If you are a registered user please log in to see more postings.
 

The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis. All posts prior to September, 2007 are in the public domain, but after September 4, only subscribers to The Analyst's Accounting Observer will see all posts going forward. Only selected, occasional posts will be released to the public domain from September 4 forward.

Subscriptions to full posts available for $500 annually.
The SEC's New Stand On Fixing Errors
Location: BlogsAAO Weblog (Public)    
Posted by: Jack Ciesielski 9/15/2006 7:01 AM
When it comes to fixing misstatements, "diversity in practice" abounds. Now a consistent approach for correcting errors is finally here. It's been in the works for what seems like forever; it was expected to be issued at least a year ago.

It's called Staff Accounting Bulletin No. 108, SAB 108 for short, and I think you'll be hearing "SAB 108" a lot in the upcoming reporting season. That's because the bulletin requires companies to evaluate known errors in accounts to a finer degree than in the past.

Consider that there are two approaches in practice for assessing how serious a misstatement might be: the “rollover” and “iron curtain” approaches. In the rollover approach, a firm reckons that an account is misstated based on the amount of the error originating in the current year income statement; any previous years' misstatements are ignored, because they were assessed the same way in the previous years and found to be immaterial. Problem is, any prior misstatements are carried forward on the balance sheet - and the balance sheet becomes less than factual.

In the "iron curtain" method, the grounds for whether or not a misstatement is material are based on the end-of-current-year balance sheet effects of correcting it - regardless of the year (or years) the misstatement arose. Tough love!

A simple example of the two approaches, borrowed from the bulletin: suppose a firm discovers say, an improper warranty expense accrual which overstates warranty liability by $100, accumulated over 5 years at $20 per year. In each of those previous years, the firm considered the misstatement to be immaterial. In the fifth year (now), it's quantified as a $20 overstatement of expenses. The rollover approach would be to correct the error for $20; taking the "iron curtain" view, it's considered a $100 misstatement based on the end of year balance sheet, and the correction would be to reduce the liability by $100 and also to decrease current year warranty expense by $100.

The rollover approach leaves the balance sheet misstated; the iron curtain approach misstates current year expense. Neither approach is necessarily going to provide a result that's more satisfyingly right than the other in all circumstances. Worse: in practice, firms may use one approach or the other. There could be a lot of bogus assets or liabilities on balance sheets due to the use of the rollover approach; the iron curtain approach might have affected operating results favorably (or not) in any particular quarter without investors being aware of the misstatement it caused.

What's a firm to do when it finds problems? SAB 108 says firms are going to have to use BOTH approaches to evaluate misstatements. In the example, if the $100 misstatement is considered material to the financial statements, adjustment would be required. If the $100 correction will materially misstate the current year reporting of warranty expense, the firm would have to consider restating the prior financial statements for the $80 error.

The SAB won't require firms to necessarily reissue old financials: corrections will be allowed the next time the firm files prior year financial statements. There's a grace period: the SEC staff won't object if firms do not restate financial statements for fiscal years ending on or before November 15, 2006, asl long as errors were properly considered under either the iron curtain or rollover approach. But if they choose not to restate for errors they still need to fully disclose the effects of the catch-up adjustments.

What does it mean for the upcoming reporting season? Given the worship slathered on the income statement by companies and investors alike, you'd have to believe that the rollover method has been more common in practice than the iron curtain method. It's likely, then, that we'll see a lot more cumulative errors being reported, and they might show how poorly companies have handled known errors. How widespread? No idea here; to say you know how widespread it is implies that you know where all the errors currently exist, which is quite impossible. (Wouldn't need a policy for error correction, would we? But I suppose there are financial economists who would say so.)

The SEC has an idea of how widespread error correction problems might be due to its catbird seat: it sees financials before investors do, and has a view into corporate error-handling. See if this excerpt from the bulletin wakes you up:

"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." [Emphasis added.]

It'll be a very interesting reporting season indeed. As if it wasn't going to be interesting enough with the possibility of backdating corrections all over the financial reporting landscape.
Permalink |  Trackback