| SEC Issues SAB on Materiality By Thomas Ray
The Securities
and Exchange Commission (SEC) staff has released Staff
Accounting Bulletin (SAB) No. 99 which addresses the
application of materiality thresholds to the preparation
and audit of financial statements filed with the SEC.
SABs are interpretations and practices followed by the
staff of the Office of the Chief Accountant and the
Division of Corporation Finance in administering the
disclosure requirements of the federal securities laws;
they are not rules or interpretations of the SEC.
The SAB states
that it does not create new standards or definitions for
materiality, but reaffirms the concepts of materiality
expressed in the accounting and auditing literature as
well as in long-standing case law. Indeed, the SAB draws
heavily on the existing auditing and accounting
literature on materiality, and makes some important
statements, including the following:
- Registrants
and auditors may not rely solely on numerical
thresholds to determine what is material.
- The
materiality of misstatements discovered in the
financial reporting and auditing processes must
be considered both individually and in the
aggregate.
- Intentional
misstatements that are not material are
inappropriate and may be unlawful.
The SAB
addresses the evaluation of misstatements discovered in
the financial reporting and auditing processes, and does
not affect the auditor's consideration of materiality in
planning the audit.
Qualitative Characteristics of Materiality
Registrants and
the auditors of their financial statements should not
rely exclusively on quantitative benchmarks or rules of
thumb to determine whether an item is material to the
financial statements. A numerical threshold may provide
the basis for a preliminary assumption that an amount is
unlikely to be material; however, it is not a substitute
for a full analysis. Financial Accounting Standards Board
Statement of Financial Accounting Concepts No. 2,
Qualitative Characteristics of Accounting Information,
reminds us that an amount is material if the
"magnitude of the item is such that it is probable
that the judgment of a reasonable person relying upon the
[financial] report would have been changed or influenced
by the inclusion or correction of the item." Thus,
management and auditors must consider both quantitative
and qualitative aspects of unadjusted differences and
omissions.
Statement on
Auditing Standards (SAS) No. 47, Audit Risk and
Materiality, provides auditors with guidance on
evaluating audit findings (AU sec. 312.35-.40). SAS No.
58, Reports on Audited Financial Statements, also
provides guidance on evaluating the materiality of
departures from generally-accepted accounting principles
(AU sec. 508.36). The SAB presents some additional
qualitative factors to consider, and states that among
the considerations that may well render material a
quantitatively small misstatement of a financial
statement item are whether the misstatement —
- Arises
from an item capable of precise measurement or
whether it arises from an estimate and, if so,
the degree of imprecision inherent in the
estimate;
- Masks a
change in earnings or other trends;
- Hides a
failure to meet analysts' consensus expectations
for the enterprise;
- Changes a
loss into income or vice versa;
- Concerns a
segment or other portion of the registrant's
business that has been identified as playing a
significant role in the registrant's operations
or profitability;
- Affects
the registrant's compliance with regulatory
requirements;
- Affects
the registrant's compliance with loan covenants
or other contractual requirements;
- Has the
effect of increasing management's compensation,
for example, by satisfying requirements for the
award of bonuses or other forms of incentive
compensation;
- Involves
concealment of an unlawful transaction.
In the context
of the SAB, for example, management and auditors may be
expected to be aware of analysts' consensus expectations
and consider them in evaluating unadjusted differences.
The SAB also
emphasizes the possible effect of misstatements on
segment disclosures. For example, the SAB states that a
misstatement of the revenue and operating profit of a
relatively small segment that is represented by
management to be important to the future profitability of
the entity is more likely to be material to investors
than a misstatement in a segment that management has not
identified as especially important.
Auditors and
management may wish to consider expanding their
documentation of the reasons for concluding that
unadjusted misstatements are not material to include
salient qualitative considerations.
Aggregation of Unadjusted Differences
The SAB reminds auditors that, when
evaluating the materiality of unadjusted differences, the
differences should be considered both individually and in
the aggregate. An individually material misstatement
should not be aggregated with offsetting immaterial
amounts as part of an analysis that justifies that, as a
whole, the misstatements are not material. In addition,
SAS No. 47 (AU sec. 312.34) states that “the auditor
should aggregate misstatements that the entity has not
corrected in a way that enables him or her to consider
whether, in relation to individual amounts, subtotals, or
totals in the financial statements, they materially
misstate the financial statements taken as a whole.”
Also, the SEC staff believes that, in
considering the aggregate effect of multiple
misstatements on a subtotal or total, registrants and the
auditors of their financial statements should exercise
particular care when considering whether to offset (or
the appropriateness of offsetting) a misstatement of an
estimated amount with a misstatement of an item capable
of precise measurement.
Intentional Misstatements
The SAB states that management should
not make intentional immaterial errors in a
registrant’s financial statements to
“manage” earnings, and that in certain
circumstances, intentional immaterial misstatements are
unlawful. The SAB makes some subtle observations about
management’s intent and the legality of intentional
misstatements, some of which are discussed below. It
further reminds registrants of their legal responsibility
to keep books, records, and accounts that, in reasonable
detail, accurately and fairly reflect transactions and
the disposition of assets. The SAB also reminds auditors
of their obligation to inform management and, in some
cases, the audit committee of illegal acts that come to
the auditor’s attention.
The SEC staff believes that a
registrant and the auditors of its financial statements
should not assume that even small intentional
misstatements in financial statements are immaterial.
Although management’s intent does not render a
misstatement material, it may provide significant
evidence of materiality. The evidence may be particularly
compelling when management has intentionally misstated
items in the financial statements to manage reported
earnings. In that instance, management presumably has
done so believing that the resulting amounts and trends
would be significant to users of the registrant’s
financial statements. The SEC staff believes that
investors generally would regard such a practice as
significant.
In discussing the legality of
misstatements, the SAB focuses on intent. The SAB states
that it is unlikely that it is ever
“reasonable” for registrants to record
immaterial misstatementsor not to correct known immaterial
misstatements as part of an ongoing
effort directed by or known to senior management for the
purposes of managing earnings. Therefore, when evaluating
the materiality of unadjusted misstatements, it becomes
important to consider factors such as analysts’
consensus estimates and other factors that might be
motivating management
The SAB reminds auditors of their
responsibilities under GAAS and the securities laws to
report illegal acts to management and, in certain
circumstances, to the audit committee. However, the SAB
does not provide any definitive conclusions about when an
immaterial misstatement is an illegal act. If the auditor
identifies otherwise immaterial misstatements that he or
she suspects are either intentional or were not corrected
“as part of an ongoing effort directed by or known
to senior management for the purposes of managing
earnings,” he or she may need to consider consulting
with legal counsel.
Registrants and their
auditors are urged to read the SAB fully and carefully.
The Auditing Standards Board has established a task force
to consider whether the auditing standards should be
amended or interpreted, or whether additional guidance is
needed.
Additional sources of guidance on the
evaluation of materiality include the following:
- A “White Paper” on
materiality developed by a task force of the five
largest accounting firms. This paper also is
available on the AICPA’s Web site at
www.aicpa.org/members/div/auditstd/big5.htm.
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