The Dual Approach: FASB Proposal on Quantifying the Effects of Misstatements

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January 08, 2014

A recently issued proposed FASB Staff Position (FSP) will change the way privately held nongovernmental entities, including not-for-profit organizations, analyze uncorrected financial statement misstatements. This could result in the correction of misstatements that may not have been corrected under an entity’s prior approach to evaluating financial statement misstatements.

Proposed FSP 154-a, Considering the Effects of Prior-Year Misstatements When Quantifying Misstatements in Current-Year Financial Statements, is designed to address the diversity in practice that currently exists in quantifying financial statement misstatements. In practice two common techniques are used to quantify misstatements— either the rollover or iron curtain approach—as a basis for evaluating the materiality of misstatements in the current-year financial statements. Under the proposed FSP, an entity would be required to quantify misstatements using both of those approaches (the “dual approach”).

For example, entities that apply the rollover approach only consider the impact of errors originating in the current year income statement. Only applying this approach could result in the accumulation of errors in the balance sheet that may be immaterial to a particular income statement, but could misstate one or more balance sheet accounts or cause a material error in the income statement if the error(s) are adjusted in the current year.

The FASB issued the proposed FSP for the sole purpose of soliciting public comments. The FSP is not finalized and may include substantive changes if and when the Board approves the FSP for issuance.

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The Dual Approach
The dual approach requires entities to apply both of the following approaches as a basis for evaluating the materiality of misstatements in current-year financial statements:

  • Rollover approach—quantifies a misstatement based on the amount of the error originating in the current-year income statement (or the statement of activities, statement of changes in net assets, or statement of operations).
  • Iron curtain approach—quantifies a misstatement based on the effects of correcting the misstatement or misstatements that have accumulated in the balance sheet at the end of the current year.

Evaluating and Correcting the Error
Although the proposed FSP does not provide criteria for determining whether a misstatement is material, it would require the materiality assessment to consider all relevant quantitative and qualitative factors, as well as the effect of misstatements on future periods. If a misstatement is deemed material using either approach, the entity would first adjust its current-year financial statements. If a misstatement relating to prior years exists after adjusting the current-year financial statements, the entity would be required to correct the remaining misstatement if it is material to the current year. The entity must correct the remaining misstatement in the prior-year financial statements, regardless of whether it is material to the previously issued financial statements

Scope
The proposed FSP would apply to privately held nongovernmental entities, including not-for-profit organizations, that are outside the scope of SEC Staff Accounting Bulletin (SAB) 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 provides similar guidance for entities that are required to apply SABs.

Effective Date
The guidance in the proposed FSP would be effective for financial statements issued for fiscal years ending after June 15, 2007, with earlier application permitted. Therefore, if the FSP is finalized as proposed, an entity with a December 31 fiscal year-end would apply the FSP for its financial statements issued for the fiscal year ended December 31, 2007.

Transition
The proposed FSP provides special transitional guidance on initial adoption for entities that previously applied either the rollover or iron curtain approach properly. Those entities could elect to recognize the impact of applying the dual approach by recording a one-time cumulative-effect adjustment to beginning retained earnings. Alternatively, these entities could restate previously issued financial statements in accordance with FASB Statement 154, Accounting Changes and Error Corrections.

Entities that did not apply, or did not properly apply, either the rollover or iron curtain approach would be required to restate previously issued financial statements in accordance with Statement 154.

Disclosures
Entities that elect to recognize the impact of applying the dual approach by recording a cumulative-effect adjustment would be required to disclose the following for each error being corrected:

  • Nature and amount of each error
  • When and how each error arose
  • The fact that each error had been previously considered immaterial

Entities that do not reflect the transition to a dual approach through a cumulative-effect adjustment would be required to apply the disclosure guidance in Statement 154.

Illustrative Example
The following example illustrates the application of the dual approach. For simplicity, this example excludes the impact of income taxes.

Assume that at December 31, 20X6 an entity is evaluating a miscellaneous accrued expense of $100 that is not supportable. That accrual has increased by $20 each year since 20X2.

In each of the previous years, the entity evaluated the misstatement under the rollover approach and concluded that the $20 error was immaterial to the financial statements. Under the rollover approach, an entity only considers the current-year impact of the error ($20). However, under the iron curtain approach, an entity would consider the cumulative amount of the error existing in the current-year financial statements ($100).

Under the proposed FSP, the entity would need to evaluate both the $20 error and $100 error resulting from the two approaches and determine if either amount materially misstates the financial statements.

Take Note!
If the FSP is finalized as proposed, entities with a year ending June 30, 2007 would be required to apply the guidance in the proposed FSP in their June 30, 2007 financial statements. Therefore, these entities should closely monitor the FASB’s redeliberations and consider accumulating and evaluating uncorrected misstatements in the near future.

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