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FASB to Address Materiality of Prior Misstatements

December 29, 2006

The Financial Accounting Standards Board (FASB) said it would issue guidance specifying that private companies (including not-for-profit organizations) should use the same methods as public companies to evaluate the materiality effects that prior-year adjustments have on current-year financial statements. Currently, public companies must adhere to the requirements set forth in Staff Accounting Bulletin (SAB) No. 108, "Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements," but private companies are not bound by them. FASB said it would focus the guidance solely on evaluation of prior years' audit differences and the impact on the current year's financial statements.

Currently, under SAB 108, two methods are being used to quantify current-year misstatements resulting from the carryover or reversal of prior-year misstatements:

1. the rollover approach, which looks at the amount by which the current-year income statement is misstated; and

2. the iron curtain approach, which looks at the cumulative amount by which the balance sheet is misstated to determine materiality.

For public companies, the SEC currently requires that registrants quantify misstatements using both the rollover and iron curtain approaches. If either method results in a material error, the financial statements must be adjusted.

For non-public companies, FASB will evaluate the SAB 108 concepts as part of a narrow-scope look at the issue in either a FASB staff position or an interpretation. The board said it also would issue guidance modifying current standards to allow for a one-time, cumulative-effect adjustment for private companies to correct misstatements resulting from the carryover or reversal of prior-year misstatements. FASB said that private companies, for which misstatements have accumulated from the carryover or reversal of prior year misstatements, should be given the same favorable opportunity as public companies to correct the misstatements without having to restate prior-year financial statements.