Why are most restatements negative? Behavioral accounting at work

Marie Pupecki Date published: Nov 27, 23

In our most recent report we found that 68% of restatements resulted in a negative income impact during 2022. If most restatements are a result of complex accounting rules that are misapplied or misunderstood, why is the accounting error more likely to be in the company’s favor? Errors are easy to make in a high stake, ever-evolving ecosystem that is the public company. Why then this disparate impact?

The factors at play

Is it the nature of the accounts themselves? The level of inherent risk is based on the nature and type of the business. Multiple different and/or complex transactions require a high degree of judgment, leading to a high level of risk. The prudence concept tells us that it is more likely that assets and revenue will be overstated, and liabilities or expenses understated. Are auditors more likely to find negative adjustments? Is it more likely that management errs on the side of more beneficial decisions?

The top overall restatement issues are related to debt/equity, revenue recognition, expense recording, and liability issues. The recent spike in special purpose acquisition company (SPAC) restatements were related to warrants and financial instruments indexed to the company’s stock. Warrants and financial instruments grew increasingly complex and the interpretations previously varied before the Securities and Exchange Commission (SEC) stepped into the fray.  Revenue recognition errors are easier to understand. Despite all attempts to make it more formulaic, it's still is subject to interpretation.

The auditor's perspective

For auditors there are certain risk reduction and legal reasons for conservatism and negative adjustments to earnings. Earnings management is real, thus requires an offsetting risk response. Litigation resulting from accounting errors is often tied to stock price declines upon a negative restatement.  Auditing Standard No 14 requires that: “the auditor should evaluate the qualitative aspects of the company’s accounting practices, including potential bias in management’s judgments about the amounts and disclosures in the financial statements.” It gives us the following examples:

1. The selective correction of misstatements brought to management’s attention during the audit 
2. The identification by management of additional adjusting entries that offset misstatements accumulated by the auditor
3. Bias in the selection and application of accounting principles
4. Bias in accounting estimates

There have been multiple studies on behavioral accounting. They find that bias affects the overall interpretations of issues cited: “Cognitive biases, systemic deviations from rationality or normative standards in judgment and decision-making, can affect how people perceive, process, interpret, and use information, leading to errors, distortions, or biases in their choices and actions.” (Nikolopoulou, 2022). In addition, studies have shown the role of the following types of bias:

1. Overconfidence bias
2. Anchoring bias
3. Confirmation bias
4. Hindsight bias

Here's an example of how this may work in a typical scenario. The VP of Sales is off making deals and it’s the quarter end.  The revenue contract is signed, some performance occurs and the accountant finally receives a copy of the contract. The revenue accountant is presented with this 'deal', fait accompli as a signed contract.

The VP of Sales is already counting his commissions and the CEO sees this deal as saving the quarter. The accountant is hopeful that it meets the requirements for current period revenue recognition. Fingers crossed, they plow through the details of ASC 606. It's easy to put more weight on the factors that would allow immediate recognition and summon arguments against the deferral – confirmation bias is at work.

A valid argument is made, with supporting facts. Is it the best argument, the best conclusion, or good enough? They did their job and since there is verifiable logic to the decision, it feels fairly low risk. Unlikely to happen in an argument to defer revenue to a future period, except perhaps for a tax related motive.

Factors affecting an auditor's judgement

This is where one would expect an auditor’s independence and judgement to come into play.  Another potential influence is quite interesting.  A study by Columbia Law found a link between the overall economic situation when an auditor began their career and the frequency of audit adjustments: “We find evidence that auditors who entered the labor market during a period with heightened exposure to audit failure investigations develop a higher degree of professional skepticism than their peers.”

Or they are suffering from hindsight bias because the last time they questioned the client’s revenue decisions, it went to their national office and the office confirmed the client’s conclusion? It could be a grey area (there are still plenty of those in the accounting rules) where the conclusion could go either way and it certainly is easier to support the client’s decision than to oppose it.

The impact of bias

There’s a lot more happening here for both accountants and their auditors than you might expect.  The next time you find yourself searching through the literature for arguments to support your accounting decision and don’t apply the same level of scrutiny to those facts that don’t support it, it may be time to step back and consider the important impact of bias.  Nobody wants an error requiring a restatement, and as the numbers show its far more likely to be a negative event.

1. Overconfidence bias: This bias can lead managers to overstate their earnings forecasts, overinvest in risky projects, underestimate the likelihood of negative events or outcomes, or delay the recognition of losses or impairments (Aren & Nayman Hamamci, 2021).
2. Anchoring bias: This bias can lead managers to base their accounting estimates or valuations on irrelevant or arbitrary anchors, such as historical costs, initial offers, industry averages, or round numbers (Hofmann, 2022). It can also lead auditors to accept management’s estimates without sufficient skepticism or adjustment (Hofmann, 2022).
3. Confirmation bias: This bias can lead managers to manipulate earnings or engage in earnings management to confirm their prior expectations or targets (Costa et. al., 2017). It can also lead auditors to collect and evaluate evidence that supports management’s assertions without considering alternative explanations or contradictory evidence (Costa et. al., 2017).
4. Hindsight bias: This bias can lead managers to rationalize their past decisions or actions after observing their outcomes, or to claim that they predicted them correctly (Berthet, 2022).