Financial reporting errors can create serious problems for public companies, their boards and their owners – and over the past several years, accounting concerns have been increasing amongst U.S. public companies. This puts audit committees, which play an integral role in overseeing the financial reporting process, under the spotlight at the same time their role is evolving to include oversight of risk management, cybersecurity, ESG, and other emerging topics.

In this post, we consider several factors contributing to the rise in financial reporting related concerns, including an influx of newly public special purpose acquisition companies (“SPACs”), the increasingly expansive responsibilities of public company audit committees, and a talent shortage within the accounting industry. In addition, we discuss the regulatory response, investor views on the topic, and how Glass Lewis has updated its Benchmark Voting Policy to reflect the current landscape of financial reporting.

Rise in Accounting Errors

Since 2021, the number of SEC enforcement actions related to issuer reporting, audit and accounting has increased by more than 50%, from 70 in 2021 to more than 100 in 2023. This surge aligns with Glass Lewis’ observations. In the 2023 proxy season, for the first time in over five years, financial reporting related concerns, particularly those relating to material weaknesses and restatements, represented one of the most common drivers of against recommendations under Glass Lewis’ Benchmark Policy, occurring 2.5 times more frequently than in the 2022 season.

Adverse Voting Recommendations – Material Weakness

The increase reflects a market environment in which less established issuers are still developing strong internal controls – however, these errors are not only affecting less established issuers. In announcing the results of its enforcement actions for the 2023 fiscal year, the SEC highlighted a wide range of alleged misconduct at a wide range of issuers, including many companies that only recently went public by way of SPAC mergers, such as Hyzon Motors, Inc., Spruce Power Holding Corporation (formerly XL Fleet), and Canoo Inc., as well as many more established companies, such as DXC Technology Company, Fluor Corporation, and Newell Brands Inc. Public company misstatements and internal controls deficiencies were highlighted as areas of particular concern.

Adverse Voting Recommendations – Restatements

A recent example of a large and well established company with financial reporting concerns is S&P 500 component and food processing multinational Archer-Daniels-Midland Company (ADM). On January 22, 2024, ADM announced it had launched an investigation into its internal accounting practices, and that the company had placed its CFO on administrative leave. The announcement led to a 24% decline in the company’s share price, representing a loss of more than $8.8 billion in shareholder value.

The ADM case underscores that accounting and financial reporting concerns are not limited to any one market segment and do not appear to be diminishing in frequency. While issues like material weaknesses are much more likely at smaller and less established companies, when they do occur at larger companies like ADM, which has been listed on the NYSE since 1924 and has been audited by Ernst & Young since 1930, they have the potential to have a much more destructive effect on shareholder value.

What’s Driving the Increase in Financial Reporting Related Concerns?

SPAC and IPO Boom

One factor driving the increase in accounting and financial reporting related concerns is the increasing number of newly-public companies, driven in large part by the 2020-2021 SPAC and IPO boom that saw 1,500 new listings on U.S. exchanges. Many of these less established public companies may have less experience dealing with the rigor of public company financial reporting, even compared to typical newly-public issuers, since the SPAC process allows companies to bypass some of the regulatory obstacles involved in an IPO.

Substandard stock performance has been a common issue for de-SPAC companies that went public during the SPAC boom, with de-SPAC companies underperforming traditional IPOs by 26%. In some cases, that underperformance was extensive enough to raise questions about the viability of the business. According to research from Audit Analytics, approximately 30% of going concern opinions in fiscal year 2022 were reported by de-SPAC companies despite their making up less than 10% of U.S. publicly traded companies. This overrepresentation suggests that the expedited timelines of SPAC mergers might have led many companies to enter the public markets before they were financially stable.

Those who closely monitor regulatory updates may recall the April 2021 SEC guidance concerning accounting for SPAC-issued warrants that led to many financial restatements. Specifically, the SEC staff suggested that warrants issued by many SPACs should be properly accounted for under the liability method on the balance sheet. The SEC staff advised that companies with such warrants outstanding (whether SPACs or the combined company following a de-SPAC transaction) consider the need to amend previously filed audited and unaudited financial statements.

Given these circumstances, Glass Lewis’ Benchmark Policy has generally refrained from recommending against de-SPAC audit committees in cases where a restatement resulted from this SEC guidance. Yet even excluding these cases, we have nonetheless identified a spike in the number of accounting and financial reporting concerns, indicating that the scope of the problem goes beyond the SPAC and IPO boom.

Lack of Qualified Accountants

A shortage of qualified accounting personnel is another factor contributing to the increase in accounting-related concerns. In the past year, more companies have attributed material weaknesses at least in part to a lack of qualified staff or accounting personnel.

Though these disclosures are more typical of smaller reporting companies, larger, more established companies have also been affected. For example, S&P 500 members Dentsply Sirona Inc. and Advance Auto Parts, as well as Russell 3000 members Plug Power Inc., CarGurus Inc., and Warby Parker Inc., have each cited difficulties sourcing qualified staff or accounting personnel in their material weakness reporting.

In its February 2023 10-K, Dentsply Sirona disclosed that it “did not maintain a sufficient complement of personnel with an appropriate level of knowledge…in a manner commensurate with our financial reporting requirements.” This admission came just a few months after the company announced that it had identified material weaknesses in its internal controls, which led to a misstatement in its 2021 financial statements. Later in 2023, the company disclosed that its auditor, PricewaterhouseCoopers (PwC), had identified an additional material weakness as part of a routine internal quality review. In its February 2024 10-K, Dentsply Sirona stated that its material weaknesses had been fully remediated as of the fiscal year end. However, just a week later the company announced that it had dismissed PwC and approved the appointment of Deloitte & Touche in its place.

In general, companies looking to fill vacant accounting positions must face a difficult labor market where qualified candidates are increasingly scarce. The Wall Street Journal reported that some universities are reporting “double-digit” percentage declines in accounting degree enrollments, with U.S. Census Bureau data suggesting that accountant salaries have failed to outpace inflation in recent years. Perhaps not unrelatedly, hundreds of thousands of existing accountants have sought career changes in more lucrative sectors.

Even when qualified candidates are available, challenges remain. For example, after disclosing an internal control deficiency “specifically relating to a lack of a sufficient complement of qualified technical accounting and financial reporting personnel to perform control activities surrounding complex and non-routine transactions,” Plug Power Inc. brought on over 60 accounting and finance personnel. Yet the company reported that this influx of new staff resulted in delays in the timeliness of executing controls, and that these added resources and the implementation of newly designed controls required additional time to demonstrate operating effectiveness. Despite taking significant steps to bolster its team, in August 2023 Plug Power agreed to a $1.25 million fine to settle SEC charges relating to its controls, and the company could pay another $5 million under the settlement if material weaknesses have not been remediated by August 2024. As of December 31, 2023, the company stated that its disclosure controls and procedures remained ineffective.

Increasing Oversight Responsibilities

At the same time that auditors are struggling with staffing, audit committees are being asked to take on a broader remit. As the responsibilities associated with the board expand to cover external risks stemming from new technologies and environmental and societal changes, as well as increased disclosure and reporting requirements, so do expectations around committee performance – with much of that responsibility placed on the audit committee. The core expectation of audit committees to oversee accounting and financial reporting remains, but for many companies, the scope of these expectations has grown to include oversight of issues such as cybersecurity and ESG.

A 2023 survey of 164 companies by audit firm Deloitte showed that 53% of respondents delegated cybersecurity oversight to the audit committee, with 26% delegating to the board and 11% to the risk committee. Though the margin was narrower for ESG oversight, a plurality of respondents also delegated that responsibility to the audit committee. This trend is understandable –the audit committee’s role in overseeing risk factors lends to its ability to manage cybersecurity and ESG. However, boards and investors should be mindful that, absent additional resources commensurate with the increased scope, these new areas of oversight might also divert audit committee members’ attention from their core responsibilities.

Regulatory Response

While investors and boards should be mindful of the trends discussed above, it’s also worth noting the impact of the SEC itself. As discussed above, the agency’s April 2021 guidance, aimed at promoting sound reporting standards, prompted a spike in the number of SPAC restatements. Similarly, an increase in targeted enforcement campaigns, including use of data analytics to filter companies of potential concern, may be contributing to an increase in the number of issues identified.

More broadly, the SEC has continued its efforts to promote a proper focus on the integrity of financial reporting. In June 2023, the Public Company Accounting Oversight Board (“PCAOB”) opened a public comment period for amendments to its auditing standard AS 2405, which currently states that it is the auditor’s responsibility to detect and report misstatements resulting from illegal acts having a direct and material effect on financial statements. The amended AS 2405 expands the auditor’s current responsibilities to include detecting and reporting misstatements resulting from non-compliance with laws and regulations (“NOCLAR”), rather than just from illegal acts.

Proponents of the PCAOB’s proposal maintain that the amendments provide valuable updates to existing auditing standards, but critics have expressed concern that the amendments would overburden auditors with responsibilities typically delegated to management. The expanded definition included in the amendments might also place further strain on audit committees in their role of evaluating, selecting and rotating company auditors, and reshape the relationship between auditors and audit committees.

In January 2024, the SEC also adopted new rules which would promote transparency at SPACs by requiring them to disclose potential conflicts of interest between pre-merger companies and their sponsors, and assign additional legal responsibilities to de-SPAC companies which normally apply to traditional IPOs. Specifically, the new rules expand Section 11 of the Securities Act of 1933, which covers registration statements, to SPAC merger targets as well as their executives and directors.

Investor Views – Glass Lewis Client Policy Survey

Oversight of financial reporting and internal controls was one of the topics included in Glass Lewis’ 2023 Client Policy Survey. We were interested in how our clients viewed the audit committee’s accountability for managing a company’s response when a material weakness has been identified, and asked whether committee members should face adverse voting recommendations in several scenarios.

Where a material weakness was identified in the past year, 78.7% of investor respondents indicated that they would not make adverse voting decisions for audit committee members on this basis if a detailed remediation plan was disclosed. Remediation plans are key to investor’s understanding of how companies plan to address internal control deficiencies, as these plans outline the detailed steps that will be taken in order to restore the effectiveness of internal controls.

However, if the remediation plan fails to resolve the issue within a year, those voting decisions are likely to change. Over 95% of investor respondents indicated that they would vote against audit committee members if the material weakness was ongoing for more than a year and the company’s remediation plan had not been updated – and half would vote against after a year even if the remediation plan was being updated.

Glass Lewis’ View

General Approach

In our analysis of board performance, Glass Lewis is mindful that an audit committee does not prepare financial statements. Rather, members of the audit committee are responsible for monitoring and overseeing the process and procedures that management and auditors perform. The effectiveness of internal controls should provide reasonable assurance that the financial statements are materially free from errors.

The issues that most frequently raise concerns are material weaknesses and restatements. A material weakness indicates that there is a reasonable possibility that a material misstatement of financial statements will not be prevented or detected on a timely basis, and restatements indicate that investors can no longer rely upon previously issued financial statements. In cases where we have identified material financial reporting concerns, such as material weaknesses or restatements, our Benchmark Policy may recommend voting against members of the audit committee.

2024 Policy Update

We anticipate that present developments in corporate accounting, including de-SPAC companies, accounting personnel shortages and expanding audit committee responsibilities, will continue to influence the volume of financial reporting related concerns we review in our research. In response to these developments and to reflect investor expectations in the current landscape, we have made updates to our Benchmark Policy on material weaknesses. However, our underlying approach remains unchanged: we will continue to evaluate material weaknesses and restatements on a case-by-case basis.

Glass Lewis’ updated Benchmark Policy emphasizes the audit committee’s responsibility for ensuring that companies disclose a credible remediation plan and resume effective internal control over financial reporting on a timely basis. In particular, the policy focuses on audit committees that fail to provide material updates to their remediation plans when a material weakness has been ongoing for more than one year, and will consider recommending against audit committee members in cases where this disclosure has not been provided or the material weakness has not been remediated on a timely basis.

Our evaluation of restatements predominantly focuses on the materiality of adjustments to key financial statement line items. Where such adjustments exceed relevant thresholds, or where fraud or insider manipulation is involved, the Benchmark Policy will also consider recommending against audit committee members.

Looking Ahead

In the coming proxy season, we will be keen to understand whether the recent spike in accounting-related concerns reflects systemic challenges facing the accounting industry and increased burden on audit committees, or is primarily attributable to the recent SPAC and IPO boom – and, if the latter, whether the trend will subside now that many of these companies have had more time to establish appropriate frameworks for governance and oversight.

It may be useful for all public companies, regardless of how well established, to review their board’s structure and the breakdown of responsibilities assigned to different committees. In particular, boards need to meet increasing investor expectations regarding the oversight of subjects such as cybersecurity and ESG, without undermining their effectiveness in more traditional areas of oversight. With a range of tools at their disposal, including increases in board size, formation of new committees, or more frequent hiring of specialized consultants, we will continue to closely monitor how companies approach this challenge — and how investors respond.