The Securities and Exchange Commission has decided it’s time for companies to clean up their financial statements this fall, shoring up errors that have been hiding like dust bunnies under the sofa for years.
Under the leadership of newly appointed Chief Accountant Conrad Hewitt, the SEC staff has issued Staff Accounting Bulletin No. 108 to require that companies take a fresh look at errors that have been accumulating in their financial statements for years, correct them, and do so without restating.
SAB 108 tells companies the SEC is not picking sides and directing companies to choose between the two common approaches companies follow to determine if errors are material and require correction. Instead, it’s telling companies to use both approaches and fix the mistakes once and for all—with no restatement required.
Selling
When companies find errors in prior year financial statements, they’re faced with several dilemmas about whether and how to fix them. U.S. Generally Accepted Accounting Principles “have long specified only one solution to error correction: restatement of all periods affected,” says Tom Selling, a financial reporting consultant and adviser to the Association of Audit Committee Members.
But since nobody relishes in having to restate, especially for small mistakes that don’t have a material impact on the outcome, two partial solutions have become popular as substitutes for full restatement, Selling says. Neither offers a perfect correction, however, so minute errors in calculations can linger and even accumulate over time. That is what disturbs the SEC, and is what SAB 108 seeks to change.
The “rollover,” or income statement approach, quantifies an error as the amount by which the current year's income statement is misstated. The “iron curtain,” or balance sheet approach, quantifies an error as the amount by which the current year's balance sheet is misstated. When errors in prior years are uncorrected, these approaches result in two different answers.
EXCERPT
Below is an excerpt of the SEC's SAB 108.
The staff believes registrants must quantify
the impact of correcting all misstatements, including both the carryover and reversing effects of prior year misstatements, on the current year financial statements. The staff believes that this can be accomplished by quantifying an error under both the rollover and iron curtain approaches as described above and by evaluating the error measured under each approach. Thus, a registrant’s financial statements would require adjustment when
either approach results in quantifying a misstatement that is material, after considering all relevant quantitative and qualitative factors.
Source
Securities and Exchange Commission (Sept. 13, 2006)
“The rollover approach corrects the error in the current year, but leaves the effect of prior years uncorrected,” Selling says. “The iron curtain approach corrects the cumulative error in assets and liabilities, but recognizes the cumulative effect of the errors in the current period’s income statement only.”
Companies typically choose one method or the other, but the SEC says it wants companies to look at their mistakes under both approaches. “The SEC staff believes that registrations should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material,” the SEC said in a statement.
Hewitt, who assumed his post as chief accountant at the SEC in late July, says the dual method will result in more accurate financial reporting—and he’s giving companies a one-time holiday from restatement to make a catch-up adjustment.
“The staff will not object if a registration records a one-time cumulative effect adjustment to correct errors existing in prior years that previously had been considered immaterial—quantitatively and qualitatively—based on appropriate use of the registrants’ previous approach,” he said in a statement.
The SEC has long pondered how to address the problem of correcting immaterial errors because they can accumulate over time to create material distortions in a company’s balance sheet. The two different approaches that companies and auditors have developed and used over the years have created diversity in practice and lack of comparability that furrows the brow among SEC staff. In various speeches over the past several years, SEC staffers have addressed the subject and indicated that they were working on a solution.
Scheuerell
“This has been a long time coming,” says Frank Scheuerell, a partner at accounting firm Callaway Partners and a former staff member at the Financial Accounting Standards Board. “This is an issue that’s been debated among accountants for years.”
That’s at least in part because the concept of materiality is an area so subject to judgment, Scheuerell contends. The rule for most companies, he says, is 5 percent of net income; anything above that threshold can lead to a restatement. Other factors also help determine if 5 percent is material, like whether making the adjustment would change investors’ minds about whether to invest.
In a speech last year at an accounting conference, SEC professional accounting fellow Brian Roberson provided an illustration of how the two different approaches companies follow resolve only part of the problem and potentially create an accumulating error that never gets fixed.
“A simple example is a liability that was overstated by $80 in the prior year and is overstated by $100 in the current year,” he said. “The rollover approach would quantify the error as the amount by which the current year income statement is misstated, or $20 in this example, while the iron curtain approach would quantify the error as the amount by which the current year balance sheet is misstated, or $100.”
The rollover approach could allow large errors to accumulate on the balance sheet as long as the change is immaterial to income in each year, he said, but the iron curtain approach has its shortcomings as well.
“In this example, if the $80 prior-year error was corrected in the current year, the rollover approach would quantify the error as the $80 overstatement of current year income due to the out-of-period correction, while the iron curtain approach would disregard the error since the end of period balance sheet is correct,” he said.
Roberson said at that time—and other SEC staffers had said even earlier—that the staff was mulling a more comprehensive approach. Yet Hewitt, less than two months on the job, has issued the definitive guidance calling for the comprehensive approach and giving a pass on full-scale restatement as companies face the cleanup effort.
Bishop
That’s significant, says Keith Bishop, a partner at the law firm Buchalter Nemer and a former securities regulator for the state of California, because it sends a signal that Hewitt likes certainty. “It’s his first effort out of the box, and you might read from this that he is trying to give as much guidance as possible,” Bishop says.
Lynn Turner, former chief accountant for the SEC and now managing director of research for investment research and proxy firm Glass, Lewis & Co., said companies may react differently to the guidance perhaps depending on how it affects their financials. “I suspect how people will react depends on how big the errors are in their financial statements that they will now be required to clean up, and in doing so, how embarrassing it will be for them to disclose [that] they previously had those errors,” he says.
Turner
Turner says the accumulation of errors was a significant discovery when accounting problems came to light at trash disposal giant Waste Management. “Arthur Andersen had allowed the company to record errors each year because each year they were small enough to be immaterial, but after a number of years they had built up to be quite substantial,” Turner says.
The adjustments companies will be making may “open up doors to private action,” Selling warns. “Even though an amended report has not been filed, investors and their attorneys will have quantitative fodder for questioning a company’s materiality judgments … If a known error, albeit immaterial, existed, why didn’t the company simply make the appropriate entries to fix it when it was discovered? Failure to make a little-or-no-cost correction may be viewed as a tacit admission of materiality.”
The guidance is effective for fiscal years ending after Nov. 15, 2006, so calendar-year companies will begin showing adjustments and related disclosures with their year-end filings, Scheuerell says.
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