Sunbeam & the 'Iron Curtain': Why a Dual Test for Materiality Assessment Was Necessary

CPA Journal, The, Aug 2007 by Bryan, Stephen, Carmichael, Douglas R, Lilien, Steven

The financial community will soon be presented with previously unknown errors in prior financial statements. These prior-period errors, although known by management and the companies' outside auditors, had not been corrected because they had not been deemed material. On September 16, 2006, the SEC released Staff Accounting Bulletin (SAB) 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements." SAB 108 provides "guidance on the consideration of the effects of prior year misstatements in quantifying current-year misstatements for the purpose of a materiality assessment." The new standard means that many prior-period errors previously considered immaterial will now, in hindsight, be considered material and therefore will require adjustment. (The concept of materiality is defined and interpreted in SAB 99, "Materiality," and FASB Concept Statement 2, "Qualitative Characteristics of Accounting Information.")

Prior to SAB 108, companies used one of two methods to assess materiality: the "rollover" or the "iron curtain." When used individually, these methods can lead to false negative assessments of no material errors. This article illustrates these two methods and discusses their shortcomings to show the need for the dual approach promulgated in SAB 108. The authors also illustrate how registered companies will adjust their financial statements upon initial adoption of the dual approach. Because the case of Sunbeam Corporation was central to the SEC's decision to change the method for assessing materiality, the authors also show how the misstatements at Sunbeam would likely have been deemed material under SAB 108, and therefore would have been corrected. Sunbeam's improper accounting treatment would have been exposed in a more timely manner, and the company's purported turnaround would have been exposed as illusory.

SAB 108 Background and Basic Requirements

According to SAB 108, the rollover method of assessing materiality "quantifies a misstatement based on the amount of the error originating in the current-year income statement" and "ignores the carryover effects of prior-year misstatements." By contrast, 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."

Prior to the issuance of SAB 108, the AICPA' s Auditing Standards Board (ASB) had considered revising Statement on Auditing Standards (SAS) 47, Audit Risk and Materiality in Conducting an Audit, to require the use of the iron curtain approach:

The rollover, widely used in practice, has characteristics that the SEC and some in the accounting profession perceive as drawbacks. The most significant is that the rollover merely postpones to another period the adjustments that will ultimately have to be recorded. This may facilitate earnings management and abuse.

This revision to SAS 47 was dropped because public companies were concerned about negative shareholder reaction. Companies believed that exceeding the materiality threshold was more likely under the iron curtain than under the rollover, and therefore the iron curtain would require more and greater restatements. The ASB was concerned about the effect on companies' income statements from the corrections that would be necessary for adjustments that had been waived as immaterial in the past, but that had accumulated in the balance sheet to become significant.

Although the SEC had initially favored the iron curtain, the commission subsequently saw the need to clarify its position, which had changed, in part, because of cases such as Sunbeam, whose auditors had used the iron curtain. Therefore, SAB 108 (page 6) promulgates the dual approach, which requires an adjustment to a registrant's financial statements "when either approach results in quantifying a misstatement that is material, after considering all relevant quantitative and qualitative factors."

The ASB is deliberating an amendment to SAS 107 to provide additional guidance now that the SEC has decided on the dual approach.

With regard to implementation issues, SAB 108 does not require companies to restate prior years' financial statements upon initial adoption, as long as the registrant's initial registration statement was in effect on or before November 15, 2006 (SAB 108, Question 3). Instead, in the year of transition, a registrant may cumulatively adjust opening retained earnings, but must then disclose the nature and amount of each misstatement that is corrected in the cumulative adjustment, as well as the fact that the company previously considered the misstatement to be immaterial. Beyond the adoption (that is, after the first fiscal year after November 16, 2006), SEC filers will not have the option of the cumulative adjustment to retained earnings. Additionally, SFAS 154, Accounting Changes and Error Corrections (issued May 2005), may apply. SFAS 154, which requires restatements of earlier comparative periods, applies to misstatements discovered after issuance of the financial statements and not to those known and waived as immaterial prior to issuance.