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SEC Issues Guidance on Quantifying Financial Statement Misstatements

The SEC's Office of the Chief Accountant and the Divisions of Corporation Finance and Investment Management have issued Staff Accounting Bulletin No. 108 to address the diversity of approaches used to quantify financial statement misstatements. The staff has concluded that the exclusive reliance on either the rollover or the iron curtain approach does not appropriately quantify all misstatements that could be material to users of financial statements. While some have suggested that errors be permitted to remain on the balance sheet as assets or liabilities in perpetuity, the staff believes that registrants must quantify the impact of correcting all misstatements, including the carryover and reversing effects of prior year misstatements on the current year's financial statements. This can be achieved by evaluating the error under both approaches, according to the staff.

Staff Accounting Bulletin 108 explains that the diversity in approaches for quantifying the amount of misstatements most frequently relates to the effects of misstatements that were not corrected at the end of the prior year. These prior year misstatements should be considered in quantifying misstatements in the current year's financial statements, according to the staff.

The rollover approach quantifies a misstatement based on the amount of the error in the current year income statement. It ignores the carryover effects of prior year misstatements. The iron curtain approach quantifies a misstatement based on the effects of correcting the misstatement that exists in the balance sheet at the end of the current year, regardless of the year of the misstatement's origination.

The primary weakness of the rollover approach is that it can result in the accumulation of significant misstatements on the balance sheet that are considered immaterial since the amount that originates each year is quantitatively small. This approach, on occasion, has resulted in a situation in which a registrant has allowed an erroneous item to accumulate on the balance sheet to the extent that its elimination would result in a material error in the income statement if adjusted in the current year.

The primary weakness of the iron curtain approach is that it does not consider the correction of prior year misstatements in the current year to be errors. The result is that a misstatement in the current year income statement may not be evaluated as an error at all.

Accordingly, the staff has concluded that registrants must quantify the impact of correcting all misstatements, including both the carryover and the reversing effects of prior year misstatements on the current year financial statements. Financial statements must be adjusted when either approach results in quantifying a misstatement that is material after considering all relevant quantitative and qualitative factors.

The correction of prior year financial statements for immaterial errors would not require previously filed reports to be amended. The correction can be made the next time the registrant files the prior year financial statements. Further, the staff will not object if a registrant does not restate financial statements for fiscal years ending on or before November 15, 2006 if management properly applied its previous approach, as long as all relevant qualitative factors were considered.

The staff advised that registrants electing not to restate prior periods should reflect the effects of initially applying the guidance in their annual financial statements for the first fiscal year ending after November 15, 2006. The cumulative effect of the initial application of the guidance should be reported in the carrying amounts of assets and liabilities as of the beginning of the fiscal year. The offsetting adjustment should be made to the opening balance of retained earnings for that year. The staff added that registrants should disclose the nature and amount of each error that is being corrected in the cumulative adjustment. The disclosure should describe when and how the error arose and that it was previously considered immaterial.

The staff encourages early application of its guidance for any interim period of the first fiscal year ending after November 15, 2006. If the cumulative effect of applying the guidance is first reported in an interim period other than the first interim period for the first fiscal year ending after November 15, 2006, previously filed interim reports need not be amended.

Comparative information that is presented in reports for interim periods in the first year subsequent to the initial application of the guidance should be adjusted to reflect the cumulative effect adjustment as of the beginning of the year of initial application. The adjusted results should also be disclosed in the selected quarterly information required by Regulation S-K Item 302.

Staff Accounting Bulletin No. 108 (SEC) will be published in a forthcoming Report.