Misstatements, particularly if detected after the financial statements have been produced and distributed, may under certain circumstances be left uncorrected. This decision is directly impacted by judgments about materiality. The financial statement preparer is expected to exercise professional judgment in determining the level of materiality to apply in order to cost-effectively prepare full, complete, and accurate financial statements in a timely manner. However, there have been instances where the materiality concept has been used to rationalize the non-correction of errors that should have been dealt with, and indeed even to excuse errors known when first committed. The fact that the concept of materiality has sometimes been abused led to the promulgation of further guidance relative to error corrections.
Although independent auditors are charged with obtaining sufficient evidence to enable them to provide the financial statement user with reasonable assurance that management’s financial statements are free of material misstatement, the financial statements are primarily the responsibility of the preparers. Certain auditing literature is therefore germane to the preparers’ consideration of matters such as error corrections and application of materiality guidelines.
These matters are further explored in this post. Follow on…
Types of Misstatements
Preparers of financial statements obviously will need to have control procedures to reduce the risk of accounting errors being committed and not detected.
From the auditors’ perspective, it is required that the examination be conducted in a manner that will provide reasonable assurance of detecting material misstatements, including those resulting from errors. Auditors will evaluate both known misstatements and likely misstatements (i.e., those projected to exist based on sample data gathered during the audit), as defined in SAS 107 of the auditing literature. “Known misstatements“ arise from:
- Incorrect selection or application of accounting principles
- Errors in gathering, processing, summarizing, interpreting, or overlooking relevant data
- An intent to mislead the financial statement user to influence their decisions
- To conceal theft
“Likely misstatements“ arise from:
- Differences in judgment between management and the auditor regarding accounting estimates where the amount presented in the financial statements is outside the range of what the auditor believes is reasonable.
- Amounts that the auditor has projected (the statistical term “extrapolated” is also used in this context) based on the results of performing statistical or non-statistical sampling procedures on a population.
Under auditing standards, auditors are responsible for accumulating all known and likely misstatements except those that, in the auditor’s judgment, are trivial or inconsequential. In forming judgments regarding the triviality of misstatements, auditors consider whether the misstatement individually or when aggregated with other similar amounts would be considered immaterial to the financial statements.
Despite many efforts to develop a firm definition of materiality that have been made by academicians and the profession over the decades, a universally agreed-upon definition of materiality remains elusive, and thus a matter for professional judgment (although the legal definition, of being likely to affect the conclusion reached by a decision maker, remains useful).
Auditors are expected to communicate known and likely misstatements to management in a timely manner, distinguishing between these categories. Timely communication is important in order to provide management the opportunity to evaluate whether they concur that the items are misstatements and to determine whether to adjust the financial statements or request that the auditor obtain additional evidence.
Auditors are obligated by professional standards to request that management record adjustments to correct all known misstatements, other than those deemed to be trivial. Because some of these may be based on audit sampling results, some management may either resist because there is inherent distrust of projections, or because it will not be clear how corrections can be recorded when the error items cannot be specifically identified.
“Likely misstatements“ are treated as follows:
- If the likely misstatement results from a projection to the population from examination of a sample, auditors will request management to examine the relevant population from which the sample was drawn. This might be a class of transactions, an account balance, or the information required to be presented in a disclosure. The purpose of the requested examination is for management to identify and correct misstatements in the remaining population, (i.e., the items [units] in the population that the auditors did not select for detailed testing). For example, the auditor may identify a misstatement caused by an error in inventory pricing relative to raw materials. Management would be requested, in this case, to reexamine the entire raw materials inventory to determine whether it includes other misstatements and to correct any other misstatements found as a result of the reexamination.
- If the likely misstatement results from differences in estimates—such as the magnitude of the amount needed for the allowance for uncollectible accounts receivable—the auditors should request that management review the methods and assumptions used to develop their estimate.
Ultimately, management is responsible for deciding how to respond to auditor’s requests and whether it wishes to correct some or all of the misstatements brought to its attention by the auditors. Both the auditors and management, in assessing the impact of uncorrected misstatements, are required to assess materiality both quantitatively and qualitatively, from the standpoint of whether a financial statement user would be misled if a misstatement were not corrected or if, in the case of informative disclosure errors, full disclosure was not made.
Qualitative considerations include (but are not limited to) whether the misstatement:
- Arose from estimates or from items capable of precise measurement and, if the misstatement arose from an estimate, the degree of precision inherent in the estimation process.
- Masks a change in earnings or other trends
- Hides a failure to meet analysts’ consensus expectations for the reporting entity
- Changes a loss to income or vice versa
- Concerns a segment or other portion of the reporting entity’s business that has been identified as playing a significant role in operations or profitability
- Affects compliance with loan covenants or other contractual commitments
- Increases management’s compensation by affecting a performance measure used as a basis for computing it
- Involves concealment of an unlawful transaction
Misstatements from Prior Years [Rollover Vs Iron Curtain Methods]
Management, with the concurrence of the reporting entity’s auditors, may have decided to not correct misstatements that occurred in one or more prior years because, in their judgment at the time, the financial statements were not materially misstated. Two methods of making that materiality assessment—sometimes referred to as the “rollover” and the “iron curtain” methods—have been widely used in practice.
These are described and illustrated in the following paragraphs. Read on…
The rollover method quantifies a misstatement as its originating or reversing effect on the current period’s statement of income, irrespective of the potential effect on the balance sheet of one or more prior periods’ accumulated uncorrected misstatements.
The iron curtain method, on the other hand, quantifies a misstatement based on the accumulated uncorrected amount included in the current, end-of-period balance sheet, irrespective of the year (or years) in which the misstatement originated.
Each of these methods, when considered separately, has strengths and weaknesses, as follows:
- Focuses on: Current period income statement
- Strength: Focuses on whether the income statement of the current period is materially misstated assuming that the balance sheet is not materially misstated
- Weakness: Material misstatement of the balance sheet can accumulate over multiple periods
Iron curtain Method:
- Focuses on: End of period balance sheet
- Strength: Focuses on ensuring that the balance sheet is not materially misstated irrespective of the year or years in which a misstatement originated
- Weakness: Does not consider whether the effect of correcting a balance sheet misstatement that arose in one or more periods is material to the current period income statement.
Guidance for SEC Registrants on How Treat Misstatement
The SEC staff issued SAB 108, Considering the Effects of Prior Year Misstatements in Current Year Financial Statements, in order to address how registrants (i.e., publicly held corporation) are to evaluate misstatements. SAB 108 prescribes that if a misstatement is material to either the income statement or balance sheet, it is to be corrected in a manner set forth in the bulletin and illustrated in the example below.
Lie Dharma Putra, the CFO of Royal Industries, is preparing the company’s 2009 financial statements. The company has consistently overstated its accrued liabilities by following a policy of accruing the entire audit fee it will pay its independent auditors for auditing the financial statements for the reporting year, even though approximately 80% of the work is performed in, and is thus an expense of, the following year.
Due to regular increases in audit fees, the overstatement of liabilities at 12/31/2009 has accumulated as follows:
Year ended 12/31 Amount of misstatement End-of-year
originating during year accumulated misstatement
2005 $15 $15
2006 5 20
2007 5 25
2008 5 30
2009 10 40
Lie has consistently used the rollover approach to assess materiality and, in all previous years, had judged the amount of the misstatement that originated during that year to be immaterial.
Lie analyzes the misstatement as follows:
- Applying the rollover approach, as he had done consistently in the past, Lie computes the misstatement as the $10 that originated in 2009. In his judgment, this amount is immaterial to the 2009 income statement.
- Applying the iron curtain approach, Lie evaluates whether the accumulated misstatement of $40 materially misstates the balance sheet at 12/31/2009. Lie believes that, considering both quantitative and qualitative factors, the misstatement has grown to the point where it does result in a materially misstated balance sheet.
According to SAB 108 and as shown on the diagram, Lie would record an adjustment to correct the balance sheet as follows:
[Debit]. Accrued professional fees = $40,000
[Credit]. Professional fees (general and administrative expenses) = $40,000
Note: To correct balance sheet by reversing misstated accrual for audit fees not yet incurred.
Upon review of the effect of the correcting entry, Lie believes that recording the entry will result in a material misstatement to the 2009 income statement. Consequently, to avoid this result, the prior years’ financial statements of Royal Industries would, under normal circumstances, be required to be restated as previously discussed in the section of this chapter covering error corrections. This would be the case even if the adjustment to the prior year financial statements was, and continues to be, immaterial to those financial statements. The SEC would not, however, require Royal Industries to amend previously filed reports; instead, registrants are permitted to make the correction in the next filing submitted to the SEC that includes the prior year financial statements.
In addition, the SEC provided transition relief for certain reporting entities initially adopting SAB 108. The SEC staff indicated in SAB 108 that in the following circumstances the ASC 250 requirement for prior period restatement would be waived:
- The reporting entity’s initial registration statement was effective on or before November 15, 2006; and
- Management had, in the past, properly applied its pervious method of evaluating misstatements (either iron curtain or rollover), including consideration of all relevant qualitative factors (which the SEC set forth in SAB 99, Materiality).
Registrants that meet these criteria are permitted to reflect the results of initial application of SAB 108 as a cumulative effect adjustment to retained earnings as of the beginning of the fiscal year. Disclosures are required of:
- The nature and amount of each individual error correction included in the cumulative effect adjustment;
- When and how each error arose; and
- The fact that the errors had been previously considered to be immaterial.
The SEC encouraged early adoption of this guidance in any report for an interim period ending in the first fiscal year ending after November 15, 2006, that is filed after September 13, 2006, the publication date of SAB 108. If the cumulative effect adjustment occurs in an interim period other than the first interim period, the SEC waived the requirement that previously filed interim reports for that fiscal year be amended. Instead, comparative information presented for interim periods of the first year subsequent to initial application are to be adjusted to reflect the cumulative effect adjustment as of the beginning of the fiscal year of initial application. The adjusted results are also required to be included in the disclosures of selected quarterly information that are required by Regulation S-K, Item 302.
Entities that do not meet the criteria to use the cumulative effect adjustment are required to follow the provisions of ASC 250 that require restatement of all prior periods presented in the filing.
Misstatement Treatment Guidance for Private Entities
FASB had proposed the issuance of a proposed FSP FAS 154-a, Considering the Effects of Prior-Year Misstatements When Quantifying Misstatements in Current-Year Financial Statements, in early 2007.
If it had been issued as proposed, the FSP would have, in essence, adopted SAB 108 for all nongovernmental reporting entities that are not subject to SAB 108, including not-for-profit organizations.
It would have, in common with SAB 108, permitted a onetime cumulative effect adjustment to retained earnings upon initial application, if management had previously evaluated misstatements for materiality using both quantitative and relevant qualitative factors using either the rollover method or the iron curtain method (but not both).
FASB subsequently decided to not issue this FSP, and removed the project from its agenda. Notwithstanding this development, readers are reminded that SABs offer useful guidance even for non-registrants and their auditors. In the authors’ opinion, these bulletins would be among the non-authoritative literature to be considered when deliberating application of GAAP in the absence of authoritative guidance found in higher levels of the formal GAAP hierarchy.