SEC issues SAB 108

By: Cydney Posner

The SEC announced today the release of SAB 108, which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. Click here for Staff Accounting Bulletin No. 108.

There have been two common approaches used to quantify and evaluate the materiality of these types of errors. The "rollover approach" quantifies a misstatement based on the amount of the error originating in the current year income statement (that is, the auditors look only at the current period and do not take into account any prior uncorrected mistakes). The SEC believes that approach ignores the "carryover effects" of prior year misstatements. The "iron curtain" approach quantifies the error as the cumulative amount by which the current year balance sheet is misstated (that is, the auditors aggregate total misstatements from prior periods that have not been adjusted, sometimes referred to as "passed adjustments" and then compare this aggregate to the financial statements). (Of course, those of you who have studied Part V, question 44 of Cooley's audit committee handbook already know all about this.) The SEC sees potential problems with both approaches: with the rollover approach, erroneous items can accumulate on the balance sheet to the point where eliminating the error would itself result in a material error in the income statement if adjusted in the current year. In those cases, companies have sometimes concluded that the improper asset or liability should remain on the balance sheet in perpetuity. In contrast, the iron curtain approach does not consider the correction of prior year misstatements in the current year (i.e., the reversal of the carryover effects) to be errors; as a result, "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."

In the SAB, the SEC advocates that companies should quantify and evaluate errors using both approaches. A company'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. In applying the iron curtain approach, however, the SAB provides that, if the misstatement is material to the current year, "the prior year financial statements should be corrected, even though such revision previously was and continues to be immaterial to the prior year financial statements. Correcting prior year financial statements for immaterial errors would not require previously filed reports to be amended. Such correction may be made the next time the registrant files the prior year financial statements."

The SAB states that the staff will not object if a public reporting company does not restate financial statements for fiscal years ending on or before November 15, 2006, if management properly applied its previous approach, either iron curtain or rollover, so long as all relevant qualitative factors were considered.

The SAB reminds us that a change from an accounting principle that is not generally accepted to one that is generally accepted is a correction of an error. The SAB is just full of helpful examples if you want to delve into this topic further.

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