Screw-up? True-up? Restatements Explained

Auditor reports will now say whether a company restatement is the result of an error or simply a change in accounting, thanks to a new rule approved today.

In a development likely to calm investors and cheer some companies that have been forced to restate financial results, auditors signing off on corporate financial reports may now specify whether the company has restated its financial results because of an error, or whether it has done so simply because accounting rules themselves have changed.

On Tuesday, the Public Company Accounting Oversight Board voted to approve Auditing Standard No. 6 (AS6), Evaluating Consistency of Financial Statements. The new standard brings the rules for auditors up-to-date with FAS 154, Accounting Changes and Error Corrections. That rule, published by Financial Accounting Standards Board in May 2005, required that companies restate their current and previous financial reports whenever an accounting rule changed, and also when companies voluntarily decided to change their choice of a particular accounting method. (For more, see our earlier story, “Restatement: Screw-up or True-up?“)

FAS 154 was originally resisted by companies, who historically recorded such changes as a one-time cumulative effect on the income statement. They feared that retroactive restatements would confuse investors, who are used to seeing such restatements only when companies had made errors or deliberate misstatements.

FAS 154 “likely added confusion as [investors] may be unable to tell whether the restatement resulted from a change to a more preferable — or new — accounting standard, or was due to the correction of an error,” Denise Dickins, assistant professor of accounting and auditing at East Carolina University, explained to CFO.com last year.

And, to be sure, company fears about investor confusion were justified. To date, auditors have not specified the reason for restatements in their audit reports, leaving investors unclear on the reason. AS6 specifically states that auditors should indicate in their reports whether an adjustment to earlier financial statements is the result of a change in accounting principle or the correction of a misstatement.

“Auditing Standard No. 6 will improve the quality of the auditor’s reporting on items that affect the consistency of financial statements, such as a company’s adoption of a new accounting principle or its correction of a material misstatement,” said Mark Olson, PCAOB chairman. “Investors should benefit from these improvements.”

AS6 was not the only effort by the PCAOB Tuesday to bring auditing standards up to speed with accounting standards. In the same meeting, the PCAOB also voted to eliminate the generally accepted accounting principles hierarchy from its own auditing standards because FASB has proposed to incorporate the hierarchy into its accounting. The hierarchy is essentially a list of accounting principles issued by different accounting bodies over the years, and a roadmap of sorts for how companies should select them when preparing their financial statements. “The board believes that it is appropriate to locate the GAAP hierarchy in the accounting standards rather than in the auditing standards,” a PCAOB statement noted.

Both the new auditing standard and amendments require the approval of the Securities and Exchange Commission. The rule would become effective 60 days after that approval.

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