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30.7 Correction of an error
Publication date: 28 Feb 2022
us Financial statement presentation guide
A reporting entity should evaluate the materiality of errors, individually and in the aggregate, relative to the period of origination and correction to determine whether a restatement or revision of the previously issued annual or interim financial statements is required.
When a reporting entity identifies an error in previously issued financial statements, the first step is to consider whether the error is material to any previously issued financial statements. If not, the reporting entity must then evaluate whether the correction of the error in the current period would result in a material misstatement of the current period’s financial statements. For SEC registrants (and as a best practice for all reporting entities), SAB 99, Materiality, (codified in ASC 250-10-S99), requires both a qualitative and quantitative assessment of materiality. Figure FSP 30-1 depicts the materiality framework for evaluating errors in previously issued financial statements.
Figure FSP 30-1 illustrates a framework to evaluate errors in previously issued financial statements.
Figure FSP 30-1
Framework for evaluating errors in previously issued financial statements
Framework for evaluating errors in previously issued financial statements
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* The materiality evaluation requires significant professional judgment and includes consideration of all relevant qualitative and quantitative factors.
** 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 presented. The “iron curtain” error method does not impact the decision regarding whether or not previously issued financial statements are materially misstated.
Materiality analyses require significant judgment. A materiality analysis must consider all relevant qualitative and quantitative factors (including company and industry-specific factors). Qualitative factors may cause misstatements of quantitatively small amounts to be material.
In accordance with SAB 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements (codified in ASC 250-10-S99-2), errors in financial statements filed with the SEC must be evaluated using both the “iron curtain” method (for the current period) and the “rollover” method (for prior periods) to consider whether the errors are quantitatively significant.
- The “rollover” method assesses income statement errors based on the amount by which the income statement for the period is misstated—including the reversing effect of any prior period errors. Identified misstatements in the previous period that were not corrected need to be considered to determine any “carryover effects.”
- The “iron curtain” method assesses 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 at the end of the period were corrected through the income statement during that period.
Many reporting entities whose financial statements are not filed with the SEC also evaluate errors using both methods. The use of both methods is commonly referred to as the “dual” method of evaluating errors.
The quantified materiality of an error must be evaluated with respect to each affected financial statement, as well as each financial statement line item and financial statement disclosure. For example, in addition to considering the income statement, a materiality evaluation under the "rollover" method would also include consideration of the impact on the statement of cash flows. It would also consider whether the cumulative unadjusted errors in the balance sheet result in a material misstatement of the balance sheet or the statement of stockholders' equity.
30.7.1 Restatements (error corrections)
Upon determination that the previously issued financial statements are materially misstated, they should be corrected promptly.
- For an SEC registrant, the correction of a material misstatement is ordinarily accomplished by performing both of the following:
- Filing an Item 4.02 Form 8-K to indicate that the previously issued financial statements should no longer be relied upon. The reporting entity should consult with its counsel to determine the appropriate steps and timing for providing notice that the financial statements should no longer be relied upon.
- Amending prior filings (e.g., filing Form 10-K/A and/or Form 10-Q/A, or, in limited circumstances, a Form 10-K when filing of the subsequent year’s Form 10-K is imminent)
- For a private company, the correction of a material misstatement is ordinarily accomplished by the company issuing corrected financial statements that indicate that they have been restated and include its auditor’s reissued audit report. Alternatively, it is permissible to reflect the restatement in the soon-to-be issued comparative financial statements. When the restatement is to be reflected in the soon-to-be issued comparative financial statements, the financial statements and auditor’s report would indicate that the prior periods have been restated. Users of the previously issued financial statements also must be notified that they should no longer rely on those financial statements.
Excerpt from ASC 250-10-45-23
Restatement requires all of the following:
- The cumulative effect of the error on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
- An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
- Financial statements for each individual prior period presented shall be adjusted to reflect correction of the period-specific effects of the error.
When only a single period is presented, the cumulative effect of the error should be recorded as an adjustment to beginning retained earnings.
Further, ASC 250 requires specific financial statement disclosures with respect to a correction of an error.
When financial statements are restated to correct an error, the entity shall disclose that its previously issued financial statements have been restated, along with a description of the nature of the error. The entity also shall disclose both of the following:
a. The effect of the correction on each financial statement line item and any per-share amounts affected for each prior period presented
b. The cumulative effect of the change on retained earnings or other appropriate components of equity or net assets in the statement of financial position, as of the beginning of the earliest period presented.
When prior period adjustments are recorded, the resulting effects (both gross and net of applicable income tax) on the net income of prior periods shall be disclosed in the annual report for the year in which the adjustments are made and in interim reports issued during that year after the date of recording the adjustments.
When financial statements for a single period only are presented, this disclosure shall indicate the effects of such restatement on the balance of retained earnings at the beginning of the period and on the net income of the immediately preceding period. When financial statements for more than one period are presented, which is ordinarily the preferable procedure, the disclosure shall include the effects for each of the periods included in the statements. (See Section 205-10-45 and paragraph 205-10-50-1.) Such disclosures shall include the amounts of income tax applicable to the prior period adjustments. Disclosure of restatements in annual reports issued after the first such post-revision disclosure would ordinarily not be required.
These disclosures are required in the financial statements of the interim (if applicable) and annual period of the change, but do not need to be repeated when the subsequent period annual financial statements are issued.
While including only narrative disclosure is not prohibited, a tabular format, supplemented with a narrative discussion, may be clearer given the amount of information that usually needs to be disclosed. Consistent with current practice, we recommend prominent placement of the restatement disclosure in the footnotes to ensure that readers understand the impact of the changes to the financial statements and any related footnotes.
The reporting entity may be required to present historical, statistical-type summaries of financial data for a number of periods—commonly 5 or 10 years. Whenever an error correction has been recorded, the corresponding financial data should be restated and include disclosures as appropriate.
The reporting entity should also consider how the error impacts its conclusion regarding internal control over financial reporting and/or disclosure controls and procedures, as appropriate. This analysis of the control implications should be for the most recent annual and current year interim period.
30.7.2 Revisions and out-of-period adjustments (error corrections)
If the previously issued financial statements are not materially misstated, then the error may be corrected prospectively. While ASC 250 only contemplates reporting the correction of an error by restating the previously issued financial statements, many identified errors do not result in a material misstatement to previously issued financial statements. In that case, the error may be corrected in one of two ways:
- Recording an out-of-period adjustment, with appropriate disclosure, in the current period, if such correction does not create a material misstatement in the current year
- Revising the prior period financial statements the next time they are presented
When the correcting amounts are material to current operations or trends, reporting entities should revise the previously issued financial statements the next time they are issued.
A revision disclosure is similar to a restatement disclosure. However, the financial statement columns should not be labeled “as restated.” Further, revising prior year financial statements would not require previously issued auditor reports to be corrected as users can continue to rely on those previously issued financial statements. The reporting entity should consult with its counsel to determine whether it should provide disclosure of prospective corrections that are expected to be made in future financial statements. It may not be necessary to file a Form 8-K under Item 4.02 because the previously issued 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 example, 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.
Example FSP 30-2 illustrates the evaluation of an identified error.
EXAMPLE FSP 30-2
Example of the error evaluation process
Example of the error evaluation process
FSP Corp is a calendar year-end SEC registrant. In early April 20X5, FSP Corp identified a long-term incentive compensation obligation for one of its salespeople which it had inadvertently neglected to record since 20X1. If FSP Corp had properly accounted for the bonus, it would have recorded an additional $30 of compensation expense in each of the years 20X1 through 20X4.
- FSP Corp’s reported income in each of the years 20X1 through 20X4 was $1,000.
- FSP Corp projects its 20X5 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-of-period” adjustments), those errors would also need to be considered in the materiality analysis.
What analysis should FSP Corp perform to consider if the errors are material?
Analysis
Quantifying the errors in the previously issued financial statements
FSP Corp has quantified the errors under both the “rollover” and the “iron curtain” methods as follows:
Year |
Reported income |
Rollover method |
Iron curtain method |
20X1 |
$1,000 |
$30 (3%) |
N/A |
20X2 |
$1,000 |
$30 (3%) |
N/A |
20X3 |
$1,000 |
$30 (3%) |
N/A |
20X4 |
$1,000 |
$30 (3%) |
N/A |
20X5 |
$1,000 (Projected) |
N/A |
$120 (12%) |
Evaluating whether the affected financial statements are materially misstated
FSP Corp 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 20X1 through 20X4. In making this analysis, FSP Corp 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 also consider the impact of the error on the full financial statements, including disclosures (e.g., segment reporting).
Determining how to correct the errors
If FSP Corp determines that any of the years 20X1 through 20X4 are materially misstated when the errors are evaluated under the “rollover” method, then those years must be promptly corrected (as discussed in FSP 30.7.1).
If FSP Corp determines that none of the years 20X1 through 20X4 (or quarters for 20X4) are materially misstated when the errors are quantified under the “rollover” method, then the errors can be corrected prospectively in current or future filings (as discussed in FSP 30.7.2). Depending on the circumstances, prospective correction may be accomplished in one of two ways:
- FSP Corp may correct the errors as an “out-of-period” adjustment in its first quarter 20X5 interim financial statements if the correction would not result in a material misstatement of the estimated fiscal year 20X5 earnings ($1,000) or to the trend in earnings. This is true even if the “out-of-period” adjustment is material to the first quarter 20X5 interim financial statements. If the “out-of-period” adjustment is material to the first quarter 20X5 interim financial statements (but not material with respect to the estimated income for the full fiscal year 20X5 or to the trend of earnings), then the correction may still be recorded in the first quarter, but should be separately disclosed (in accordance with ASC 250-10-45-27).
- If FSP Corp cannot correct the errors as an “out-of-period” adjustment without causing a material misstatement of the estimated fiscal year 20X5 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 first quarter of 20X4 and the December 31, 20X4 balance sheet presented in FSP Corp’s March 31, 20X5 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).
30.7.3 Misclassifications (error corrections)
A change in classification to correct an error should be evaluated using the framework discussed in FSP 30.7 and should be clearly disclosed as an error.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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