaterial errors corrected by revisions)
and 1,034 out-of-period adjustment occurrences.
Table 2, Panels A and B provide descriptive statistics of immaterial errors corrected by
revisions, immaterial errors corrected by out-of-period adjustments, and for comparison
purposes, material errors corrected by restatements. With regard to how the corrections are
disclosed, the first announcement of an immaterial error is about 75% more likely to occur in in a
periodic filing (Form 10-K or Form 10-Q) than a non-routine disclosure such as an 8-K or press
17
For example, guidance to its audit professionals provided by PricewaterhouseCoopers, Dataline, A Look at
Current Financial Reporting Issues, 2013 revision, refers explicitly to the December 2008 SEC speech.
18
We select this time period because out-of-period adjustments data from Audit Analytics are complete over this
time period.
15
release.19 Specifically, 29.7% (54.5%) of material errors, but less than 5% of immaterial errors,
are disclosed for the first time in a press release (8-K filing). Conversely, 34.2% (32.0%) of
revisions (out-of-period adjustments) are disclosed for the first time in Form 10-K and 44.0%
(66.4%) of revisions (out-of-period adjustments) are disclosed for the first time in Form 10-Q, as
compared with 5.3% of restatements disclosed in these routine periodic filings. With regard to
consequences, SEC investigations, board involvement, and auditor letters with language about
the error are far less likely to be associated with immaterial errors than material errors; one or
more of these events is associated with the vast majority of restatements, while auditor letters
contain language about the error for 36% of immaterial errors, there is SEC/board involvement
in less than 1% of immaterial error corrections. Both the way errors are reported and the
governance and regulatory consequences of errors are consistent with the view that managers
and those who monitor them pay less attention to immaterial errors.
With regard to financial statement impacts, immaterial errors are more than twice as
likely as material errors to have no income impact (43.8% of immaterial errors and 19.1% of
material errors have zero net income effect), consistent with the idea that financial reporting
materiality is associated with, if not determined by, income effects. The difference is largely
driven by immaterial errors that are corrected by revisions (61.4%) as opposed to out-of-period
adjustments (12.3%). Immaterial errors relate only to classification issues for 10.8% of
immaterial errors, as compared with 7.1% for material errors; reclassification-only issues are
more likely to relate to revisions (20.9%) than to adjustments (0.4%). In terms of directional
effects on income, 27.4% of revisions decrease income as compared to 59.8% of material error
restatements and 51.5% of out-of-period adjustments. Error corrections with positive income
effects are more frequent among out-of-period adjustments (36.2%) which flow through current
period net income, relative to immaterial errors (11.3%) recorded as revisions and to material
error corrections (21.1%). Both material and immaterial errors involve on average between one
and two accounting issues. Both material and immaterial error corrections tend to affect between
one and two fiscal years (1.75 and 1.69 years, respectively).20
19
For our purposes, it is not important to distinguish between Form 10-Q which is reviewed but not audited and
Form 10-K which is audited, because both filings are subject to the same materiality guidance and the same
securities laws.
20
Data on the number of fiscal periods covered is available only for restatements and revisions and is not generally
reported for out-of-period adjustments.
16
Immaterial errors are on average much smaller in magnitude than material errors when
measured by the absolute value of the EPS effect/ price, by the absolute value of the income
effect/price and the absolute value of the income effect/assets, before and after excluding errors
with no income effect, supporting the notion of quantitative assessments of materiality. That
said, the means of the scaled income effects, particularly the effects of revisions, approach or
even exceed the standard quantitative materiality thresholds of 5% of pretax income and 0.5% of
assets. For example, the average absolute income effect/pretax income is 10.5% for revisions
and 6.8% for out-of-period adjustments, including errors with zero income effects; analogous
amounts when the scalar is total assets are 0.4% and 0.2%. These amounts suggest that
materiality judgments are not the result of simply comparing the error magnitude to quantitative
thresholds but rather reflect other qualitative considerations as required by SAB 99.
One implication of the use of qualitative factors in reaching materiality judgments is that
the empirical distributions of material errors and immaterial errors will overlap—some smallermagnitude errors will be deemed material and some larger-magnitude errors will be deemed
immaterial. We illustrate the overlap in Figure 3, which shows the signed income effects of
correcting the errors, divided by assets, for restatements, revisions and out-of-period
adjustments. While the distribution of restatement effects is more extreme than the distribution of
immaterial error effects, there is also visual evidence of overlap. We conclude that while larger
magnitudes of error effects are clearly a distinguishing feature of restatements, the application of
qualitative factors results in less-than-complete separation of the empirical distributions of the
magnitudes of effects of correcting three types of reporting errors.
Table 2, Panel B displays the frequencies of material versus immaterial errors by broad
categories of financial statement line items. Visual inspection suggests that the nature of the
accounting item where an error occurs varies with the type of error. For example, the most
common error corrected by revision (25.8%) is a classification error on the statement of cash
flows. The most common out-of-period adjustment is related to the accounting for income taxes
(31.8%), followed by revenue recognition issues (11.5% frequency). In contrast, the most
frequent restatement error (17.7%) pertains to revenue recognition, followed by tax reporting
issues, debt/equity securities issues and issues related to receivables/investments/cash with
frequencies of 15.6%, 14.3%, and 12.9% respectively. Because our focus is on immaterial errors
as a class of financial reporting error, that is, our focus is on errors deemed immaterial regardless
17
of the issue(s) involved, our analysis does not consider the error type (e.g., tax reporting versus
revenue reporting) beyond including in some specifications an indicator for errors that affect
classification only.
5.2 Market responses to disclosures of immaterial errors
Our first set of empirical tests presents short window returns to immaterial error
announcements. We report mean three day (0, +2) cumulative abnormal (size-adjusted) returns
for announcements of immaterial errors, centered at the announcement date. The upper portion
of Table 3 presents average cumulative abnormal returns for announcements of immaterial
errors. The results suggest that, unconditional on whether an immaterial error is corrected by
revision or out-of-period adjustment and unconditional on how the error is disclosed,
announcements of immaterial error corrections are associated with small negative price
adjustments, -0.3% on average with a t-statistic = -1.82, significant at approximately the 0.07
level (two-tailed); most of the negative reaction is associated with announcements of revisions (0.3% average price response, significant at approximately the 0.13 level). When we condition on
how the error is disclosed, we find that the response to an immaterial error disclosed in a routine
filing (form 10-Q or form 10-K) is not reliably different from zero (-0.2%, with a t-statistic of 1.06). However, when the error is disclosed in a non-routine filing such as an 8-K or an
amended periodic filing, the price response is both larger in magnitude (-1.0%) and reliably
negative at conventional levels (t-statistic = -1.95, significant at the 0.052 level). The difference
in returns between routine and non-routine disclosures of immaterial error is significant at the
0.06 level.
As a benchmark for comparison, we report mean three-day market reactions to material
errors in the lower portion of Table 3. Consistent with prior research (e.g., Palmrose et al. 2004;
Files et al. 2009) we find average negative market reactions to material errors of about -2.9%,
significant at better than the 0.01 level. The market response to material error corrections
disclosed in non-routine filings (mostly form 8-K) is also -2.9%, significant at better than the
0.01 level. Finally, the average market response to 33 material error corrections reported in a
routine periodic filing (form 10-Q or form 10-K) is -3.3%, significantly negative at
approximately the 0.11 level with a t-statistic of -1.64; the reduced level of significance may be
18
due to a small sample size. Using a significance level of 0.10, we find no reliable evidence that
returns surrounding material error corrections differ between routine and non-routine disclosures.
Table 3 reports a difference in price responses to immaterial error disclosures depending
on whether the disclosure appears in a non-routine vs a routine filing. We conjecture that this
difference may arise for two non-exclusive reasons. First, an error correction is more visible,
hence more noticed by investors, when it appears in a non-routine filing than when it appears in a
long and complex routine filing surrounded by a wealth of other (possibly correlated) financial
information. Second, managers may disclose more severe immaterial errors in non-routine
filings. To investigate this conjecture we first note that, as indicated in Tables 1 and 3, most
announcements of immaterial error corrections occur in the same routine periodic filing (form
10-K or form 10-Q) that contains details of the correction plus all the other required information
for that filing. This disclosure medium reflects a management choice about how to present
information about the error. To separate the effect of the error correction per se, we regress the
market reaction to an immaterial error announcement on both an indicator for disclosure in a
non-routine filing (non-routine disclosure) and characteristics of the error itself. Specifically, we
regress two-day size adjusted returns at the error announcement (the filing date) on three
measures of the nature (the severity or importance) of the error: (1) absolute value of the income
effect divided by total assets; (2) number of issues associated with the error as reported by Audit
Analytics; (3) Non-reclassification, set to 1 if the error is not a reclassification adjustment only;
(4) inclusion of language about the error in the audit report. As control variables, we include
change in ROA; size (log of market value of equity); and book value of equity/market value of
equity, a proxy for growth.
Table 4 reports the results of this estimation for all immaterial errors and for revisions
and out-of-period adjustments separately; we again report results for restatements for comparison
purposes. For all immaterial errors considered together, results in column 1 indicate that only
severity as measured by number of issues is reliably associated with more negative price
responses (t-statistic = -2.22) and this effect is driven by revisions (column 2, t-statistic on
number of issues = -2.06); the only reliably non-zero effect for out-of-period adjustments is
associated with non-classifications (coefficient = -0.04, with a t-statistic = -1.67). Turning now to
salience as captured by announcing the error in a non-routine disclosure, we find that non-routine
disclosure is associated with a more negative price response for immaterial errors as a whole
19
(estimated coefficient = -0.0091, t-statistic = -1.66) with most of this effect arising from nonroutine disclosure of out-of-period adjustments (coefficient = -0.0317, t-statistic = -2.04).21
Column (4) reports market reactions to material errors (restatements) which we use to
benchmark results of immaterial errors. We see that three variables related to error severity are
associated with more negative price responses at the 0.10 level or better (income effect; number
of issues and auditor language), but disclosure in a non-routine filing is not.22 The explanatory
power of this regression, 5.8%, is over three times greater than the explanatory power of any
immaterial error regression, suggesting differences how investors process information about
material errors vs immaterial errors.
Viewed as a whole, the results in Tables 3 and 4 suggest that investors respond negatively
to announcements of immaterial errors, especially to those corrected as revisions, those including
a larger number of issues and those disclosed in a non-routine filing. Investor responses to
immaterial errors, especially revisions, are also linked to firm size (which moderates the price
response). In all cases, the investor response to an immaterial error is appreciably less in both
magnitude and significance than to a material error that is disclosed in a press release or 8-K
report. We interpret these findings as evidence of, first, the equity-valuation relevance of
immaterial errors that are corrected as revisions and second, the importance of error severity and
channel of error disclosure in analyzing share price responses to immaterial errors.23
5.3 Predictive ability of immaterial errors for the reliability of financial reporting systems
As previously discussed, we posit that errors deemed immaterial by management can
nonetheless indicate either problems with or improvements in the entity’s financial reporting. If
so, these errors should be associated with future adverse reporting outcomes that indicate a lack
of reporting system reliability. To shed light on this possibility, we consider two adverse
21
Detailed review of non-routine disclosures of adjustments confirms that these disclosures do not co-mingle with
other, more severe error disclosures, but could be disclosed with other negative news (e.g. late or amended filing,
press release, 8-K).
22
As shown in Table 1, approximately 85% of restatements of material errors are announced in press releases or
form 8-K.
23
In untabulated tests, we repeat the Table 4 analysis using investor disagreement, proxied by stock return volatility
(the standard deviation of returns over the 7-days beginning with the error announcement) as the dependent variable,
after controlling for return volatility at preceding 10-K or 10-Q filing dates. For material errors, we find that error
magnitude (the absolute income effect/total assets) is positively associated with volatility (t-statistic = 1.94). In the
case of immaterial errors, the presence of auditor language (non-routine disclosure) is negatively (positively)
associated with immaterial errors as whole, mostly because of the associations for revisions.
20
reporting outcomes that indicate lack of reliability of the financial reporting system: future
reporting errors (section 5.3.1) and future material weaknesses in internal controls (section
5.3.2).
5.3.1 Predicting future financial reporting errors
We examine the predictability of immaterial errors for future reporting errors using the
following model:
Errort+1 = α0+ α1Immaterial Errort + α2 Material Errort + α3 Controlst
+ α4 Yeart + α5 Industryt + et
(3)
In equation (3) the dependent variable is an indicator set to 1 if the firm corrected a material or
immaterial financial reporting error at period t+1 and the main test variable is an indicator set to
1 for an immaterial reporting error corrected at period t; we again include an indicator for
material errors for comparison purposes. Similar to the restatement and bankruptcy literature, we
use a pooled cross-sectional approach that includes all treatment and control observations with
available data.24 We measure errors by the period they are discovered and reported, not by the
period affected, to avoid a mechanical relation driven by the fact that errors often affect multiple
financial reporting periods. Immaterial Errort is an indicator equal to 1 if the firm reported a
revision or an adjustment in period t. Material Errort is an indicator equal to 1 if the firm
reported a material error in an Item 4.02 disclosure in period t. A finding that α1 > 0 indicates
predictive ability of a current period immaterial error for a future (period t+1) error. As the
dependent variable is binary, we estimate equation (3) using logit. We include year fixed effects,
industry fixed effects with industry defined as two digit SIC codes, and we cluster standard
errors by firm.25
24
An alternate approach is to use a matched sample design that matches firms with errors (material weaknesses)
with otherwise similar firms that do not have errors (material weaknesses). We do not use a matched sample design
for two reasons. First, the purpose of the test is prediction, not an evaluation as to whether errors in period t cause
errors in period t+1 as implied by a matched sample design. Second, a matched sample approach distorts the
unconditional probability of an error such that coefficients and marginal effects may be affected if strict assumptions
are not satisfied (e.g., Zmijewski 1984, Section 3).
25
Sample sizes vary across Tables 5, 6 and 7 because some industry fixed effects are perfect predictors of various
errors (material weakness) that leads to sample attrition. We estimate Equation 3 in OLS to confirm documented
results are not affected by concerns with estimating logit models with industry fixed effects and find that our
inferences are not affected except that we find larger marginal effects in OLS results than in those tabulated.
21
We identify and define control variables based on studies that examine the determinants
of restatements (e.g., Burns and Kedia 2006; Efendi et al. 2007). We include an indicator if the
firm has a material weakness (MW) as this should predict material errors (e.g., Rice and Weber
2012). We include an indicator if the firm has a large auditor (Big 4). We control for firm size
(MVE, logarithm of market value of equity), book-to-market ratio (BM), reported losses (LOSS,
indicator set to 1 for loss years), performance (EARN, net income/total assets), leverage
(LEVERAGE, long-term debt/assets), significant acquisition activity (ACQUISITION, indicator
set to 1 for years when sales related to acquisitions exceeds 20 percent of total sales), capital
raising activity (CAPITAL RAISING, indicator set to 1 for years when debt and equity capital
raised exceeds 20 percent of assets), intangible investment (INTAN, (Advertising + R&D)/total
assets), capital investment (CAPEX, capital expenditures/assets), and percentage of institutional
ownership (INST OWN) as of year-end from the Thompson Reuters 13F filings.
Table 5 reports the results of estimating equation (3) when the dependent variable (Error)
is a material error (i.e., restatement) in period t+1 and the test variable is a period t immaterial
error. Column 1 shows results for all immaterial errors combined (both revisions and out-ofperiod adjustments) and Column 2 shows results for the two types of immaterial errors
separately. From Column 1, a period t immaterial error is associated with a greater likelihood of
discovering a future restatement (p<0.01), as are current period restatements (p < 0.01). Using a
marginal effects analysis that evaluates other variables at the mean, we find that the marginal
effect of an immaterial error is a 0.99% increase in the probability of future material errors,
comparable to the marginal effect of a material error, 0.77%.26 To place these effects in context,
the unconditional probability of a material error is 2.2% in our sample period (untabulated). An
F-test confirms there is no statistically reliable difference between the coefficients on immaterial
errors and material errors (p=0.61; untabulated). As shown in Column 2, the predictive ability of
immaterial errors for future restatements (that is, material errors) comes from revisions, not outof-period adjustments, supported by a positive and significant coefficient on revisions (p<0.01,
marginal effect 1.4%), and an insignificant coefficient on out-of-period adjustments (p>0.10).
While the coefficient on revisions (0.69) exceeds the coefficient on restatements (0.45) the
differences are not significant using an F-test (p=0.27; untabulated).
26
We also evaluate average marginal effects, which tend to be similar to, and slightly higher than, the marginal
effects reported.
22
Results for control variables are consistent with results from prior research, in that future
restatements are positively associated with material weaknesses in internal controls, loss
incidence, acquisitions and capital raising and are less likely for larger firms, firms with Big 4
auditors and firms with greater leverage. The greatest marginal effect, not surprisingly, arises
from a material weakness (11.6% increase in the probability of a future restatement). Other
marginal effects are smaller and in many cases are comparable to the marginal effect of reporting
an error corrected as a revision.
Table 6 reports the results of estimating equation (3) when the dependent variable is both
types of immaterial errors combined (Panel A) and separately for revisions and out-of-period
adjustments (Panel B). Results in Panel A indicate that immaterial errors are likely to reoccur
and are likely to follow restatements; coefficients on both variables are significant at the 0.05
level or better. However, the coefficients are significantly different (p<0.01; untabulated), as
immaterial errors have a much larger coefficient (1.06) relative to restatements (0.34). In terms
of marginal effects, an immaterial error is associated with an 8.8% increase in the probability of
a future immaterial error, exceeding the marginal effect of a restatement (2.2% increase). The
unconditional probability of reporting a future immaterial error in our sample is 7.5%
(untabulated). When revisions are considered separately from out-of-period adjustments as
predictors of any type of immaterial error (Column 2), each type of error has predictive ability
for future immaterial errors, with estimated coefficients that are significant at better than the 0.01
level and significantly different using F-tests (p<0.01; untabulated). The marginal effect of a
revision is a 5.8% increase in the likelihood of a future immaterial error, smaller than the
marginal effect of an out-of-period adjustment (11.3%) and larger than the marginal effect of a
restatement (2.0%). Results for control variables are similar to results reported in Table 5,
except that greater profitability is reliably associated with fewer immaterial errors in period t+1
while leverage is unrelated; intangibles intensity and institutional ownership are, respectively,
negatively and positively associated with future immaterial errors.
Panel B of Table 6 reports results of estimating equation (3) separately for period t+1
revisions (Column 1) and out-of-period adjustments (Column 2). In these specifications,
restatements decline in both significance (t-statistics for estimated coefficients on restatements in
the regressions with t+1 revisions and out-of-period adjustments as dependent variables are 1.90
and 1.25 respectively), while both revisions and adjustments predict both types of immaterial
23
errors. Coefficients on both types of errors indicate significance at the 0.01 level or better. The
marginal effect of a current period revision is a 4.5% (1.1%) increase in the probability of a
future revision (out-of-period adjustment) and the marginal effect of a current period out-ofperiod adjustment is a marginal increase of 3.3% for revisions and 5.2% for out-of-period
adjustments. Untabulated F-tests indicate differences in explanatory power between revisions
and adjustments when predicting future adjustments (p<0.01), but provide no evidence of a
difference when predicting future revisions. The unconditional probability of reporting a future
revision and out-of-period adjust in our sample is 4.8% and 3.1%, respectively (untabulated).
We interpret the results of Tables 5 and 6 as indicating that immaterial errors, especially
revisions, contain information about the future likelihood of material errors and that this
information, as measured by a marginal effects analysis, is comparable to the information in a
material error itself. Furthermore, current period immaterial errors increase the likelihood of
future immaterial errors, which are themselves adverse indicators of financial reporting quality.
Taken together, these results provide a potential explanation for investor attention to the
reporting of immaterial errors, namely, investors assess firms that report immaterial errors as
having relatively poorer financial reporting quality.
5.3.2 Predicting future material weakness
Rice, Weber, and Wu (2015) show increased capital market penalties for firms reporting
material errors if those firms had previously disclosed internal control deficiencies (material
weaknesses). In addition, results in Tables 5 and 6 (and results in previous research) indicate
that material weaknesses are predictors of restatements and immaterial errors. Building on these
findings, we evaluate whether immaterial errors are informative for future material weaknesses
over internal controls, a precursor to material errors. These tests replace the dependent variable
in Equation (3) with an indicator set to 1 if the firm reports a material weakness in period t+1
(Material Weakness). Except for this change, all control variables and regression specifications
remain the same; in particular, we include the material weakness indicator for period t. A finding
that α1>0 would indicate an association between current period reporting errors and future period
internal control deficiencies.
Table 7 reports the results of this analysis for revisions and out-of-period adjustments
combined (Column 1) and for these two types of immaterial errors separately (Column 2). From
24
Column 1, both immaterial errors and material errors corrected by restatement are associated
with future internal control deficiencies (p< 0.01). The marginal effect of a period t immaterial
error on a period t+1 material weakness is 0.86%, compared to a 1.2% marginal effect of a
restatement. Untabulated F-tests suggest no statistically reliable difference between the
coefficients on immaterial errors and material errors (p=0.57). The unconditional probability of
reporting a future material weakness in our sample is 2.2% (untabulated).
The results in Column 2 suggest that the predictive ability of immaterial errors for
material weaknesses in internal controls is associated with revisions, but not out-of-period
adjustments. The predictive ability of restatements for material weaknesses in this specification
is similar to that presented in Column 1. The marginal effects of immaterial and material errors
are also similar, with approximately a 1.2% greater propensity for newly reported internal
control weaknesses. Untabulated F-tests suggest no statistically reliable differences between the
coefficients on revisions and restatements (p=0.57) and some evidence of statistical difference
between revisions and adjustments (p=0.08).
We interpret these results as corroborating the inferences from our analyses of the
predictive ability of current period immaterial errors for future material and immaterial errors
and as supporting the interpretation that immaterial financial reporting errors are indicators of
poor reporting quality. Our main conclusion from Tables 5, 6 and 7 is that immaterial errors have
the qualitative characteristic predictability for future (adverse) reporting outcomes.
5.4 Variation in predictive ability of immaterial errors as a function of persistence and severity
In this section we present two extensions of the results in Tables 3 and 4, that investor
responses to immaterial financial reporting errors are associated with indicators of the severity of
those errors, and the results in Tables 5 and 6, that immaterial errors have predictive ability for
future reporting errors. In section 5.4.1, consistent with the notion that even an immaterial
reporting error could indicate poor quality financial reporting, we consider whether any material
or immaterial reporting error in period t or period t-1 is reliably associated with a period t+1
reporting error, that is, error persistence. In section 5.4.2, consistent with the notion that investor
responses to errors are associated with error severity, we consider whether error severity of
period t errors is differentially associated with predictability of reporting errors and material
weaknesses in period t+1.
25
5.4.1 Error persistence and predictive ability
To assess whether a reporting error in either or both period t and period t-1 is linked to a
period t+1 reporting error, we modify Equation (3) as follows:
ErrorTypet+1 = α0+ α1ErrorTypet + α2 ErrorTypet-1 + α3 Controlst
+ α4 Yeart + α5 Industryt + et
(4)
In equation (4) the dependent variable is either a material error (restatement) in period t+1 or
an immaterial error in period t+1. This specification is similar to Equation (3) except that the
right-hand side variables include any of the three error types (material error, revision, out-ofperiod adjustment) in period t and/or in period t-1. In light of results in Tables 5 and 6, we
expect α1 > for some error types; a finding that α2 > 0 indicates that errors are persistent. Control
variables and industry and year variables are not changed from Tables 5 and 6.
Results of estimating equation (4) are presented in Table 8. Consistent with results in Table
5, results for predicting period t+1 restatements, presented in column 1 for comparison purposes,
show that period t revisions but not period t out-of-period adjustments are reliably associated
with period t+1 restatements. With regard to error persistence, these results show that period t-1
immaterial errors are not associated with period t+1 restatements. Perhaps surprisingly, the
coefficient on the period t-1 restatement is positive and significant at the 0.10 level but the
coefficient on the period t restatement is not.27 In contrast, results for period t+1 immaterial
errors, presented in column 2, show that both revisions and out-of-period adjustments in both
period t and period t-1 are statistically linked to period t+1 immaterial errors, with coefficients
significant at the 0.01 level or better.
One interpretation of these results is that management responds differently to material errors
than to immaterial errors. If the management response to a material error is immediate corrective
action, there would be no statistical association between current period restatements and
preceding-period restatements; but to the extent the corrective action is not entirely successful
there would be some association between past (t-1) errors and future errors. On the other hand, if
there is little or no management response to an immaterial error, under the view that the errors
are not meaningful, then immaterial errors would be expected to persist. The results in Tables 6
27
We verify that this result is not due to high correlations which result in shared variation. Lagged autocorrelations
of revisions, out-of-period adjustments and restatements have significance levels of 0.06 or weaker.
26
and 8 present corroborating support for the idea that investors respond negatively to immaterial
reporting errors because those errors indicate a (persistently) poor quality financial reporting
system.
5.4.2 Error severity and predictive ability
As reported in Table 4, error severity measured as the absolute income effect/assets is not
reliably associated with the price response to immaterial errors but the number of issues involved
in the error is reliably negatively related to the price response to revisions. In Table 9, we report
results of analyzing the associations between a period t+1 restatement (panel A), immaterial error
(panel B) and internal control weakness (panel C) and the four measures of error severity
considered in Table 4 (absolute income effect/assets; number of issues; indicator for nonreclassification errors; presence of auditor language about the error in the audit report). In panel
A, we find that no period t restatement severity measure is reliably associated with period t+1
restatements, conditional on the effect of the period restatement itself. In contrast, two measures
of immaterial error severity do have reliable associations: the income effect/assets and the
number of issues are negatively and positively associated, respectively. Taken at face value, this
result suggests that when confronted with a relatively larger immaterial error, management takes
corrective action to deter future problems but the same is not true when severity is measured by
an error that affects more than one issue. That is, management is more likely to attend to a larger
problem and less likely to attend to multiple smaller problems.
Panel B presents analogous results for immaterial errors; the number of issues and the
presence of auditor language are positively related to t+1 immaterial errors at the 0.15 and 0.05
levels, respectively and there is no association between restatement severity indicators and t+1
immaterial errors. Finally, results in panel C suggest that both restatements and immaterial
errors in period t are associated with period t+1 material weaknesses and error severity matters
for restatements but not immaterial errors. Accepting these results at face value and placing them
in the context of the results in Table 8, we infer that the internal control difficulties and reporting
quality difficulties that manifest in immaterial errors tend to repeat regardless of their severity
characteristics.
27
6.0 Conclusion
We provide evidence on two qualitative characteristics of financial reporting errors
deemed immaterial under authoritative guidance and benchmark this evidence against
characteristics of errors deemed material by management and corrected by restatements. In
contrast to previous research, our analysis distinguishes between two types of immaterial errors
based on how those errors are corrected, as revisions or as out-of-period adjustments. We regard
revisions as more likely to be informative than out-of-period adjustments because revisions are
by definition large enough to distort current period financial reports. In contrast, out-of-period
adjustments are smaller and possibly more likely to include a more heterogeneous group of
financial reporting errors, ranging from reclassifications on the statement of cash flows to
corrections of revenues. However, our results show that small versus large magnitude per se, as
inferred from the classification of an error as corrected by revision versus out-of-period
adjustment, does not in and of itself determine the qualitative characteristics of the reporting
error.
To assess the qualitative characteristic equity valuation relevance, we analyze the share
price response to disclosures of immaterial errors. To assess whether immaterial errors have the
qualitative characteristic predictability for poor reporting quality, we assess whether immaterial
errors reported in the current period are associated with future material and immaterial financial
reporting errors and future material weaknesses over internal controls. We find that immaterial
errors corrected as revisions have discernible adverse share price responses that are smaller than
the responses associated with restatements disclosed on Form 8-K. We also find that both
immaterial errors corrected as revisions and immaterial errors corrected as out-of-period
adjustments have predictive ability for poor reporting quality as measured by future material
errors, future immaterial errors and future internal control material weaknesses.
Based on these analyses, we conclude that errors deemed immaterial under authoritative
guidance have the potential to affect shareholder inferences, not necessarily because of the errors
themselves but rather because those errors are linked to future adverse reporting outcomes. This
conclusion does not suggest a misapplication of the current guidance for materiality judgments,
because that guidance does not specify consideration of future error incidence. However, to the
extent the conclusion that shareholders use immaterial errors to assess financial reporting quality
including future error incidence is descriptive of actual capital market outcomes, we suggest a
28
possible input to the Financial Accounting Standards Board in its consideration of promulgating
additional guidance on preparer materiality judgments.
29
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31
Appendix A: Examples of Material and Immaterial Financial Reporting Errors
1.0 Examples of restatements (corrections of material errors)
1.1 Williams Companies errors in periods 1/1/2011 – 12/31/2011
1.1.1 Williams Companies Item 4.02 in 8-K disclosed on 5/1/2012
On May 1, 2012, The Williams Companies, Inc. (the “Company”) will restate its financial
statements in Amendment No. 2 on Form 10-K/A to its Annual Report for the year ended December 31,
2011. The accounting correction reflected in the restated financial statements has no impact on our
Consolidated Statement of Operations, Consolidated Statement of Cash Flows or previously announced
earnings, cash flows and dividend guidance. The restated financial statements reflect an increase to our
noncurrent deferred income tax liability and a corresponding decrease to capital in excess of par value for
all periods presented. This increase to our deferred income tax liability would only result in a current tax
payable if we disposed of our investment interest in Williams Partners L.P. (“WPZ”). Management has
stated that it has no intent to dispose of this investment.
Financial Metrics ($ in millions)
Net income attributable to The Williams
Companies, Inc.
Total assets
Total liabilities
Total stockholders’ equity
Increase in cash and cash equivalents
As of and for the Year Ended
December 31, 2011
Previously
Reported
Correction
Restated
$
$
$
$
$
376
16,502
13,419
1,793
94
$
$
$
$
$
—
—
497
(497)
—
$
376
$ 16,502
$ 13,916
$ 1,296
$
94
On April 26, 2012, management of the Company recommended, and on April 30, 2012 the audit
committee of the Company’s board of directors (“Audit Committee”) concluded, that our previously
issued financial statements filed on April 11, 2012 in our Amendment No. 1 on Form 10-K/A for the year
ended December, 31, 2011, should no longer be relied upon because of a material error in such financial
statements. Management and the Audit Committee discussed the matters relating to the restatement with
Ernst & Young LLP, the Company’s independent registered public accounting firm.
The restated financial statements reflect a correction to our noncurrent deferred income tax liability
arising from the difference between our financial and income tax bases in our investment in WPZ related
to gains previously recognized in stockholders’ equity on units that WPZ issued in prior years. Though
the accounting correction had no impact on our Consolidated Statement of Operations or Consolidated
Statement of Cash Flows, the error was material to the Consolidated Balance Sheet and Consolidated
Statement of Changes in Equity.
In accordance with Accounting Standards Codification (ASC) 810 Consolidation (and as previously
issued as Statement of Financial Accounting Standards No. 160 Noncontrolling Interests in Consolidated
Financial Statements—An Amendment of ARB No. 51), which was effective for us beginning January 1,
2009, on a prospective basis, and previously in accordance with our policy election under the Securities
and Exchange Commission Staff Accounting Bulletin No. 51 Accounting for Sales of Stock by a
Subsidiary, we recorded “gains” associated with such issuances of WPZ units as a component of our
stockholders’ equity.
32
We previously had not recorded deferred income taxes associated with these equity “gains.”
However, in accordance with ASC 740 Income Taxes, we have concluded that we should recognize
deferred income taxes for the future tax effects arising from the difference between our financial and
income tax bases in our WPZ investment resulting from these transactions.
1.1.2 Williams Companies 10-K/A filed on 5/1/2012
Explanatory Note
This Amendment No. 2 on Form 10-K/A for the fiscal year ended December 31, 2011, is filed to
restate the Selected Financial Data in Item 6 and Controls and Procedures in Item 9A, both as filed in our
Form 10-K on February 27, 2012, as well as the Financial Statements and Supplementary Data in Item 8,
as filed in our Amendment No. 1 on Form 10-K/A on April 11, 2012. The restatement reflects a
correction to our accounting for deferred income taxes related to our investment in Williams Partners L.P.
(WPZ). More specifically, this impacts our noncurrent deferred income tax liability related to financial
and income tax bases differences arising from amounts previously recognized in capital in excess of par
value as a result of the issuance of common units of our consolidated master limited partnership, WPZ.
The impact of the correction is an increase to our noncurrent deferred income tax liability and a
corresponding decrease to capital in excess of par value for all periods presented. There is no impact to
our Consolidated Statement of Operations or Consolidated Statement of Cash Flows.
In accordance with Accounting Standards Codification (ASC) 810 Consolidation (and as previously
issued as Statement of Financial Accounting Standards No. 160 Noncontrolling Interests in Consolidated
Financial Statements - An Amendment of ARB No. 51) (ASC 810), which was effective for us beginning
January 1, 2009, on a prospective basis, and previously in accordance with our policy election under the
Securities and Exchange Commission Staff Accounting Bulletin No. 51 Accounting for Sales of Stock by
a Subsidiary, we recorded “gains” associated with such issuances of WPZ units as a component of our
stockholders’ equity.
We previously had not recorded deferred income taxes associated with these equity “gains”.
However, in accordance with ASC 740 Income Taxes, we should recognize deferred income taxes for the
future tax effects arising from the differences in our financial and income tax bases in our WPZ
investment resulting from these transactions. This would only result in a current tax payable if we
disposed of our investment interest in WPZ. Management has stated that it has no intent to dispose of this
investment.
See additional discussion of the correction within Note 1 of Notes to Consolidated Financial
Statements in Item 8 of this filing.
Basis of Presentation
Correction of error
The accompanying Consolidated Balance Sheet and Consolidated Statement of Changes in Equity
have been restated to correct an error related to our accounting for deferred income taxes associated with
our investment in WPZ. In accordance with Accounting Standards Codification (ASC)
810 Consolidation (and as previously issued as Statement of Financial Accounting Standards
No. 160 Noncontrolling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51)
(ASC 810), which was effective for us beginning January 1, 2009, on a prospective basis, and previously
in accordance with our policy election under the Securities and Exchange Commission Staff Accounting
Bulletin No. 51 Accounting for Sales of Stock by a Subsidiary, we recorded “gains” associated with
issuances of WPZ units as a component of our stockholders’ equity.
33
We previously had not recorded deferred income taxes associated with these transactions. However,
in accordance with ASC 740 Income Taxes, we should recognize deferred income taxes for the future tax
effects arising from the difference in our financial and income tax bases in our WPZ investment resulting
from these transactions.
The accompanying Consolidated Balance Sheet and Consolidated Statement of Changes in Equity
have been restated to reflect the correction. There is no impact to our Consolidated Statement of
Operations or Consolidated Statement of Cash Flows. The correction resulted in an increase to our
noncurrent deferred income tax liability and a corresponding decrease to capital in excess of par value for
all periods presented, as detailed in the following table.
Deferred income taxes
Capital in excess of par value
As of December 31,
2011
2010
2009
2008
(Millions)
$ 497
$ 485
$ 457
$ 457
(497)
(485)
(457)
(457)
…
THE WILLIAMS COMPANIES, INC.
CONSOLIDATED BALANCE SHEET
December 31,
2011
2010
(Millions, except per-share amounts)
(Restated)
(Restated)
ASSETS
Current assets:
Cash and cash equivalents
Accounts and notes receivable (net of allowance
of $1 at December 31, 2011 and 2010,
respectively)
Inventories
Assets of discontinued operations
Regulatory assets
Other current assets and deferred charges
$
Total current assets
Investments
Property, plant, and equipment – net
Assets of discontinued operations
Regulatory assets, deferred charges, and other
Total assets
$
889
$
758
637
169
—
40
159
497
225
897
51
102
1,894
2,530
1,391
12,580
—
637
1,240
11,754
8,828
620
16,502
$
24,972
LIABILITIES AND EQUITY
Current liabilities:
34
Accounts payable
Accrued liabilities
Liabilities of discontinued operations
Long-term debt due within one year
$
Total current liabilities
Long-term debt
Deferred income taxes
Liabilities of discontinued operations
Regulatory liabilities, deferred income, and other
Contingent liabilities and commitments (Note 16)
Equity:
Stockholders’ equity:
Common stock (960 million shares
authorized at $1 par value; 626 million
shares issued at December 31, 2011 and
620 million shares issued at December 31,
2010)
Capital in excess of par value
Retained deficit
Accumulated other comprehensive income
(loss)
Treasury stock, at cost (35 million shares of
common stock)
Total stockholders’ equity
Noncontrolling interests in consolidated
subsidiaries
Total equity
Total liabilities and equity
$
691
631
—
353
$
432
738
896
508
1,675
2,574
8,369
2,157
—
1,715
8,600
2,223
2,179
1,262
626
7,920
(5,820)
620
7,784
(478)
(389)
(82)
(1,041)
(1,041)
1,296
6,803
1,290
1,331
2,586
8,134
16,502
$
24,972
35
1.2 Hartford Financial errors in periods 7/1/2012-9/30/2012
1.2.1 Hartford Financial 4.02 disclosure in 8-K dated 3/1/2013
Item 4.02 Non-Reliance on Previously Issued Financial Statements or a Related Audit Report
or Compleo or Completed Interim Review
As noted above, on February 25, 2013, based on accounting review and validation procedures performed
in connection with the financial reporting and close process for the fourth quarter of 2012 and subsequent
to the filing of the Third Quarter 2012 Form 10-Q, the Company identified that the impact of certain
reinsurance recoverable balances associated with the Transaction was incorrectly omitted in determining
the estimated gain or loss on disposition associated with the Transaction. On February 26, 2013, the
Company preliminarily concluded that it would be necessary to recognize an estimated pre-tax loss on the
Transaction of $533 million, comprised of the impairment of goodwill attributed to the Individual Life
business of $342 million and a loss accrual for premium deficiency of $191 million, which should have
been recorded in the third quarter of 2012. The estimate is subject to change pending final determination
of the net assets sold, transaction costs, and other adjustments. Subsequent to the discovery of the error,
management performed additional procedures in order to confirm the extent of the error. As a result of
these procedures and the conclusions reached regarding the error, the Company is filing the Q3 Form 10Q/A to recognize such third quarter 2012 loss on disposition of business through the impairment of
goodwill and a loss accrual for premium deficiency.
Therefore, the Company has concluded that the previously issued financial statements contained in the
Company's Third Quarter 2012 Form 10-Q should not be relied upon.
The Company's Audit Committee has discussed the matters described above with Deloitte & Touche
LLP, the Company's independent registered public accountants.
1.2.2 Hartford Financial 10-Q/A filed on 3/1/2013 for period ended 9/30/2012
18. Restatement
The Condensed Consolidated Financial Statements for the three and nine months ended September 30,
2012 and related disclosures in this Amendment No. 1 to the Quarterly Report on Form 10-Q have been
restated in accordance with the changes described below.
On September 27, 2012, the Company announced it had entered into a definitive agreement to sell its
Individual Life insurance business to The Prudential Insurance Company of America ("Prudential"), a
subsidiary of Prudential Financial, Inc., (the "Transaction") for cash consideration of $615 consisting
primarily of a ceding commission. The sale, which is structured as a reinsurance transaction, closed on
January 2, 2013.
Based on accounting review and validation procedures performed in connection with the financial
reporting and close process for the fourth quarter of 2012 and subsequent to the filing of the Original
Form 10-Q, the Company identified that the impact of certain reinsurance recoverable balances associated
with the Transaction was incorrectly omitted in determining the estimated gain or loss on disposition
associated with the Transaction. As a result of such identification, the Company concluded that it would
be necessary to recognize an estimated pre-tax reinsurance loss on disposition of $533, comprised of the
impairment of goodwill attributed to the Individual Life business of $342 and a loss accrual for premium
deficiency of $191, which should have been recorded in the third quarter of 2012. The estimate is subject
to change pending final determination of net assets sold, transaction costs, and other adjustments.
The effect of the restatement on the Company’s Condensed Consolidated Balance Sheet, Condensed
Consolidated Statements of Operations and Condensed Consolidated Statement of Cash Flows was as
follows:
36
Goodwill
Deferred income taxes, net
Total assets
Other liabilities
Total liabilities
Retained earnings
Total liabilities and stockholders' equity
As of September 30, 2012
As previously
reported
Adjustment
As restated
$
1,006 $
(342)
$
664
$
1,248 $
145
$
1,393
$
308,918 $
(197)
$ 308,721
$
10,477 $
191
$
10,668
$
285,548 $
191
$ 285,739
$
11,235 $
(388)
$
10,847
$
308,918 $
(197)
$ 308,721
Reinsurance loss on disposition
Income (loss) from continuing operations before
income taxes
Income tax expense (benefit)
Net income (loss)
Net income (loss) available to common shareholders
Total comprehensive income
Income (loss) from continuing operations, net of tax,
available to common shareholders per common
share:
Basic
Diluted
Net income (loss) available to common shareholders
per common share:
Basic
Diluted
Three Months Ended September 30, 2012
As previously
As
reported
Adjustment restated
$
— $
533
$
533
$
$
$
$
$
511
108
401
391
1,440
$
$
$
$
$
(533)
(145)
(388)
(388)
(388)
$
(22)
$
(37)
$
13
$
3
$ 1,052
$
$
0.90
0.83
$
$
(0.89)
(0.82)
$
$
0.01
0.01
$
$
0.90
0.83
$
$
(0.89)
(0.82)
$
$
0.01
0.01
37
Reinsurance loss on disposition
Income (loss) from continuing operations before income
taxes
Income tax expense (benefit)
Net income (loss)
Net income (loss) available to common shareholders
Total comprehensive income
Income (loss) from continuing operations, net of tax,
available to common shareholders per common share:
Basic
Diluted
Net income (loss) available to common shareholders per
common share:
Basic
Diluted
Nine Months Ended September 30,
2012
As previously
As
reported
Adjustment restated
$
—
$
533
$
533
$
$
$
$
$
264
(136)
396
365
2,440
$
$
$
$
$
(533)
(145)
(388)
(388)
(388)
$ (269)
$ (281)
$
8
$
(23)
$ 2,052
$
$
0.84
0.79
$
$
(0.88)
(0.83)
$
$
(0.04)
(0.04)
$
$
0.83
0.78
$
$
(0.88)
(0.83)
$
$
(0.05)
(0.05)
Nine Months Ended September 30, 2012
As previously
As
reported
Adjustment
restated
Operating Activities:
Net income (loss)
Adjustments to reconcile net income to net cash
provided by operating activities:
Change in accrued and deferred income taxes
Reinsurance loss on disposition
Net cash provided by operating activities
$
396
$
(388)
$
$
$
$
(118)
—
2,212
$
$
$
(145)
533
—
$
$
$
8
(263)
533
2,212
38
2.0 Examples of Corrections of Immaterial Errors: Revisions
2.1 Nike Inc Errors in periods 12/1/2012 – 2/28/2013 disclosed in 10-Q on 4/7/2014
Revisions
Certain prior year amounts have been revised in the unaudited condensed consolidated balance sheets to
recognize certain inventory amounts held at third parties, which resulted in an increase in the amount of
$96 million to both inventories and accrued liabilities. In addition, prior year amounts on the unaudited
condensed consolidated statements of cash flows were revised to reflect the related cash flow impact of $36
million, which had no net impact on operating cash flows.
Additionally, prior period amounts in the unaudited condensed consolidated statements of cash flows were
revised for non-cash additions to property, plant, and equipment, which increased cash provided by
operations and decreased cash provided by investing activities in the amount of $24 million. The Company
assessed the materiality of these misstatements on prior periods’ financial statements in accordance with
SEC Staff Accounting Bulletin ("SAB") No. 99, Materiality, codified in ASC 250 ("ASC 250"),
Presentation of Financial Statements, and concluded that these misstatements were not material to any prior
annual or interim periods. Future filings will include revisions to reflect the above adjustments.
2.2 ConocoPhillips errors in periods 10/1/2011 – 12/31/2011 disclosed in 10-Q on 7/31/12
Note 16—Accumulated Other Comprehensive Income
Accumulated other comprehensive income in the equity section of the balance sheet included:
Millions of Dollars
Net
Accumulated
Unrealized
Foreign
Other
Defined
Gain on
Currency
Comprehensive
Benefit Plans Securities Translation Hedging
Income
December 31, 2011*
Other comprehensive
income
Separation of
Downstream business
$
June 30, 2012
$
—
5,223
76
1
334
6
417
683
—
(469)
—
214
—
3,877
(1,971)
(1,212)
1
5,088
(6)
3,246
*The beginning balance of retained earnings has been restated primarily to reflect certain intercompany
loans as permanently invested in 2004 and prior periods, which resulted in a $160 million increase in
Foreign Currency Translation and Accumulated Other Comprehensive Income, a $15 million decrease to
Total Liabilities, and a $145 million reduction in Retained Earnings. The impact on net income and
earnings per share was de minimis for the three- and six-month periods ended June 30, 2012 and 2011.
There were no items within accumulated other comprehensive income related to noncontrolling
interests.
39
2.3 Caterpillar Inc. errors in periods 1/1/2013-12/31/2013 disclosed in 10-Q on 8/1/2014
We have revised previously reported amounts on the Consolidated Statement of Cash Flow for the
six months ended June 30, 2013 to correct for customer advances invoiced but not yet paid and to
correct for certain non-cash transactions impacting Receivables - trade and other and Accounts
payable. Although these revisions did not impact Net cash provided by operating activities, cash
provided by Receivables - trade and other decreased by $200 million, cash provided by Accounts
payable increased by $83 million and cash used for Customer advances decreased by $117
million from the amounts previously reported for the six month period ended June 30, 2013.
Management has concluded that the impact was not material to any period presented.
2.4 Kraft Foods Group, Inc error in 1/1/2012 – 9/30/2012 disclosed in 10-Q on 10/31/2013
Beginning with the quarter ended September 28, 2013, we record expense related to certain
consumer incentive programs as a reduction of net revenues. Previously, we included this
expense in selling, general and administrative expenses. We have revised these prior periods to
reflect this in our current presentation. The impacts of these revisions, which were not material to
any prior period, reduced net revenues and selling, general and administrative expenses by $18
million in the three months and $66 million in the nine months ended September 30, 2012. We
will present the corrected historical periods in future filings.
2.5 Corning Inc/NY error for periods 1/1/2010 – 12/31/2011 reported in 10-K on 2/13/2013
During 2012, the Company made corrections in the 2011 consolidated balance sheet for errors
primarily related to the classification of deferred tax balances. These corrections resulted in (a) a
$528.6 gross-up of “Deferred income tax assets – noncurrent” and “Deferred income tax
liabilities – noncurrent” related to an incorrect application of the jurisdictional tax netting
accounting requirements in 2011 and (b) a $36.9 correction in classification from “Deferred
income tax assets – current” to “Other current assets” resulting from the tax effect on profits in
inventory relating to intercompany sales.
The Company determined that the cumulative impact of recording the corrections described
above were not material, either individually or in aggregate, to any prior years. However, if
uncorrected, the comparability of prior periods to 2012 would be impacted. Accordingly, the
Company has revised its 2011 consolidated balance sheet.
The impact of the corrections to the Company’s consolidated balance sheet as of December 31,
2011 was as follows:
Previously
Reported
Consolidated Balance Sheet
Deferred income tax assets – current
Other current assets
Deferred income tax assets – noncurrent
$
135.6
111.8
529.4
Adjustments
$ (36.9)
36.9
528.6
Revised
$
98.7
148.7
1,058.0
40
Deferred income tax liabilities –
noncurrent
1.6
528.6
530.2
In addition, the effect of the classification change between “Deferred income tax assets –
current” and “Other current assets” impacted certain line items within the operating activities
section of the consolidated statements of cash flows. The consolidated statements of cash flows
have been revised as follows:
Year ended December 31, 2010
Previously
Reported
Consolidated Statements of Cash Flows
Changes in deferred taxes, net
Changes in other operating assets and
liabilities
$
151.9
Adjustments
$
(5.7)
5.2
Revised
$
(5.2)
157.1
(10.9)
Year ended December 31, 2011
Previously
Reported
Consolidated Statements of Cash Flows
Changes in deferred taxes, net
Changes in other operating assets and
liabilities
$
283.8
60.1
Adjustments
$
(11.9)
11.9
Revised
$
271.9
72.0
Examples of Corrections of Immaterial Errors: Out-of-period adjustments
3.1 Caterpillar Inc. errors disclosed in 10-Q filed 5/2/2014
The provision for income taxes in the first quarter of 2014 also includes a charge of $55
million to correct for an error which resulted in an understatement of tax liabilities for prior
years. This error had the effect of overstating profit by $27 million and$28 million for the years
ended December 31, 2013 and 2012, respectively. These amounts are not material to the
financial statements of any affected period. This charge was offset by a $33 million benefit to
reflect a settlement with the U.S. Internal Revenue Service (IRS) related to 1992 through 1994
which resulted in a $16 million benefit to remeasure previously unrecognized tax benefits and
a $17 million benefit to adjust related interest, net of tax. The first quarter of 2013 tax provision
also included a benefit of $87 million primarily related to the U.S. research and development tax
credit that was extended for 2012.
41
3.2 General Dynamics Corporation error disclosed in 10-Q filed 5/1/2012
Out-of-period adjustments
In the first quarter of 2012, we recorded adjustments impacting revenues, operating costs
and contracts in process that reduced earnings before income taxes by $67. These adjustments
were made after completing an analysis at one of our European subsidiaries related to
recognition of contract receivables and relief of inventories that determined certain transactions
were not recorded properly in prior periods. After evaluating the quantitative and qualitative
effects of these adjustments, individually and in the aggregate, we have concluded that their
impacts on the Company’s prior periods’ and current period Consolidated Financial Statements
were not material.
3.3 Prudential corporation error disclosed in 10-K filed 2/27/2014
Out-of-period adjustments
As previously disclosed in its Annual Report on Form 10-K for the year ended
December 31, 2012, during 2012, the Company recorded out of period adjustments resulting in
an aggregate net decrease of $170 million to “Income from continuing operations before income
taxes and equity in earnings of operating joint ventures” for the year ended December 31, 2012.
These adjustments primarily resulted from 1) a decline in the value of a real estate-related
investment, where, based on a review of the underlying collateral and a related guarantee, the
Company determined that impairments of $75 million should be recognized, of which $61
million should have been recorded in prior years; 2) an increase of $61 million in reserves for
estimated payments arising from use of new Social Security Master Death File matching criteria
to identify deceased policy and contract holders which should have been reflected in the third
quarter of 2011; and 3) an increase of $54 million in recorded liabilities for certain employee
benefits based on a review of the consistency of recognition of such liabilities across the
Company which should have been recorded in prior years. Management evaluated the
adjustments and concluded they were not material to any previously reported quarterly or annual
financial statements. For additional information on the impact of these adjustments to our
operating segments, see Note 22.
3.4 Marathon Petroleum Corporation error disclosed in 10-Q filed on 5/5/2014
During the three months ended March 31, 2014, we recorded an out-of-period adjustment for
additional expenses related to the prior year's bonus programs of $29 million, included in total
costs and expenses on the consolidated statements of income. The impact to our consolidated
results of operations for three months ended March 31, 2014 and for the year
ended December 31, 2013 was immaterial. We do not expect this adjustment to have a material
impact to our results of operations for the year ended December 31, 2014.
42
Figure 1: Determination of Whether a Financial Reporting Error is Immaterial
Identify Financial Statement Error: misapplication
of GAAP or a misuse of facts at the time financial
statements were prepared (ASC 250)
Evaluate Materiality of Error
using authoritative guidance
(e.g. SAB 99, SAB 108)
If preparer deems error as
material (reasonable
investor would view as
important)
If preparer deems errors as
immaterial to each financial
statement period considered in
isolation
Disclosure: Item 4.02 Statement of
non-reliance disclosure in an 8-K
and revised retrospective financial
statements (i.e. Restatement)
following SEC Rule 33-8400
Revision:
summation of errors
recorded this period
distorts current
period financial
statements
Disclosure: Nature of error, period
which financials contain error, and
summary of financial statement
effects. Correction recorded in
retained earnings, prior
comparative financials revised
(ASC 250)
Out of Period
Adjustment: summation
of errors recorded this
period does not distort
current period financial
statements
Disclosure: Nature of error,
summary of financial statement
effects. Correction flows through
current period net income (ASC
250)
43
Figure 2: Frequency of Financial Reporting Errors over Time, 2004-2014
0.1
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
2004
2005
2006
2007
2008
2009
Restate
2010
2011
2012
2013
2014
Immaterial
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
2004
2005
2006
2007
2008
Restate
2009
2010
Revision
2011
2012
2013
2014
Adjust
Figure 2 depicts the frequency of material errors (restatements) and immaterial errors
(revisions and out-of-period adjustments) between 2004 and 2014. Data are from Audit
Analytics. The top graph combines all immaterial errors and the bottom graph shows
revisions separately from out-of-period adjustments, which are available starting 2008.
44
Figure 3: Distributions of Signed Income Effects for Restatement, Revision and Out-of-Period Adjustment Errors
Figure 3 plots the signed income effect of restatements, revisions and out-of-period adjustments for the sample described in Table 1.
The amounts shown are the income effect of the corrected error/total assets.
45
Table 1: Sample Determination
Number of
Observations
Error Events From Audit Analytics that correspond to reports from fiscal
periods ending after October 15, 2008 and before December 31, 2014
Less: Observations without Compustat links and related data
Less: Observations without CRSP links, return, or price information
Total error observations
6,103
(1,653)
4,450
(1,470)
2,980
Breakdown of error observations by type
Number of restatement/material error (Big R error) observations
Number of revision (little r error) observations
Number of out-of-period adjustment error observations
Total error observations
622
1,324
1,034
2,980
Total firm year observations28
2,837
28
There are 2,980 error instances and 2,837 firm year observations because some firm-year observations have more
than one type of error.
46
Table 2: Sample Descriptive Statistics
Panel A: Frequency of Error Characteristics for Revisions, Out-of-Period Adjustments and
Material Errors (Restatements)
Variable
Announcement in 10-K
Announcement in 10-Q
Announcement in press release
Announcement in 8-K
Announcement in other
Revisions
Mean
34.2%
44.0%
5.8%
2.1%
13.9%
Immaterial Errors
Adjustments
Combined
Mean
Mean
32.0%
33.3%
66.4%
53.8%
0.3%
3.4%
0.1%
1.2%
1.2%
8.3%
Material
Errors
Restatements
Mean
3.5%
1.8%
29.7%
54.5%
10.5%
SEC investigations involved
Board involvement
Auditor letter contains language
about the error
0.5%
1.1%
37.7%
0.4%
0.6%%
28.7%
0.5%
0.8%
36.0%
12.1%
92.6%
96.1%
Net income effect is zero
Net income effect is positive
Net income effect is negative
Net income effect is missing
61.4%
11.3%
27.4%
1.4%
12.3%
36.2%
51.5%
14.2%
43.8%
20.3%
36.0%
6.6%
19.1%
21.1%
59.8%
3.2%
|EPS Effect| / Price
Without zero income effects
|NI Effect| / |Pre tax Income|
Without zero income effects
|NI Effect| / |Total Assets|
Without zero income effects
0.9%
2.4%
10.5%
27.2%
0.4%
1.1%
0.3%
0.4%
6.8%
7.7%
0.2%
0.2%
0.6%
1.0%
8.7%
15.5%
0.3%
0.6%
10.5%
14.0%
55.7%
68.9%
5.1%
6.3%
Error affects classification only
Number of financial reporting issues
Number of Periods Affected (years)
20.9%
1.73
1.69
0.4%
1.46
10.8%
1.77
7.1%
1.77
1.75
Number of observations
1,324
1,034
2,358
622
47
Panel B: Frequency of Accounting Issues for Revisions, Out-of-Period Adjustments and
Material Errors (Restatements)
Issue Description
Tax expense/benefit/deferral/other
Cash flow statement classification
Revenue recognition issues
Expense (payroll, SGA, other) recording
Liabilities, payables, reserves & accrual
estimate failures
Inventory, vendor and/or cost of sales issues
Debt, quasi-debt, warrants & equity security
Accounts/loans receivable, investments &
cash
Foreign, related party, affiliated, or subsidiary
PPE intangible or fixed asset
(value/diminution)
Consolidation issues including Fin 46 variable
interest & off-B/S
Acquisitions, mergers, disposals, re-org acct
Deferred, stock-based and/or executive comp
Foreign, subsidiary
Acquisitions and mergers
PPE issues - Intangible assets, goodwill
Depreciation, depletion or amortization
Consolidation, foreign currency/inflation
Fin Statement, footnote & segment disclosure
Balance sheet classification of assets
Pension and other post-retirement benefit
EPS, ratio and classification of income
statement
Financial derivatives/hedging (FAS 133)
Intercompany, investment in subs./affiliate
Immaterial Errors
Revision Adjustments Combined
Mean
Mean
Mean
19.9%
31.8%
27.4%
25.8%
0.5%
15.9%
10.1%
11.5%
11.5%
8.5%
9.9%
9.9%
Material
Errors
Restate
Mean
15.6%
6.6%
17.7%
8.2%
7.6%
6.9%
8.7%
9.6%
7.5%
4.4%
9.3%
7.9%
7.2%
7.1%
9.0%
14.3%
8.4%
7.5%
4.5%
3.5%
7.1%
6.3%
12.9%
6.8%
5.3%
6.1%
6.1%
6.8%
4.9%
5.1%
3.2%
6.6%
3.2%
3.0%
2.1%
2.3%
4.3%
4.0%
1.7%
5.5%
5.6%
7.4%
2.3%
4.3%
3.8%
4.3%
3.7%
1.0%
0.5%
3.0%
5.9%
5.8%
5.4%
5.1%
4.0%
3.8%
3.5%
3.3%
3.0%
2.8%
2.6%
7.2%
8.7%
5.6%
5.5%
6.8%
2.6%
3.7%
1.8%
1.6%
0.8%
1.3%
3.4%
1.7%
2.7%
0.2%
2.0%
1.0%
2.1%
2.0%
2.0%
4.5%
3.4%
1.6%
48
Table 3: Cumulative Abnormal Returns Surrounding Error Announcements
Error Type
Immaterial Errors:
Revision
Out-of-period adjustment
Combined
Disclosed in routine filing (10-K or 10-Q)
Disclosed in non-routine filing
(amended filing, 8-K, press release, other)
Material Errors (Restatements):
Disclosed in routine filing (10-K or 10-Q)
Disclosed in non-routine filing
(amended filing, 8-K, press release, other)
All restatements
CAR (0, 2)
Std Dev
Q1
Median
Q3
Test (CAR = 0)
t
p-value
N
Mean
1,324
1,034
2,358
-0.003
-0.002
-0.003
0.073
0.071
0.072
-0.027
-0.025
-0.026
0.000
-0.001
-0.001
-0.003
-0.002
-0.003
-1.54
-1.00
-1.82
0.1238
0.3162
0.0685
2,053
305
-0.002
-0.010
0.069
0.090
-0.024
-0.051
0.000
-0.007
-0.002
-0.010
-1.06
-1.95
0.2906
0.0522
33
589
-0.033
-0.029
0.114
0.142
-0.078
-0.070
-0.023
-0.018
0.027
0.021
-1.64
-4.98
0.1098
0.0000
622
-0.029
0.141
-0.071
-0.018
0.021
-5.20
0.0000
Table 3 reports the average cumulative abnormal returns (size-adjusted) over the (0, 2) window surrounding error announcements, where day zero represents the
day the error is announced. Reported p-values are two-sided.
49
Table 4: Cross-sectional Variation in Price Responses to Error Announcements Based on
Error Severity and Means of Disclosure
CAR (0, 2) = α0 + α1 Severity of Errort + α2 Controlst + α3 Yeart + e t
Measures of
Error Severity
|NI effect| / Assets
Number of Issues
Non-Reclassification
Auditor Language
Disclosure
Type
Non-Routine Disclosure
Controls
Size
Book to Market
Change in ROA
Observations
R-squared
All
(1)
-0.0841
(-0.35)
-0.0037**
(-2.22)
0.0005
(0.12)
0.0001
(0.04)
-0.0091*
Material
Immaterial
Revisions Adjustments Restatements
(4)
(2)
(3)
-0.0732
-0.0434
-0.2434**
(-0.29)
(-0.16)
(-2.30)
-0.0046**
-0.0026
-0.0087*
(-2.06)
(-1.13)
(-1.85)
0.0019
-0.0408*
-0.0310
(0.37)
(-1.67)
(-0.85)
0.0007
-0.0087
-0.0398*
(0.16)
(-0.74)
(-1.70)
-0.0072
-0.0317**
0.0022
(-1.66)
0.0026**
(2.25)
0.0007
(0.23)
0.0109
(0.83)
(-1.23)
0.0033**
(2.27)
0.0027
(0.62)
0.0114
(0.69)
(-2.04)
0.0015
(0.79)
-0.0029
(-0.70)
0.0062
(0.26)
(0.11)
-0.0080
(-1.35)
-0.0155
(-1.47)
0.0418
(1.59)
2,184
0.014
1,298
0.017
886
0.019
598
0.058
Table 4 presents the results of regressing the cumulative abnormal returns (size-adjusted) surrounding error
correction announcements on measures of error severity and an indicator variable for Non-Routine Disclosure that
takes the value 1 if the error is announced in a non-routine disclosure, zero otherwise. Returns are over the (0, 2)
window, where day zero represents the day the error is announced. |NI effect|/Assets is the absolute value of the
error’s effect on net income scaled by assets. Number of Issues is the number of error-related issues identified by
Audit Analytics in the error announcement. Non-Reclassification is an indicator set equal to 1 if the error does not
represent only a reclassification of a financial statement item where one or more of the issues in Table 2 Panel A are
present with no other issues (Tax-Fin 48 reclassification, balance sheet classification of assets, cash flow statement
classification, Debt and/or equity classification, and EPS ratio classification issues). Auditor Language is an
indicator variable set equal to 1 if the firm’s auditor provided modified language in the audit report in connection
with the error. Size is the log of market value of equity. Book to market is common equity divided by market value
of equity. Change in ROA is net income before extraordinary items divided by assets for period t less period t-1.
Regressions include year fixed effects with standard errors clustered by firm. Statistical significance (two-sided) is
denoted by *** p<0.01, ** p<0.05, * p<0.1.
50
Table 5: Predictive Ability of Current Period Immaterial Errors for Future Period
Material Errors (Restatements)
Restatet+1 = α0+ α1Immaterial Errort + α2 Material Errort + α3Controlst + α4Yeart + α5Industryt + et
Error Types
Immaterial Error
Logit
0.5305***
(3.95)
(1)
Marginal Effects
0.0099***
(3.20)
Revision
Adjustment
Restate
Controls
Material
Weakness
Big 4
Size
Book to Market
Loss
Earnings
Leverage
Acquisition
Capital raising
Intangibles
Capital
Expenditures
Institutional
Ownership
Observations
Pseudo R2
0.4254**
(2.50)
2.3318***
(16.52)
-0.7338***
(-6.84)
-0.1064***
(-4.49)
0.0011
(0.05)
0.3727***
(3.77)
-0.0184
(-1.15)
-0.1090***
(-2.68)
0.5267***
(2.76)
0.5613***
(6.19)
-0.2113
(-0.99)
0.1411
(0.21)
0.0008
(0.48)
0.0077**
(2.06)
0.1157***
(7.40)
-0.0119***
(-6.23)
-0.0016***
(-4.47)
0.0000
(0.05)
0.0058***
(3.62)
-0.0003
(-1.14)
-0.0016***
(-2.67)
0.0100**
(2.19)
0.0096***
(5.43)
-0.0031
(-0.99)
0.0021
(0.21)
0.0000
(0.48)
31,525
0.105
Logit
(2)
Marginal Effects
0.6879***
(4.64)
0.0400
(0.16)
0.4503***
(2.65)
2.3323***
(16.48)
-0.7240***
(-6.74)
-0.1063***
(-4.48)
0.0014
(0.07)
0.3691***
(3.73)
-0.0180
(-1.12)
-0.1096***
(-2.69)
0.5247***
(2.75)
0.5630***
(6.22)
-0.2092
(-0.98)
0.1512
(0.22)
0.0010
(0.57)
0.0140***
(3.49)
0.0006
(0.15)
0.0082**
(2.16)
0.1156***
(7.40)
-0.0117***
(-6.13)
-0.0016***
(-4.47)
0.0000
(0.07)
0.0057***
(3.58)
-0.0003
(-1.12)
-0.0016***
(-2.68)
0.0099**
(2.18)
0.0096***
(5.45)
-0.0031
(-0.98)
0.0022
(0.22)
0.0000
(0.57)
31,525
0.106
51
Notes: Restate at t and t+1 is an indicator set to 1 if the firm has an error reported in an Item 4.02 8-K which denotes
the error is materially affecting prior financial statements. Immaterial error is an indicator set to 1 if the firm has
either a Revision or Adjustment error in period t. Revision (adjustment) is an indicator if the immaterial error was
not disclosed in an Item 4.02 8-K, but was corrected by adjusting prior (current) year financial statement values to
correct the error. Material Weakness (Unqualified Opinion) [Big 4] are indicators if the firm disclosed at least one
material weakness over internal controls (auditor noted an unqualified opinion with language) [auditor is among
Deloitte, Pricewaterhouse Coopers, KPMG, or Ernst & Young]. Size is the log of market value of equity. Book to
market is common equity divided by market value of equity. Loss is an indicator if net income before extraordinary
items is less than zero. Earnings is net income before extraordinary items scaled by assets. Leverage is long term
debt divided by total assets. Acquisition is an indicator set to l to one if sales related to acquisitions exceeds 20% of
total sales. Capital Raising is an indicator set to one if debt and equity capital raised exceeds 20% of assets.
Intangibles is the sum of advertising and research and development expenses divided by total assets. Capital
expenditures is capital expenditures divided by total assets. Institutional Ownership is the percentage of shares held
by institutional investors in the last quarter of the fiscal year. We include year and industry (defined as 2 digit SIC
code) fixed effects with standard errors clustered by firm. Statistical significance (two-sided) is denoted by ***
p<0.01, ** p<0.05, * p<0.1.
52
Table 6: Predictive Ability of Current Period Immaterial Errors for Future Period
Immaterial Errors
Panel A. All Immaterial Errors
Immaterial Errort+1 = α0 + α1 Error Typest + α2 Controlst + α3Yeart + α4 Industryt + e
Error Types
Immaterial Error
Logit
1.0603***
(15.66)
(1)
Marginal Effects
Adjustment
Controls
Material
Weakness
Big 4
Size
Book to Market
Loss
Earnings
Leverage
Acquisition
Capital raising
Intangibles
Capital
Expenditures
Institutional
Ownership
Observations
Pseudo R2
0.3418**
(2.46)
0.9198***
(8.22)
0.7772***
(11.16)
-0.0347**
(-2.30)
-0.0162
(-1.01)
0.2249***
(4.00)
-0.0421**
(-2.56)
0.0126
(0.34)
0.4573***
(3.99)
0.2007***
(3.67)
-0.6396***
(-3.45)
-0.4099
(-0.87)
0.0076***
(8.84)
0.7655***
(9.16)
1.2261***
(13.35)
0.3173**
(2.27)
0.9219***
(8.17)
0.7692***
(10.96)
-0.0347**
(-2.29)
-0.0169
(-1.05)
0.2282***
(4.05)
-0.0426***
(-2.58)
0.0142
(0.38)
0.4607***
(4.01)
0.2001***
(3.64)
-0.6351***
(-3.42)
-0.4367
(-0.92)
0.0074***
(8.58)
0.0576***
(6.98)
0.1129***
(8.85)
0.0199**
(2.00)
0.0753***
(5.86)
0.0400***
(11.61)
-0.0019**
(-2.29)
-0.0009
(-1.04)
0.0128***
(3.97)
-0.0023***
(-2.59)
0.0008
(0.38)
0.0308***
(3.35)
0.0115***
(3.48)
-0.0349***
(-3.43)
-0.0240
(-0.92)
0.0004***
(8.65)
0.0879***
(11.14)
Revision
Restate
Logit
(2)
Marginal Effects
0.0217**
(2.15)
0.0749***
(5.90)
0.0403***
(11.80)
-0.0019**
(-2.30)
-0.0009
(-1.01)
0.0126***
(3.92)
-0.0023**
(-2.57)
0.0007
(0.34)
0.0304***
(3.33)
0.0115***
(3.51)
-0.0351***
(-3.46)
-0.0225
(-0.87)
0.0004***
(8.90)
31,937
0.074
31,937
0.075
53
Panel B. Immaterial Errors separated into Revisions and Out-of-Period Adjustments
(Revision or Adjustment)t+1 = α0 + α1 Error Typest + α2 Controlst + α3 Yeart + α4 Industryt + et
(1)
Revisiont+1
Error Types
Revision
Adjustment
Restate
Controls
Material
Weakness
Big 4
Size
Book to Market
Loss
Earnings
Leverage
Acquisition
Capital raising
Intangibles
Capital
Expenditures
Institutional
Ownership
Observations
Pseudo R2
Logit
0.8222***
(8.64)
0.6517***
(5.71)
0.3044*
(1.90)
1.0454***
(8.29)
0.5235***
(6.55)
-0.0393**
(-2.29)
-0.0122
(-0.61)
0.2377***
(3.60)
-0.0459***
(-2.71)
0.0248
(0.64)
0.4563***
(3.39)
0.1990***
(3.11)
-0.6189***
(-2.95)
-0.2112
(-0.40)
0.0050***
(5.13)
Marginal Effects
0.0448***
(6.35)
0.0332***
(4.40)
0.0133*
(1.68)
0.0642***
(5.58)
0.0191***
(6.84)
-0.0015**
(-2.28)
-0.0005
(-0.61)
0.0093***
(3.51)
-0.0017***
(-2.71)
0.0009
(0.64)
0.0213***
(2.80)
0.0079***
(2.98)
-0.0235***
(-2.96)
-0.0080
(-0.40)
0.0002***
(5.15)
31,932
0.055
(2)
Adjustmentt+1
Logit
0.5790***
(4.66)
1.5787***
(13.79)
0.2851
(1.25)
0.6277***
(3.68)
1.4627***
(9.83)
-0.0172
(-0.72)
-0.0242
(-0.88)
0.1960**
(2.17)
0.2138**
(2.57)
-0.0834
(-0.71)
0.4081**
(2.29)
0.2140**
(2.39)
-0.4821
(-1.18)
-0.7951
(-1.00)
0.0112***
(7.95)
Marginal Effects
0.0112***
(3.62)
0.0517***
(7.11)
0.0048
(1.10)
0.0126***
(2.75)
0.0203***
(10.73)
-0.0003
(-0.72)
-0.0004
(-0.88)
0.0030**
(2.13)
0.0032***
(2.63)
-0.0012
(-0.71)
0.0073*
(1.90)
0.0034**
(2.26)
-0.0071
(-1.19)
-0.0118
(-1.00)
0.0002***
(7.61)
31,841
0.124
All variables are as defined in Table 5. We include year and industry (defined as 2 digit SIC code) fixed effects with
standard errors clustered by firm. Statistical significance (two-sided) is denoted by *** p<0.01, ** p<0.05, * p<0.1.
54
Table 7: Predictive Ability of Current Period Immaterial Errors for Future Period
Material Weaknesses
Material Weaknesst+1 = α0 + α1 Error Typest + α2 Controlst + α3 Yeart + α4 Industryt + et
(1)
Marginal Effects
Error
Types
Immaterial Error
Logit
0.5071***
(4.04)
Logit
0.6282***
(3.29)
2.7810***
(22.23)
0.0843
(0.69)
0.0408*
(1.67)
-0.0445
(-1.40)
0.3487***
(3.35)
0.0300
(0.79)
-0.6681***
0.0116**
(2.47)
0.1627***
(9.19)
0.0011
(0.69)
0.0006*
(1.68)
-0.0006
(-1.41)
0.0049***
(3.25)
0.0004
(0.79)
-0.0091***
0.6566***
(3.45)
0.6548***
(4.51)
0.2266
(1.17)
2.7700***
(22.06)
0.0869
(0.71)
0.0416*
(1.70)
-0.0461
(-1.44)
0.3460***
(3.31)
0.0304
(0.79)
-0.6733***
(-3.64)
1.0092***
(5.85)
0.2988***
(2.98)
-0.3655
(-1.19)
1.5324**
(2.27)
0.0004
(0.29)
(-3.95)
0.0226***
(3.80)
0.0044***
(2.79)
-0.0050
(-1.19)
0.0208**
(2.29)
0.0000
(0.29)
(-3.65)
1.0056***
(5.81)
0.3016***
(3.01)
-0.3631
(-1.18)
1.5291**
(2.27)
0.0005
(0.33)
Adjustment
Controls
Material Weakness
Big 4
Size
Book to Market
Loss
Earnings
Leverage
Acquisition
Capital raising
Intangibles
Capital
Expenditures
Institutional
Ownership
Observations
Pseudo R2
Marginal
Effects
0.0086***
(3.29)
Revision
Restate
(2)
31,310
0.139
0.0120***
(3.42)
0.0034
(1.05)
0.0122**
(2.57)
0.1608***
(9.13)
0.0012
(0.71)
0.0006*
(1.71)
-0.0006
(-1.45)
0.0049***
(3.21)
0.0004
(0.80)
0.0091***
(-3.97)
0.0224***
(3.78)
0.0044***
(2.81)
-0.0049
(-1.18)
0.0207**
(2.29)
0.0000
(0.33)
31,310
0.140
All variables are as defined in Table 5. We include year and industry (defined as 2 digit SIC code) fixed effects with
standard errors clustered by firm. Statistical significance (two-sided) is denoted by *** p<0.01, ** p<0.05, * p<0.1.
55
Table 8: Persistence of Material Errors (Restatements) and Immaterial Errors
Error Typet+1 = α0 + α1 Error Typest + α2 Error Typest-1 + α3 Controlst + α4Yeart + α5 Industryt + e
(1)
Restatet+1
Error Types
Immaterial Errort
Immaterial Errort-1
0.4829***
(3.05)
0.0908
(0.48)
Revisiont
0.2925
(1.39)
0.3702*
(1.80)
0.6629***
(3.76)
-0.0643
(-0.27)
-0.0292
(-0.11)
0.2694
(0.93)
0.3225
(1.54)
0.3682*
(1.81)
24,016
0.117
24,016
0.118
Revisiont-1
Adjustmentt
Adjustmentt-1
Restatet
Restatet-1
Observations
Pseudo R2
(2)
Immaterial Error t+1
1.0167***
(15.09)
0.7207***
(9.46)
0.7181***
(8.14)
0.5104***
(5.10)
1.1496***
(12.40)
0.8378***
(7.91)
0.2253
0.2107
(1.36)
(1.26)
0.2138
0.1967
(1.29)
(1.17)
24,611
0.086
24,611
0.088
56
Table 9: Predictive Ability of Error Severity for Future Material Errors (Restatements),
Immaterial Errors and Material Weaknesses
Panel A. Material Errors
Restatet+1 = α0+ α1Immaterial Errort + α2Immaterial Errort x Severityt+ α3 Material Errort + α4
Material Errort x Severityt+α5Controlst + α6Yeart + α7Industryt + et
Immaterial Error
Immaterial Error x |NI effect| / Assets
(1)
0.6839***
(4.07)
-27.1049*
(-1.94)
(2)
0.1384
(0.64)
(3)
0.4935***
(3.47)
0.2197**
(2.46)
Immaterial Error x Number of Issues
Immaterial Error x Non-Reclassification
-0.3534
(-0.95)
Immaterial Error x Auditor Language
Restate
Restate x |NI effect| / Assets
0.5962***
(3.04)
-0.5803
(-0.70)
Restate x Number of Issues
0.2580
(0.93)
0.4376**
(2.49)
-0.5070
(-0.46)
-0.4247
(-0.53)
0.0898
(0.76)
0.2458
(0.33)
Restate x Non-Reclassification
Restate x Auditor Language
Observations
R-squared
(4)
0.5419***
(3.99)
0.8984
(1.11)
30,954
0.108
31,525
0.106
31,525
0.105
31,525
0.106
57
Panel B. Immaterial Errors
Immaterial Errort+1 = α0+ α1Immaterial Errort + α2Immaterial Errort x Severityt+ α3 Material
Errort + α4 Material Errort x Severityt+α5Controlst + α6Yeart + α7Industryt + et
Immaterial Error
Immaterial Error x |NI effect| / Assets
(1)
1.0766***
(14.43)
-1.0611
(-0.26)
(2)
0.9467***
(9.06)
(3)
1.0824***
(15.25)
0.0659
(1.44)
Immaterial Error x Number of Issues
Immaterial Error x Non-Reclassification
0.2165
(1.13)
Immaterial Error x Auditor Language
Restate
Restate x |NI effect| / Assets
0.1855
(1.12)
0.4736
(0.67)
Restate x Number of Issues
0.5354**
(2.22)
0.3166**
(2.19)
0.7050**
(2.24)
0.2235
(0.40)
-0.1060
(-0.94)
-0.3346
(-0.68)
Restate x Non-Reclassification
Restate x Auditor Language
Observations
R-squared
(4)
1.0422***
(15.21)
0.1291
(0.22)
31,363
0.075
31,937
0.074
31,937
0.074
31,937
0.074
58
Panel C. Material Weaknesses
Material Weaknesst+1 = α0+ α1Immaterial Errort + α2Immaterial Errort x Severityt+ α3 Material
Errort + α4 Material Errort x Severityt+α5Controlst + α6Yeart + α7Industryt + et
Immaterial Error
Immaterial Error x |NI effect| / Assets
(1)
0.5706***
(4.17)
6.2838
(1.35)
(2)
0.3620*
(1.70)
(3)
0.5117***
(3.95)
0.0808
(0.84)
Immaterial Error x Number of Issues
Immaterial Error x Non-Reclassification
0.0685
(0.15)
Immaterial Error x Auditor Language
Restate
Restate x |NI effect| / Assets
0.6624***
(3.00)
0.5278
(0.91)
Restate x Number of Issues
0.1203
(0.38)
0.6774***
(3.48)
0.2833
(0.39)
-14.3887***
(-27.79)
0.2439**
(2.13)
1.4183
(1.34)
Restate x Non-Reclassification
Restate x Auditor Language
Observations
R-squared
(4)
0.5077***
(4.02)
15.0991***
(28.56)
30,746
0.137
31,310
0.140
31,310
0.139
31,310
0.140
59