The Securities and Exchange Commission has issued guidance for companies that need to correct errors for prior period financial statements. At issue is materiality. While an error in one year may not be material, a build-up of similar errors over time may create a total error that would distort results materially if the error was corrected on current year financial statements.

A $10 million dollar error in each of 4 years may have been immaterial in each of those years, but the resulting $40 million total error could be material to this year’s financial statements. Two approaches have been used to deal with this situation:

• Rollover approach (also called current period approach or income statement approach) – The error is quantified in terms of its effect on the current year income statement.
• Iron curtain approach (also called the cumulative approach or balance sheet approach) – The error is quantified in terms of the cumulative amount by which the current year’s balance sheet is misstated.

Both approaches have drawbacks, so the SEC instructs accountants to determine whether or not an error is material based upon the larger result from these two approaches. In the first 10-K filed after this bulletin, companies must correct balance sheet errors by recording the culuative effect on the financial statements. (Instead of just restating prior year financial statements.)