Sunbeam & the ‘Iron Curtain’
Why a Dual Test for Materiality Assessment Was Necessary

By Stephen Bryan, Douglas R. Carmichael, and Steven Lilien

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AUGUST 2007 - 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 Requirement

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.

SAB 108 applies to registrants—that is, public companies that file with the SEC. The proposed FASB Staff Position (FSP) 154-a would extend the requirement of the dual approach to privately held entities and not-for-profit organizations.

Rollover Approach Can Result in False Negatives

The following example is an adaptation of the example contained in SAB 108. Consider the following facts:

  • In years 1 through 5, a company (SEC registrant) incorrectly accrues an expense of $20 per year.
  • In years 1 through 4, the company knows the $20 accruals are misstated but considers them immaterial, and therefore makes no adjustment.
  • In year 5, the current year, the company incorrectly accrues another expense of $20.

The incorrect and correct entries are shown below:

Company’s Entries
   
Incorrect
Correct
Yeasr 1 - 5 Expense
$20
$0
  Payable
$20
$0

The payable is therefore overstated by $100 (5 x $20) at the end of year 5 and the expense is overstated by $20 for year 5. The company considers the $20 incremental accrual to be immaterial, but it considers the $100 cumulative accrual to be material. If the company uses the rollover approach in assessing materiality, the company would waive the adjustment because the rollover focuses on the current income statement, and $20 is immaterial. If the company uses the iron curtain, the company would make the adjustment because the iron curtain focuses on the balance sheet, and $100 is material.

Therefore, the SEC concluded:

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 considered, the registrant’s financial statements would need to be adjusted.
The question then becomes how to implement the adjustment. SAB 108 discussed the following possibility:

SEC’s contemplated adjustmen
Year 5 adjusting entry Payable $100
  Expense $100

This adjustment would correctly reduce the liability to zero, but it would also understate the expense by $80 in year 5. This is because the company incorrectly booked the $20 expense in year 5, and then, if it had done the above adjusting entry, it would have reversed $100 of expense, netting an $80 understatement.

SAB 108 explicitly notes the dilemma of not simultaneously obtaining proper income and balance sheet amounts:

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, then 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 the company to amend previously filed reports. Such correction may be made the next time the registrant files the prior-year financial statements.

The transition adjustment that would be consistent with SAB 108 is as follows:

SEC’s transition adjustment per SAB 108
Correcting Years 1–4 (prior years) Payable $80
“Cumulative Adjustment” Retained Earnings $80
Correcting Year 5 (current year) Payable $20
  Expense $20

For the transition to SAB 108, although the company may opt to adjust retained earnings as shown above (and not restate prior-period financial statements), the company must provide disclosures about the nature of the misstatements and the fact that the company considered them immaterial in prior periods. (For simplicity, the examples here show only one year, but the SEC does require comparative financial statements.)

Iron Curtain Approach Alone Can Result in False Negatives

As previously mentioned, the SEC once favored the iron curtain because the accumulated balances under that approach were deemed more likely to exceed a materiality threshold than were incremental changes under the rollover. The previous example showed how the iron curtain identified a material misstatement, whereas the rollover approach did not.

Nevertheless, the iron curtain can fail to identify a material misstatement. Consider a company that should have accrued $3 for a reserve for years 1 and 2. Also assume that there were no reductions in the reserve either year; that is, there were no cash payments to reduce the reserve.

Assume that rather than accruing $3 each year as it should have, the company overaccrued the reserve in year 1 by booking $6 instead of $3. Then in year 2, the company reverses year 1’s overaccrual by crediting the expense and reducing the reserve by $3. The journal entries are as follows:

Company’s entries
    Incorrect   Correct
Year 1 Expense $6 Expense $3
  Reserve $6 Reserve $3
Year 2 Reserve $3 Expense $3
  Expense $3 Reserve $3

The incorrect balance in the reserve account is a credit of $3 ($6 credit – $3 debit). However, the correct balance in the reserve account is a credit of $6 ($3 credit + $3 credit).

Suppose the company has $100 of operating income in years 1 and 2 and that the auditor has set the quantitative threshold at 4% of operating income. Ignoring qualitative considerations for the purpose of this illustration, the misstatement in year 1 is considered immaterial because the $3 overaccrual, which represents 3% of operating income, is below the quantitative threshold of 4%. Therefore, the adjustment is waived.

At the end of year 2, the balance in the reserve account is a credit of $3, but it should be a credit of $6. Using the iron curtain, which focuses on the balance sheet, the $3 difference is considered immaterial, assuming the same 4% quantitative threshold. Therefore, the adjustment to correct the balance sheet would be waived.

For year 2, the expense is misstated by $6. It should be a debit of $3, but it is a credit of $3. Under the rollover, this $6 variance is considered material, assuming the same 4% quantitative threshold. Thus, even though the iron curtain failed to identify a material misstatement, the rollover did not. Both approaches are therefore required.

Simultaneously correcting both the balance sheet and income statement would require the following series of journal entries (made in year 2), consistent with SAB 108. Note that the entries are separated here for clarity:

SEC’s transition adjustment per SAB 108
1. Completely undoing year 1 Reserve $6
entry using Retained Earnings Ret. Earnings $6
2. Recording year 1 entry Ret. Earnings $3
correctly using Retained Earnings Reserve $3
3. Undoing year 2 entry Expense $3
  Reserve $3
4. Recording year 2 entry correctly Expense $3
  Reserve $3

The first entry completely reverses the incorrect journal entry for the prior period; the second entry records the correct journal entry for the prior period; the third entry reverses the incorrect journal entry for the current period; and the fourth entry records the correct entry for the current period. Thus, the cumulative effect on retained earnings is a net $3 increase with a corresponding net reduction in the reserve of $3 (entries 1 and 2).

The examples above illustrate the problem with relying exclusively on the iron curtain, which was presumed to be the preferred technique for assessing materiality. It is also the technique that Arthur Andersen used at Sunbeam.

Arthur Andersen’s Materiality Assessment at Sunbeam

According to the SEC’s Accounting and Auditing Enforcement Release (AAER) 1393, dated May 15, 2001, Sunbeam Corporation’s management engaged in improper accounting from the fourth quarter of 1996 to June 1998. This was done in an attempt to inflate the company’s stock price and present the company as a takeover candidate. Among other items, Sunbeam overaccrued restructuring and other reserves as part of a corporate reorganization in 1996, and in 1997, it reversed the overaccrual into income (commonly referred to as “cookie jar reserve” accounting). AAER 1393 also stated (in footnote 8) that the “Company’s auditors [Arthur Andersen] proposed an adjustment to reverse these expenses but agreed to pass on them as immaterial for the 1996 fiscal year.”

The amount of the restructuring overaccrual in 1996 was $12.7 million. In 1997, Sunbeam reversed the reserve to boost income for that year and to make the company’s restructuring efforts appear successful. When Sunbeam reversed the reserve in 1997, it caused the reserve to be underaccrued by $3.2 million. (There were other reserve misstatements, but this section focuses only on the restructuring reserve.)

Using the iron curtain, only $3.2 million would be restated. Using the rollover, the figure would be $15.9 million ($12.7 million + $3.2 million). Andersen’s internal policies expressed a preference for the iron curtain. The SEC’s AAER 1405 (June 19, 2001) noted that Andersen’s “Audit Objectives and Procedures Manual” stated that “reducing the total cumulative effect of current year passed adjustments by the amount passed in the prior year is ordinarily not acceptable when evaluating the materiality of current year passed adjustments.”

Sunbeam’s “as reported” income statement for 1997 is provided in the Exhibit. Using the iron curtain and considering only the restructuring reserve, $3.2 million would represent only 1.7% of income before taxes ($3.2 million divided by $189,280 million) and only 2.6% of net income from continuing operations. By contrast, using the rollover, $15.9 million would represent 8.4% and 12.9% respectively. These results are summarized below:

  Iron Curtain
Misstatement =
$3.2 million
Rollover
Misstatement = $15.9 million
% Income before taxes 1.7% 8.4%
% Net income from
continuing operations
2.6% 12.9%

Andersen waived the adjustments for materiality reasons. The rollover would have increased the likelihood that the restructuring reserve misstatement, by itself, would have been deemed material. Andersen could have argued that the current-year impact of the prior-year passed adjustments should not be aggregated with current-year proposed adjustments because they had no remaining effect on the current year-end balance sheet. In other words, the carryover effect on the current period should not be considered because under the iron curtain, once an adjustment is passed as immaterial, there can be no adjustment of a prior period.

As shown both in the examples above and in the case of Sunbeam, the iron curtain could give a false negative materiality assessment if used mechanistically. Certain transactions, such as the reversal of an overaccrual, are unusual in nature, which may lead to a spurious inference.

The dual approach is a practical solution to the problem of materiality assessment. It represents only the quantitative portion of the assessment. This article does not address qualitative factors that must be considered under SAS 107 and SAB 99. The use of the dual approach would likely have deemed the misstatement described above to be material. The fact that the auditor waived the adjustment allowed management to camouflage a turnaround as being real when in fact it was largely artificial. The net income figure reported above, $109.4 million, was actually only $38.3 million, or 65% less than originally reported.

Underscoring the Need for Qualitative Dimensions

The examples in this article show why a dual approach to assessing materiality is necessary. The article also shows how Sunbeam and its auditor were able to waive a misstatement because the particular materiality test (iron curtain) did not designate the reversal of an accrual as material. However, the authors limited their discussion to quantitative assessments of materiality, and used stylized examples with materiality thresholds to illustrate their points. The authors’ intent is to underscore the need to incorporate qualitative dimensions in materiality assessments.

Ex ante estimates inherently differ from ex post results, such as an estimate for a restructuring reserve. Among many qualitative considerations (see SAB 99), materiality assessments should consider whether the variances between the estimates made in one period and the results observed in a subsequent period stem from a willful intent to deceive. If a company’s management does not exercise good faith and does not use a reasonable basis for making estimates, a misstatement is material, regardless of its magnitude. SAB 108 is nonetheless an improvement over earlier guidance. It will result in greater transparency, which can assist investors in their determination of which financial performances are real rather than illusory.


Stephen Bryan, PhD, is an associate professor of accountancy at the Babcock Graduate School of Management of Wake Forest University, Winston-Salem, N.C.
Douglas R. Carmichael, PhD, CPA, is the Wollman Distinguished Professor of Accountancy at the Zicklin School of Business of Baruch College, City University of New York, and former PCAOB chief auditor.
Steven Lilien, PhD, CPA, is the Weinstein Professor of Accounting, also of the Zicklin School of Business of Baruch College. Carmichael and Lilien are members of
The CPA Journal Editorial Board.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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