[Federal Register Volume 71, Number 180 (Monday, September 18, 2006)]
[Rules and Regulations]
[Pages 54580-54582]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-15457]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 211

[Release No. SAB 108]


Staff Accounting Bulletin No. 108

AGENCY: Securities and Exchange Commission.

ACTION: Publication of Staff Accounting Bulletin.

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SUMMARY: The interpretations in this Staff Accounting Bulletin express 
the staff's views regarding the process of quantifying financial 
statement misstatements. The staff is aware of diversity in practice. 
For example, certain registrants do not consider the effects of prior 
year errors on current year financial statements, thereby allowing 
improper assets or liabilities to remain unadjusted. While these errors 
may not be material if considered only in relation to the balance 
sheet, correcting the errors could be material to the current year 
income statement. Certain registrants have proposed to the staff that 
allowing these errors to remain on the balance sheet as assets or 
liabilities in perpetuity is an appropriate application of generally 
accepted accounting principles. The staff believes that approach is not 
in the best interest of the users of financial statements. The 
interpretations in this Staff Accounting Bulletin are being issued to 
address diversity in practice in quantifying financial statement 
misstatements and the potential under current practice for the build up 
of improper amounts on the balance sheet.

DATES: September 13, 2006.

FOR FURTHER INFORMATION CONTACT: Mark S. Mahar, Office of the Chief 
Accountant (202) 551-5300, Todd E. Hardiman, Division of Corporation 
Finance (202) 551-3400, or Toai P. Cheng (202) 551-6918, Division of 
Investment Management, Securities and Exchange Commission, 100 F 
Street, NE., Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The statements in staff accounting bulletins 
are not rules or interpretations of the Commission, nor are they 
published as bearing the Commission's official approval. They represent 
interpretations and practices followed by the Division of Corporation 
Finance, the Division of Investment Management and the Office of the 
Chief Accountant in administering the disclosure requirements of the 
Federal securities laws.

    Dated: September 13, 2006.
Nancy M. Morris,
Secretary.

PART 211--[AMENDED]

0
Accordingly, Part 211 of Title 17 of the Code of Federal Regulations is 
amended by adding Staff Accounting Bulletin No. 108 to the table found 
in Subpart B.

[[Page 54581]]

Staff Accounting Bulletin No. 108

    The staff hereby adds Section N to Topic 1, Financial Statements, 
of the Staff Accounting Bulletin Series. Section N provides guidance on 
the consideration of the effects of prior year misstatements in 
quantifying current year misstatements for the purpose of a materiality 
assessment.

    Note: The text of SAB 108 will not appear in the Code of Federal 
Regulations.

Topic 1: Financial Statements

* * * * *

N. Considering the Effects of Prior Year Misstatements When Quantifying 
Misstatements in Current Year Financial Statements

    Facts: During the course of preparing annual financial statements, 
a registrant is evaluating the materiality of an improper expense 
accrual (e.g., overstated liability) in the amount of $100, which has 
built up over 5 years, at $20 per year.\1\ The registrant previously 
evaluated the misstatement as being immaterial to each of the prior 
year financial statements (i.e., years 1-4). For the purpose of 
evaluating materiality in the current year (i.e., year 5), the 
registrant quantifies the error as a $20 overstatement of expenses.
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    \1\ For purposes of these facts, assume the registrant properly 
determined that the overstatement of the liability resulted from an 
error rather than a change in accounting estimate. See FASB 
Statement 154, Accounting Changes and Error Corrections, paragraph 
2, for the distinction between an error and a change in accounting 
estimate.
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    Question 1: Has the registrant appropriately quantified the amount 
of this error for the purpose of evaluating materiality for the current 
year?
    Interpretive Response: No. In this example, the registrant has only 
quantified the effects of the identified unadjusted error that arose in 
the current year income statement. The staff believes a registrant's 
materiality evaluation of an identified unadjusted error should 
quantify the effects of the identified unadjusted error on each 
financial statement and related financial statement disclosure.
    Topic 1M notes that a materiality evaluation must be based on all 
relevant quantitative and qualitative factors.\2\ This analysis 
generally begins with quantifying potential misstatements to be 
evaluated. There has been diversity in practice with respect to this 
initial step of a materiality analysis.
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    \2\ Topic 1N addresses certain of these quantitative issues, but 
does not alter the analysis required by Topic 1M.
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    The diversity in approaches for quantifying the amount of 
misstatements primarily stems from the effects of misstatements that 
were not corrected at the end of the prior year (``prior year 
misstatements''). These prior year misstatements should be considered 
in quantifying misstatements in current year financial statements.
    The techniques most commonly used in practice to accumulate and 
quantify misstatements are generally referred to as the ``rollover'' 
and ``iron curtain'' approaches.
    The rollover approach, which is the approach used by the registrant 
in this example, quantifies a misstatement based on the amount of the 
error originating in the current year income statement. Thus, this 
approach ignores the effects of correcting the portion of the current 
year balance sheet misstatement that originated in prior years (i.e., 
it ignores the ``carryover effects'' of prior year misstatements).
    The iron curtain approach quantifies a misstatement based on the 
effects of correcting the misstatement existing in the balance sheet at 
the end of the current year, irrespective of the misstatement's year(s) 
of origination. Had the registrant in this fact pattern applied the 
iron curtain approach, the misstatement would have been quantified as a 
$100 misstatement based on the end of year balance sheet misstatement. 
Thus, the adjustment needed to correct the financial statements for the 
end of year error would be to reduce the liability by $100 with a 
corresponding decrease in current year expense.
    As demonstrated in this example, the primary weakness of the 
rollover approach is that it can result in the accumulation of 
significant misstatements on the balance sheet that are deemed 
immaterial in part because the amount that originates in each year is 
quantitatively small. 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.
    In contrast, the primary weakness of the iron curtain approach is 
that it does not consider the correction of prior year misstatements in 
the current year (i.e., the reversal of the carryover effects) to be 
errors. Therefore, in this example, if the misstatement was corrected 
during the current year such that no error existed in the balance sheet 
at the end of the current year, the reversal of the $80 prior year 
misstatement would not be considered an error in the current year 
financial statements under the iron curtain approach. Implicitly, the 
iron curtain approach assumes that because the prior year financial 
statements were not materially misstated, correcting any immaterial 
errors that existed in those statements in the current year is the 
``correct'' accounting, and is therefore not considered an error in the 
current year. Thus, utilization of the iron curtain approach can result 
in a misstatement in the current year income statement not being 
evaluated as an error at all.
    The staff does not believe the exclusive reliance on either the 
rollover or iron curtain approach appropriately quantifies all 
misstatements that could be material to users of financial statements.
    In describing the concept of materiality, FASB Concepts Statement 
No. 2, Qualitative Characteristics of Accounting Information, indicates 
that materiality determinations are based on whether ``it is probable 
that the judgment of a reasonable person relying upon the report would 
have been changed or influenced by the inclusion or correction of the 
item'' (emphasis added).\3\ The staff believes registrants must 
quantify the impact of correcting all misstatements, including both the 
carryover and reversing effects of prior year misstatements, on the 
current year financial statements. The staff believes that this can be 
accomplished by quantifying an error under both the rollover and iron 
curtain approaches as described above and by evaluating the error 
measured under each approach. Thus, a registrant's financial statements 
would require adjustment when either approach results in quantifying a 
misstatement that is material, after considering all relevant 
quantitative and qualitative factors.
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    \3\ Concepts Statement 2, paragraph 132. See also Concepts 
Statement 2, Glossary of Terms--Materiality.
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    As a reminder, a change from an accounting principle that is not 
generally accepted to one that is generally accepted is a correction of 
an error.\4\
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    \4\ Statement 154, paragraph 2h.
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    The staff believes that the registrant should quantify the current 
year misstatement in this example using both the iron curtain approach 
(i.e., $100) and the rollover approach (i.e., $20). Therefore, if the 
$100 misstatement is considered material to the financial statements, 
after all of the relevant quantitative and qualitative factors are

[[Page 54582]]

considered, the registrant's financial statements would need to be 
adjusted.
    It is possible that correcting an error in the current year could 
materially misstate the current year's income statement. For example, 
correcting the $100 misstatement in the current year will:
     Correct the $20 error originating in the current year;
     Correct the $80 balance sheet carryover error that 
originated in Years 1 through 4; but also
     Misstate the current year income statement by $80.
    If the $80 understatement of current year expense is material to 
the current year, after all of the relevant quantitative and 
qualitative factors are considered, the prior year financial statements 
should be corrected, even though such revision previously was and 
continues to be immaterial to the prior year financial statements. 
Correcting prior year financial statements for immaterial errors would 
not require previously filed reports to be amended. Such correction may 
be made the next time the registrant files the prior year financial 
statements.
    The following example further illustrates the staff's views on 
quantifying misstatements, including the consideration of the effects 
of prior year misstatements:
    Facts: During the course of preparing annual financial statements, 
a registrant is evaluating the materiality of a sales cut-off error in 
which $50 of revenue from the following year was recorded in the 
current year, thereby overstating accounts receivable by $50 at the end 
of the current year. In addition, a similar sales cut-off error existed 
at the end of the prior year in which $110 of revenue from the current 
year was recorded in the prior year. As a result of the combination of 
the current year and prior year cut-off errors, revenues in the current 
year are understated by $60 ($110 understatement of revenues at the 
beginning of the current year partially offset by a $50 overstatement 
of revenues at the end of the current year). The prior year error was 
evaluated in the prior year as being immaterial to those financial 
statements.
    Question 2: How should the registrant quantify the misstatement in 
the current year financial statements?
    Interpretive Response: The staff believes the registrant should 
quantify the current year misstatement in this example using both the 
iron curtain approach (i.e., $50) and the rollover approach (i.e., 
$60). Therefore, assuming a $60 misstatement is considered material to 
the financial statements, after all relevant quantitative and 
qualitative factors are considered, the registrant's financial 
statements would need to be adjusted.
    Further, in this example, recording an adjustment in the current 
year could alter the amount of the error affecting the current year 
financial statements. For instance:
     If only the $60 understatement of revenues were to be 
corrected in the current year, then the overstatement of current year 
end accounts receivable would increase to $110; or,
     If only the $50 overstatement of accounts receivable were 
to be corrected in the current year, then the understatement of current 
year revenues would increase to $110.
    If the misstatement that exists after recording the adjustment in 
the current year financial statements is material (considering all 
relevant quantitative and qualitative factors), the prior year 
financial statements should be corrected, even though such revision 
previously was and continues to be immaterial to the prior year 
financial statements. Correcting prior year financial statements for 
immaterial errors would not require previously filed reports to be 
amended. Such correction may be made the next time the registrant files 
the prior year financial statements.
    If the cut-off error that existed in the prior year was not 
discovered until the current year, a separate analysis of the financial 
statements of the prior year (and any other prior year in which 
previously undiscovered errors existed) would need to be performed to 
determine whether such prior year financial statements were materially 
misstated. If that analysis indicates that the prior year financial 
statements are materially misstated, they would need to be restated in 
accordance with Statement 154.\5\
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    \5\ Statement 154, paragraph 25.
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    Facts: When preparing its financial statements for years ending on 
or before November 15, 2006, a registrant quantified errors by using 
either the iron curtain approach or the rollover approach, but not 
both. Based on consideration of the guidance in this Staff Accounting 
Bulletin, the registrant concludes that errors existing in previously 
issued financial statements are material.
    Question 3: Will the staff expect the registrant to restate prior 
period financial statements when first applying this guidance?
    Interpretive Response: The staff will not object if a registrant 
\6\ does not restate financial statements for fiscal years ending on or 
before November 15, 2006, if management properly applied its previous 
approach, either iron curtain or rollover, so long as all relevant 
qualitative factors were considered.
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    \6\ If a registrant's initial registration statement is not 
effective on or before November 15, 2006, and the registrant's prior 
year(s) financial statements are materially misstated based on 
consideration of the guidance in this Staff Accounting Bulletin, the 
prior year financial statements should be restated in accordance 
with Statement 154, paragraph 25. If a registrant's initial 
registration statement is effective on or before November 15, 2006, 
the guidance in the interpretive response to Question 3 is 
applicable.
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    To provide full disclosure, registrants electing not to restate 
prior periods should reflect the effects of initially applying the 
guidance in Topic 1N in their annual financial statements covering the 
first fiscal year ending after November 15, 2006. The cumulative effect 
of the initial application should be reported in the carrying amounts 
of assets and liabilities as of the beginning of that fiscal year, and 
the offsetting adjustment should be made to the opening balance of 
retained earnings for that year. Registrants should disclose the nature 
and amount of each individual error being corrected in the cumulative 
adjustment. The disclosure should also include when and how each error 
being corrected arose and the fact that the errors had previously been 
considered immaterial.
    Early application of the guidance in Topic 1N is encouraged in any 
report for an interim period of the first fiscal year ending after 
November 15, 2006, filed after the publication of this Staff Accounting 
Bulletin. In the event that the cumulative effect of application of the 
guidance in Topic 1N is first reported in an interim period other than 
the first interim period of the first fiscal year ending after November 
15, 2006, previously filed interim reports need not be amended. 
However, comparative information presented in reports for interim 
periods of the first year subsequent to initial application should be 
adjusted to reflect the cumulative effect adjustment as of the 
beginning of the year of initial application. In addition, the 
disclosures of selected quarterly information required by Item 302 of 
Regulation S-K should reflect the adjusted results.

 [FR Doc. E6-15457 Filed 9-15-06; 8:45 am]
BILLING CODE 8010-01-P