Dataline A look at current financial reporting issues

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1 Dataline A look at current financial reporting issues No November 21, 2013 What s inside? Overview... 1 The main details... 2 Quantifying errors... 2 Evaluating whether the financial statements are materially misstated... 2 Determining how to correct the errors... 3 Evaluation framework and practical example... 5 Questions... 5 Appendix A: Framework for evaluating errors in previously-issued financial statements...6 Appendix B: Practical example... 7 Evaluating errors in previously-issued financial statements Applying the "dual method" Overview Errors in US GAAP financial statements filed with the SEC must be evaluated using both the "iron curtain" method and the "rollover" method. Many companies whose financial statements are not filed with the SEC (or that file local GAAP financial statements with the SEC) also evaluate errors using both of these methods. The use of both methods is commonly referred to as the "dual" method of evaluating errors. If the previously-issued financial statements are materially misstated, they should be corrected promptly. - For a public company, the correction of a material misstatement is ordinarily accomplished by amending prior filings (e.g., filing Form 10-K/A and/or Form 10- Q/A). - For a private company, the correction of a material misstatement is ordinarily accomplished by the company issuing corrected financial statements which indicate that they have been restated and including its auditor s re-issued audit report. Users of the financial statements also must be notified that they should no longer rely on the previously-issued financial statements. If the previously-issued financial statements are not materially misstated, then the error may be corrected prospectively. Materiality analyses require significant professional judgment. The materiality analysis must consider all relevant qualitative and quantitative factors (including company/industry-specific factors). Note: This Dataline updates and supersedes Dataline by providing clarifications based on questions received since Dataline was issued. National Professional Services Group CFOdirect Network Dataline 1

2 The main details Quantifying errors.1 When errors in previously-issued financial statements are identified, they must be assessed to determine whether the affected financial statements are materially misstated. The starting point for any materiality analysis is to quantify the errors. SEC Staff Accounting Bulletin No. 108 (SAB 108) 1 provides guidance to consider when quantifying errors..2 SAB 108 requires that errors be evaluated under both the "rollover" method and the "iron curtain" method. The principal difference between these two methods lies in how income statement errors are quantified. The "rollover" method quantifies income statement errors based on the amount by which the income statement is actually misstated including the reversing effect of any prior errors. Identified misstatements in the previous period that were not corrected need to be considered to determine the "carryover effects". The "iron curtain" method quantifies income statement errors based on the amount by which the income statement would be misstated if the accumulated amount of the errors that remain in the balance sheet were corrected through the income statement of that period. PwC observation: The above discussion is focused on how the "rollover" and "iron curtain" methods are applied when evaluating materiality with respect to the financial statements. However, it is important to note that the quantified materiality of an error must be evaluated with respect to each affected financial statement, as well as the impact on financial statement line items and financial statement disclosures. For instance, in addition to considering the income statement, a materiality evaluation under the "rollover" method would also include consideration of whether any cumulative unadjusted error(s) in the balance sheet(s) resulted in a material misstatement of the balance sheet(s) or the statement(s) of stockholders' equity. Similarly, the evaluation under the "rollover" method for each impacted period would include consideration of whether the rollover impact of the error(s) would materially impact the statement(s) of cash flows or disclosures. Evaluating whether the financial statements are materially misstated.3 After the errors have been quantified, the previously-issued financial statements should be evaluated to determine whether they are materially misstated. SEC Staff Accounting Bulletin No. 99 (SAB 99) provides guidance to consider when evaluating materiality..4 SAB 99 should be used as a "guide" rather than a "checklist." Not all of the factors in SAB 99 are relevant to every situation. Additionally, some factors that are relevant to the analysis may not be specifically listed in SAB 99 (e.g., industry-specific considerations). All relevant qualitative and quantitative factors (including company-specific factors) must be considered. Materiality analyses require significant professional judgment. 1 Codified in ASC S99 SEC Materials National Professional Services Group CFOdirect Network Dataline 2

3 .5 In a December 2008 speech, an Associate Chief Accountant in the SEC's Office of the Chief Accountant 2 clarified the SEC staff's view of how SAB 108 should be applied to previously-issued financial statements. The Associate Chief Accountant indicated that if the effect of a correction would not materially affect the previously-issued financial statements, those financial statements may still be relied upon, and the correction may be made in future filings (i.e., without requiring an amendment to prior filings). If the errors are material when evaluated under the "rollover" method, then the previously-issued financial statements are considered materially misstated (i.e., they should no longer be relied upon). If the errors are not material when evaluated under the "rollover" method, then the previously-issued financial statements are not considered materially misstated (i.e., they can continue to be relied upon). However, if the impact of the errors to the current period financial statements would be material when evaluated under the "iron curtain" method, then the errors need to be corrected even though the previously-issued financial statements are not materially misstated. PwC observation: When considering whether previously-issued financial statements are materially misstated, the key principle to focus on is whether the corrected financial statements would be materially different from the previously-issued financial statements. The "rollover" method is used to evaluate whether previously-issued financial statements are materially misstated. The "rollover" method is used because, as discussed above, the "rollover" method quantifies the actual financial statement errors for each period. If an error is not material to previously-issued financial statements under the "rollover" method, then those financial statements can continue to be relied upon. Errors evaluated under the rollover method are compared to the as reported amounts in previously-issued financial statements. The "iron curtain" error analysis does not drive the decision regarding whether or not previously-issued financial statements are materially misstated. The error in the previously-issued financial statements should be quantified and evaluated under the "iron curtain" method to determine how the error needs to be corrected. In other words, if an error in previously-issued financial statements is not material under the "rollover" method, but would be material under the "iron curtain" method, then the error must be corrected by revising the previously-issued financial statements the next time they are filed. An error that would be material to the previously-issued financial statements under the "iron curtain" method cannot remain as an unadjusted difference. Determining how to correct the errors.6 Once the materiality analysis is complete, the company must determine how to correct the errors. Correcting financial statements that are materially misstated.7 If the previously-issued financial statements are materially misstated (under the "rollover" method), then they should be corrected promptly. For a public company, the correction of a material misstatement is ordinarily accomplished by amending prior filings (e.g., filing Form 10-K/A and/or Form 10-Q/A). For a private company, the 2 National Professional Services Group CFOdirect Network Dataline 3

4 correction of a material misstatement is ordinarily accomplished by the company issuing corrected financial statements which indicate that they have been restated. The corrected financial statements should include the disclosures required by ASC 250, Accounting Changes and Error Corrections. These disclosures include the nature of the error and the quantitative effects of correction on each affected financial statement line item (including per share amounts). Affected column headings should be labeled "Restated" (or something comparable). An audit report on the corrected financial statements should include an explanatory paragraph indicating that the previously-issued financial statements have been restated to correct a misstatement. The explanatory paragraph should also include a reference to the company's disclosure of the correction. Refer to PCAOB AU 508, paragraphs 18A-18C or AICPA AU (as appropriate) for the audit reporting requirements. Business entities may present historical, statistical-type summaries of financial data for a number of periods commonly 5 or 10 years. Whenever error corrections have been recorded during any of the periods included, a quantitative and qualitative analysis of the error should be performed for these years. Management should consult with its counsel to determine the appropriate steps and timing for providing notice that the materially misstated financial statements should no longer be relied upon (e.g., by filing a Form 8-K under Item 4.02). The auditor should consider the guidance in PCAOB AU 561 or AICPA AU-C 560 (as appropriate). Management and/or the auditor should also consider how the error impacts their respective conclusions regarding internal control over financial reporting and/or disclosure controls and procedures, as appropriate. This analysis of the control implications should be for the current and prior period end. Correcting financial statements that are not materially misstated.8 If the previously-issued financial statements are not materially misstated, then the errors may be corrected prospectively. Prospective correction may be accomplished in one of two ways (depending on the circumstances). Correction as an "out-of-period" adjustment: Errors may be corrected as an "outof-period" adjustment if the correction would not result in a material misstatement of the estimated income/loss for the year in which the adjustments are made or to the trend in earnings. This is true even if the "out-of-period" adjustment is material to the interim financial statements in which it is recorded unless the error originated in the current year. An "out-of-period" adjustment that is material to the interim financial statements in which it is recorded (but not material with respect to the estimated income for the full fiscal year or to the trend of earnings) should be separately disclosed (in accordance with ASC ). Revising financial statements the next time they are filed: If the errors cannot be corrected as an "out-of-period" adjustment without causing a material misstatement of the estimated income/loss for the year in which the adjustment is made or to the trend in earnings, then the errors must be corrected by revising the previously-issued financial statements the next time they are filed (e.g., for comparative purposes). This is commonly termed as a revision of previouslyissued financial statements. The revised financial statements should include 3 Pre-codification APB 28, Interim Financial Reporting, paragraph 29 National Professional Services Group CFOdirect Network Dataline 4

5 transparent disclosure regarding the nature and amount of the errors being corrected. The disclosure should provide insight into how the errors affect all relevant periods. For instance, if the first filing to be corrected is a Form 10-Q, management should consider disclosing how the error will affect all interim and annual periods that will ultimately be revised. PwC observation: Management should consult with its counsel to determine whether the company should provide disclosure of prospective corrections (other than in the financial statements that reflect the prospective correction). We do not believe it would ordinarily be necessary to file a Form 8-K under Item 4.02 because the previouslyissued financial statements are not materially misstated (i.e., they can continue to be relied upon). However, there may be other situations in which separate disclosure would be appropriate. For instance, if securities are to be offered based on the uncorrected financial statements, the prospectus/offering materials may need to include additional disclosure (including quantification) of the impending correction. We do not believe an auditor s report on the revised financial statements would need an explanatory paragraph referring to the revision (although dual date may be required as described in PCAOB AU and AICPA AU-C 560.A16). This is because a conclusion has been reached that the previously-issued financial statements are not materially misstated (i.e., they can continue to be relied upon). Evaluation framework and practical example.9 Appendix A summarizes the process for evaluating errors in previously-issued financial statements. Appendix B is a practical example of the process. Questions.10 PwC clients that have questions about this Dataline should contact their engagement partners. Engagement teams that have questions about this Dataline should contact any member of SEC Services or Risk Management in the National Professional Services Group. National Professional Services Group CFOdirect Network Dataline 5

6 Appendix A: Framework for evaluating errors in previouslyissued financial statements Start Is the error material* to the previouslyissued financial statements under the ROLLOVER method?** Yes The previously-issued financial statements must be corrected promptly. For a public company, this is usually accomplished by amending prior filings (e.g., Form 10-K/A and/or Form 10-Q/ A). For a private company, this is ordinarily accomplished by issuing corrected financial statements. No The previously-issued financial statements may continue to be relied upon. The error may be corrected PROSPECTIVELY. The error CANNOT be corrected as an out-of-period adjustment. The previouslyissued financial statements must be revised the next time they are filed. Would correction as an out-ofperiod adjustment materially* misstate the YEAR in which it would be corrected or the trend in earnings? No Would the out-of-period adjustment be material* to the INTERIM PERIOD in which it would be corrected? No Yes Yes The error may be corrected as an out-of-period adjustment with transparent disclosure regarding the nature and effect of the adjustment. Alternatively, the financial statements may be revised the next time they are filed. The error may be corrected as an outof-period adjustment. Management should consider disclosure of the out-of-period adjustment. Alternatively, the financial statements may be revised the next time they are filed. Under certain circumstances, the amount may remain on the SUM, however, we encourage our clients to correct all errors. *The materiality evaluation requires significant professional judgment and should consider all relevant qualitative and quantitative factors. The evaluation may need to include factors that are not specifically mentioned in SAB 99. **The "rollover" method is used to evaluate whether previously-issued financial statements are materially misstated. The rollover method involves an analysis of the error(s) on all of the financial statements. The "iron curtain" error analysis does not drive the decision regarding whether or not previously-issued financial statements are materially misstated. National Professional Services Group CFOdirect Network Dataline 6

7 Appendix B: Practical example Company X is a calendar year-end SEC registrant. In early April 2013, Company X identified a long-term incentive compensation obligation for one of its salespeople which it had inadvertently neglected to record since If Company X had properly accounted for the plan, it would have recorded an additional $30 of compensation expense in each of the years 2009 through Company X's reported income in each of the years 2009 through 2012 was $1,000. Company X projects its 2013 income will be $1,000. Note: Income tax effects are ignored for purposes of this example. Additionally, this example assumes that there are no other errors affecting any of the years. If there were additional errors (whether unadjusted or recorded as "out-ofperiod" adjustments), those errors would also need to be considered in the materiality analysis. Quantifying the errors in the previously-issued financial statements Company X has quantified the errors under both the "rollover" and the "iron curtain" methods as follows: Year Reported income Rollover method Iron curtain method 2009 $1,000 $30 (3%) $30 (3%) 2010 $1,000 $30 (3%) $60 (6%) 2011 $1,000 $30 (3%) $90 (9%) 2012 $1,000 $30 (3%) $120 (12%) 2013 $1,000 (Projected) N/A N/A Evaluating whether the affected financial statements are materially misstated Company X should consider whether the errors quantified under the "rollover" method (i.e., $30 or 3% of income per year) are material to the financial statements for any of the years 2009 through In making this analysis, Company X should consider all relevant qualitative and quantitative factors. Note: The above analysis focuses on the effects of the errors on the income statement. However, the analysis must consider the impact of the error on the full financial statements (including disclosures). Determining how to correct the errors If Company X determines that any of the years 2009 through 2012 are materially misstated when the errors are evaluated under the "rollover" method, then those years must be promptly corrected. The usual method of correcting materially misstated financial statements would be by filing amended filings (e.g., Form 10-K/A and/or Form 10-Q/A). If Company X determines that none of the years 2009 through 2012 (or quarters for 2012) are materially misstated when the errors are quantified under the "rollover" method, then the errors can be corrected prospectively. Prospective correction may be accomplished in one of two ways (depending on the circumstances). Company X may correct the errors as an "out-of-period" adjustment in its 1st quarter 2013 interim financial statements if the correction would not result in a material misstatement of the estimated fiscal year 2013 earnings ($1,000) or to the trend in earnings. This is true even if the "out-of-period" adjustment is material to the 1st quarter 2013 interim financial statements. If the "out-of-period" adjustment is material to the 1st quarter National Professional Services Group CFOdirect Network Dataline 7

8 2013 interim financial statements (but not material with respect to the estimated income for the full fiscal year 2013 or to the trend of earnings), then the correction should be separately disclosed (in accordance with ASC ). If Company X cannot correct the errors as an "out-of-period" adjustment without causing a material misstatement of the estimated fiscal year 2013 earnings ($1,000) or to the trend in earnings, then the errors must be corrected by revising the previously-issued financial statements the next time they are filed (e.g., for comparative purposes). For instance, the quarterly financial statements for the 1st quarter of 2012 and the December 31, 2012 balance sheet presented in Company X's March 31, 2013 Form 10-Q should be revised to correct the error. The revised financial statements should include transparent disclosure regarding the nature and amount of each error being corrected. The disclosure should provide insight into how the errors affect all relevant periods (including those that will be revised in subsequent filings). National Professional Services Group CFOdirect Network Dataline 8

9 Authored by: John May Partner Phone: Marc Anderson Partner Phone: Sarah Fitch Director Phone: Declan Byrne Senior Manager Phone: Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network ( PwC s online resource for financial executives PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.