How Much is that Error on the Books?

Following new SEC guidance, companies have a new way to 'fess up on errors in their next 10-K.
Helen ShawSeptember 14, 2006

The Securities and Exchange Commission has issued guidance that will help companies erase prior misstatements on their financial statements. Additionally, the guidance explains how, going forward, companies should quantify errors and correct them.

Staff Accounting Bulletin No. 108 offers interpretive guidance on how a company with errors in its financial statements should determine whether the error is material enough to correct it. It’s a problem fraught with complications when errors that are insignificant in any given year build up over time to a point at which — if they were corrected — would materially distort the financial results in the year in which the correction is made.

For example, if a company incorrectly accrues a $20 liability every year for five years, at the end of the fifth year, the company is faced with the quandary: is the error only the $20 that is new in the fifth year, or is the error the cumulative $100 that built up over five years?

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Over the past 70 years, when calculating the misstatement amount caused by errors that span more than one reporting period, accountants have used one of two different approaches — either the “rollover” approach, or the “iron curtain” approach.

Under the rollover approach, also known as the “current period” or “income statement” approach, the error is quantified as the amount by which the current year income statement is misstated. But by relying exclusively on this approach, companies introduce an error in their balance sheet. Over time, that error can grow so large that correcting it would materially distort their financial statements. It was, in fact, this very quandary that led SEC staff to seek a better solution.

The “iron curtain” approach, also known as the “cumulative” or “balance sheet” approach, quantifies the error as the cumulative amount by which the current year balance sheet is misstated. But, just as the income statement approach can introduce errors into the balance sheet, so the balance sheet approach can cause companies to disregard the impact that correcting a past error might have on their current income statement.

Given the drawbacks of both approaches, the SEC staff guidance instructs accountants to evaluate whether an error is material based on the higher result of those two approaches, explains Scott Taub, deputy chief accountant at the SEC.

The SEC’s bulletin provides something of a middle ground for companies — not forcing them to take a huge financial hit for admitting to errors, yet not providing total amnesty either. In the first 10-K report that companies file after this SEC bulletin, companies will need to fix the misstatements on their balance sheets by recording the cumulative effect on their current year rather than restating prior year financial statements. As a result, some companies will make adjustments to shareholder equity and will explain which errors they had on their books and why in their 10-K report. “Companies are required to correct these errors, but in a less painful
way than they otherwise might have needed to,” said Taub, who added that the SEC staff realizes these misstatement situations developed at companies that did not necessarily intend to deceive.

While previous regulatory attempts at addressing this accounting dilemma have failed, the SEC staff wanted to correct the situation and fix corporate books without doing it in an extremely harsh way, noted Taub. “These difficult errors shouldn’t arise again because [companies] will be correcting things more often in the period that they discover them,” said Taub.