Not infrequently, a determination is made that previously issued financial statements contain an error. Stated simply, the “error” is typically an unintentional misstatement in the financial statements of either amounts or disclosures.
The accounting guidance related to error corrections can be found in FASB Accounting Standards Codification (FASB ASC) 250,Accounting Changes and Error Corrections. That guidance clearly distinguishes between error corrections and changes to the financial statements made as a result of a change in accounting principle or accounting estimate.
An auditor needs to discern whether any identified misstatement is a result of an unintentional error or of fraudulent activity. When there are material misstatements identified due to fraud in an audit, the auditor looks to AU-C Section 240, Consideration of Fraud in a Financial Statement Audit, for additional guidance.
The applicable attest engagement guidance when considering errors that have been identified in financial statements is as follows:
- AU-C Section 560, Subsequent Events and Subsequently Discovered Facts
- AU-C Section 700, Forming an Opinion and Reporting on Financial Statements
- AU-C Section 706, Emphasis-of-Matter Paragraphs and Other-Matter Paragraphs in the Independent Auditor’s Report
- AU-C Section 708, Consistency of Financial Statements
- AR Section 80, Compilation of Financial Statements
- AR Section 90, Review of Financial Statements
Financial Statement Guidance in FASB ASC 250
As noted previously, the guidance in FASB ASC 250 clearly distinguishes error corrections from changes in accounting principles and changes in estimates that are embodied in the financial statements.
Changes in accounting principles.Using the guidance in FASB ASC 250, changes in accounting principles represent a choice among U.S. generally accepted accounting principles (U.S. GAAP). In the preparation of financial statements, there is a presumption that an accounting principle once adopted should not be changed.
The presumption that an entity should not change accounting principles may be overcome if the reporting entity can justify the use of an alternative accounting principle on the basis that the new accounting principle is preferable to the old one (“preferability”).
Changes in estimates. Changes in accounting estimates differ from changes in accounting principles in that changes in estimates simply are necessary consequences of periodic financial reporting. Essentially, accounting estimates change as new events occur, as more experience is acquired or as additional information is obtained.
Error corrections. Error corrections result from mathematical mistakes, misapplication of accounting principles, or the oversight or misuse of facts that existed at the time the financial statements were prepared. As such, an error correction also is clearly distinguishable from a change in accounting estimate.
However, the error correction might very likely include a change in the application of U.S. GAAP (that is, a change in accounting principle) from a non-U.S. GAAP method to a U.S. GAAP method. In circumstances where the change in accounting principle – that is, a change from non-U.S. GAAP treatment to U.S. GAAP treatment of an item, event or transaction – relates to an error correction, the change in principle should be reflected in the financial statements as an error correction.
Using the guidance in FASB ASC 250, an error in financial statements of a prior period discovered subsequent to the issuance of the financial statements needs to be reported as a prior-period adjustment through restatement of prior-period financial statements. The restatement is addressed as follows:
- The cumulative effect of the error on periods prior to those presented needs to be reflected in carrying amounts of assets and liabilities as of the beginning of the first period presented.
- An offsetting adjustment, if any, needs to be made to the beginning balance of retained earnings, or other appropriate components of equity or net assets, for that period.
- Financial statements of each individual prior period need to be adjusted to reflect the correction of the period-specific effects of the error in the statements.
When statements need to be restated to correct an error, reporting entities need to disclose that the previously issued financial statements have been restated, along with a description of the nature of the error. Additionally, reporting entities need to disclose the following:
- The effect of the error correction on each financial statement line item affected for each prior period presented
- The cumulative effect of the change on retained earnings, or other appropriate components of equity or net assets, in the statement of financial position at the beginning of the earliest period presented
The accounting requirements related to error corrections are important for reporting entities, accountants and auditors to understand. Beyond the accounting requirements, accountants and auditors will also need to comply with related requirements in the auditing, review and compilation standards, as referenced above. – Bob Durak, CPA, CGMA, Director of AICPA Center for Plain English Accounting