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Practical and Conceptual Clarifications
One of the most critical phases of an audit is the evaluation of audit findings and the related actions taken by management and the auditor in response to those findings. SEC Staff Accounting Bulletin (SAB) 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements, issued in 2006, resolved a long-standing debate as to the proper treatment of misstatements in a company's opening balance sheet that affect current period results of operations. Essentially, SAB 108 mandates a dual approach in quantifying the effect of unadjusted differences in opening and closing balances and requires corrections to the financial statements when either of the two approaches indicates a material misstatement.
Rollover Versus Iron Curtain
In SAB 108, these two approaches are called me "rollover" and "iron curtain." SAB 108 states:
The rollover approach quantifies a misstatement based on the amount of error originating in the current year income statement Thus, this approach ignores the effects of correcting the portion of the current year balance sheet misstatement that originated in prior years.... 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 year(s) of origination.
The iron curtain approach is easier to understand and apply in practice. People intuitively understand how misstatements in a closing balance sheet affect currentperiod income statement amounts, largely because they can follow the effects of corrections made to the closing balance sheet to remove the errors.
The basic rationale of the rollover approach, on the other hand, can be challenging to understand, apply, or explain, especially in the realistic case of a large, multilocation enterprise where scores of misstatements of different signs, amounts, and sources exist in both opening and closing retained earnings, and where the focus inevitably is upon quantifying the dollar misstatement of net income (or a subcomponent thereof - e.g., income before extraordinary items). In such cases, it usually is impractical - and also potentially confusing and prone to error - to conceptualize rollover-approach quantifications as a series of individual misstatements affecting individual revenue or expense account balances mat affect net income when aggregated.
Rather, it is customary...