The Securities and Exchange Commission has issued guidance on how to correct errors that have built up on the books over time. In the past, companies dealt with such errors — those that are too small to fix in any given time period but cumulatively can have a material effect on the balance sheet — in a number of ways. Now Staff Accounting Bulletin No. 108 explains how to determine if the cumulative errors are material and how to fix them.
Issued in September, SAB 108 could make for larger restatements when a reporting mistake is considered material. That’s because companies must now take into account both the cumulative impact of the error on the balance sheet and its effect on the income statement in a given year. In the past, they have generally adjusted the errors on one statement or the other.
Here’s an example that the SEC provided with the ruling: a company discovers an improper warranty expense accrual that overstates a warranty liability by $100, accumulated over five years at $20 a year. In each of those previous years, the company considered the misstatement immaterial. In the fifth year, it is quantified as a $20 overstatement of expenses. Typically a company handles the misstatement in one of two ways. Under the “rollover” approach, the error of $20 would be corrected. Under the “iron curtain” view, it is considered a $100 misstatement based on the balance sheet at the end of the fifth year, and the correction would be to reduce the liability by $100 and to decrease the current year’s warranty expense by $100.
The problem? The rollover approach leaves the balance sheet misstated, while the iron-curtain approach misstates the current-year expense. “Neither approach is necessarily going to provide a result that’s more satisfyingly right than the other in all circumstances,” notes accounting expert Jack T. Ciesielski. “Worse, in practice, firms may use one approach or the other,” or at least they could do so in the past.
SAB 108 says that starting with fiscal years ending after November 15, 2006, companies must use both approaches to fix misstatements. In the example, if the $100 error is considered material to the financial statements, adjustment would be required. But if the $100 correction would materially misstate the current year warranty expense, the firm would have to consider restating the prior financial statements for the $80 error.