When the Securities and Exchange Commission gave companies a free pass last fall to fix old, accumulated errors without issuing a major restatement, companies lined up to take advantage of the opportunity.
And now that the first annual reports following that guidance are starting to appear, it seems that Corporate America had very little to fix.
That’s the conclusion of a handful of experts who have reviewed the earliest filings containing disclosures and adjustments as specified by the Commission's Staff Accounting Bulletin 108. In fact, contrary to what might be expected when correcting misstatements, one analyst who closely follows SAB 108 disclosures says a surprising number of companies have applied the guidance and booked an increase to retained earnings as a result.
Issued last September, SAB 108 requires companies to take a broader approach to their assessment of errors than previously required. Previously, companies were allowed to use one of two common methods to correct errors: the “rollover” method or the “iron curtain” method.
With the rollover method, companies might quantify a misstatement based on the amount of the error that originated in the current year income statement, ignoring any carryover effect from prior year misstatements. With the iron curtain approach, a company quantifies a misstatement based on the effects of correcting the misstatement existing in the balance sheet at the end of the current year, regardless of when the error occurred.
SAB 108 informed companies that going forward, they would be required to use both methods. But conceding that upon adoption, companies that had previously used only one method might find significant accumulated errors to correct, SAB 108 also allowed companies to book the correction as a one-time adjustment to retained earnings instead of viewing it as what otherwise might be deemed a material error requiring restatement.
Ciesielski
Jack Ciesielski, owner of research and advisory firm R.G. Associates and a frequent blogger on corporate disclosures, says he’s finding fewer juicy disclosures than he expected when it comes to SAB 108 adjustments. No clear pattern has emerged from the handful of adjustments he’s noticed so far, except that a surprising number of the adjustments are positive rather than negative, he says.
“You would figure that when companies would waive on adjustments, they would be adjustments that would hurt earnings,” he says. “Now I find that this is not statistically valid. It strikes me as odd that I’m coming up with a string of positive adjustments.”
The numbers aren’t large, Ciesielski says—just surprising in the direction they take on retained earnings. He notes, for example, an increase to retained earnings of $5.2 million for Triarc Companies, $2.4 million for CBL & Associates Properties, and about $9 million for Bowater.
Jay Hanson, partner and national director of accounting for McGladrey & Pullen, says such positive adjustments might well represent the elimination of overstated liabilities or accruals, which can accumulate as the result of immaterial, accumulated differences between estimates and actual final figures. In some cases, accruals have been billed as “cookie jar reserves” or “rainy day funds” companies have kept off the books to help pad results when the current period doesn’t turn out as they’d hoped.
“Many companies have had these excess liabilities because they had a conservative viewpoint,” Hanson says. “SAB 108 says you can’t be conservative and just leave it there.”
SAB 108
An excerpt follows from SAB 108 discussing the primary weaknesses of the rollover and iron curtain approaches.
The techniques most commonly used in practice to accumulate and quantify
misstatements are generally referred to as the “rollover” and “iron curtain” approaches.
The rollover approach, which is the approach used by the registrant in this
example, quantifies a misstatement based on the amount of the error originating in the
current year income statement. Thus, this approach ignores the effects of correcting the
portion of the current year balance sheet misstatement that originated in prior years (i.e.,
it ignores the “carryover effects” of prior year misstatements).
The iron curtain approach quantifies a misstatement based on the effects of
correcting the misstatement existing in the balance sheet at the end of the current year,
irrespective of the misstatement’s year(s) of origination. Had the registrant in this fact
pattern applied the iron curtain approach, the misstatement would have been quantified as
a $100 misstatement based on the end of year balance sheet misstatement. Thus, the
adjustment needed to correct the financial statements for the end of year error would be
to reduce the liability by $100 with a corresponding decrease in current year expense.
As demonstrated in this example, the primary weakness of the rollover approach
is that it can result in the accumulation of significant misstatements on the balance sheet
that are deemed immaterial in part because the amount that originates in each year is
quantitatively small. The staff is aware of situations in which a registrant, relying on the
rollover approach, has allowed an erroneous item to accumulate on the balance sheet to
the point where eliminating the improper asset or liability would itself result in a material
error in the income statement if adjusted in the current year. Such registrants have
sometimes concluded that the improper asset or liability should remain on the balance
sheet into perpetuity.
In contrast, the primary weakness of the iron curtain approach is that it does not
consider the correction of prior year misstatements in the current year (i.e., the reversal of
the carryover effects) to be errors. Therefore, in this example, if the misstatement was
corrected during the current year such that no error existed in the balance sheet at the end
of the current year, the reversal of the $80 prior year misstatement would not be
considered an error in the current year financial statements under the iron curtain
approach. Implicitly, the iron curtain approach assumes that because the prior year
financial statements were not materially misstated, correcting any immaterial errors that
existed in those statements in the current year is the “correct” accounting, and is therefore
not considered an error in the current year. Thus, utilization of the iron curtain approach
can result in a misstatement in the current year income statement not being evaluated as
an error at all.
The staff does not believe the exclusive reliance on either the rollover or iron
curtain approach appropriately quantifies all misstatements that could be material to users
of financial statements.
Source
Staff Accounting Bulletin 108 (Securities And Exchange Commission; Sept. 13, 2006)
Anthony Lopez, senior managing director for FTI Consulting and a former associate chief accountant for the SEC, says positive adjustments to retained earnings might occur for a variety of reasons, especially because of unadjusted differences.
Lopez gives the example of a company that has two unadjusted differences—say, a $300 credit that would be reported in the income statement and a $100 debit that would be reported as an operating expense. “Management will not want to make the adjustment even though the net credits are net $200 positive to net income, because they care more about the $100 hit to operating expense,” he explains.
For most companies, Hansen says, accruals and other errors that typically were allowed to accumulate have already been addressed in recent years as a result of Sarbanes-Oxley and its Section 404 scrutiny of internal controls over financial reporting, and the ensuing wave of restatements since 2004.
“Because of the attention [of] the last several years to Section 404 process for internal controls, companies are getting to the right answers more, so they don’t have these issues accumulating,” he says. “And with so many companies restating for many different reasons the past few years, all errors tend to get swept into that restatement, so companies haven’t had many of these uncorrected errors that SAB 108 is meant to get.”
Lopez says the SEC’s concern about the dueling methods for correcting errors dates back to 1999 when the staff issued SAB 99 on materiality. Even then, the staff was nudging companies and auditors that the SEC preferred a more comprehensive view of materiality assessments, Lopez says. “In the time since it was originally raised, from 1999 to now, some companies have simply fixed the problem themselves.”
For companies that have errors to correct, the disclosure requirements of SAB 108 require management to use some candor in describing how the error accumulated, Lopez says. “They can spin it and dress it up. But at the end of the day I don’t think companies are going to be eager to have to disclose why they had this mistake.”
That might be the sting felt these days at K-Swiss, a $500 million footwear company in Westlake Village, Calif. Under the SAB 108 guidance, Ciesielski says, the company disclosed a problem with an offshore payroll tax dating back to 1993. It’s a $5.1 million withholding underpayment, but with penalties and interest it could produce a $50 million hit to earnings, Ciesielski says.
Lane
Brian Lane, a partner in corporate securities law with Gibson, Dunn & Crutcher and a former director of the SEC’s Division of Corporate Finance, says SAB 108 may not be getting much attention because it’s highly technical and applies to a narrow population of companies.
“If you were to ask companies whether they use the rollover or iron curtain method, most people wouldn’t be able to tell you because they apply a traditional materiality analysis,” he says. “The effect of the dual approach is a quantitative analysis to see if an error is material to the income statement and the balance sheet, both in the current period and prior periods. The dual approach is really the approach most companies have been using all along.”
No comments yet