It was a stern reminder the Securities and Exchange Commission sent to the auditing world recently: Appearances do matter.
The agency delivered a $10 million rap on the knuckles to KPMG on Oct. 20, for ignoring improper revenue statements from its client Gemstar-TV Guide International. The inflated revenues themselves weren’t much: $212 million from late 1999 to early 2002, a period when Gemstar’s total revenues topped $3.43 billion. Instead, SEC officials punished KPMG because the misstatements were qualitatively material, troubling more for their meaning than their size.
“It was a problem in this case, and I don’t think it was unique,” says Kelly Bowers, assistant regional director for the SEC in California, where the complaint was made. “We hope it sends a message to the accounting community.”
Qualitative Vs. Quantitative
The message, accountants and securities lawyers say, is that auditors cannot hide behind the more common standard of quantitative materiality to avoid troubling accounting items. The industry has long considered items that disrupt earnings or revenues by 5 percent or less to be immaterial because of their small size. But with the KPMG complaint, the Commission warned auditors to consider an item’s effect on elusive variables such as stock price and investor expectation just as much as its effect on the bottom line.
Packard
“I think it’s a very wise decision to look really hard at qualitative statements,” says Bruce Packard, a securities lawyer at the Dallas-based firm Davis Munck. “For years, analysts have said revenues were good but of poor quality.”
Gemstar, which owns TV Guide magazine and develops interactive television-programming guides for cable television, had inflated its revenues in several promising new lines of business. Analysts and investors loved the supposed growth; once news of the accounting discrepancies surfaced, Gemstar’s stock price collapsed from a high of $100 per share to just $6 today.
EXCERPT
The following excerpt is from the SEC order instituting public administrative proceedings against the four KPMG auditors in the Gemstar case:
"Despite these indications of Gemstar's improper accounting and disclosure, the respondents issued unqualified audit reports representing that KPMG had conducted its audits in accordance with generally accepted auditing standards (GAAS) and that Gemstar's financial statements fairly presented its financial results in conformity with GAAP. In reaching these conclusions, the auditors unreasonably relied on representations by Gemstar's management and its inside or outside legal counsel or decided that the unsupported revenues were immaterial to Gemstar's financial statements. The auditors' reliance on these representations was unreasonable because the representations were contradicted by other evidence and contained qualifications that called into question their reliability. The auditors' materiality determinations were unreasonable in that they were based on a quantitative analysis and failed to consider whether the revenues at issue were qualitatively material."
Download Full Text Of Administrative Proceeding
Four KPMG auditors reviewed and approved Gemstar’s financial statements during the years in question. Under terms of its settlement with the SEC, those four auditors are barred from working with public companies. KPMG must also pay the $10 million fine to Gemstar shareholders, and provide training on qualitative materiality to its auditing staff.
As a concept, qualitative materiality is not new. For years, any auditor have known that some non-financial indicators—a bribe to a foreign official, for example, or misstatements to hide other violations of the law—were always material, no matter how small the numbers might actually be.
The SEC even drove home the point five years ago with Staff Accounting Bulletin 99, which clearly states that “magnitude itself ... will not generally be a basis for a materiality judgment.” One circumstance to consider, the bulletin said, was a misstatement that masks missed earnings expectations.
The Materiality Judgment
Still, experts say an enforcement action of this size over qualitative items is rare, and that the settlement is likely to have accounting firms poring over their own procedures to gauge whether they have any loopholes that might cause missteps similar to KPMG’s.
Jay Hartig, a partner and SEC specialist at PricewaterhouseCoopers, concedes that qualitative materiality “is a challenging area for us, certainly.”
Most difficult is judging an item’s materiality based on what investor sentiment might be once the event is disclosed, Hartig said. The decision is inherently uncertain, and often an event looks like a harmless error until after its disclosure. “You just have to gauge what investor reaction might be,” he says.
According to a client memo written by Wachtell Lipton Rosen & Katz partner Theodore Mirvis, "it is essential to engage in both a quantitative and qualitative analysis" when considering whether the financial statements have been fairly presented in accordance with generally accepted accounting principles. Mirvis notes that the standard is relevant not only to auditors, but to CEOs and CFOs in their certifications (see box above, right).
Mande
Vivek Mande, director of the Center for Corporate Reporting and Governance at California State University, believes the SEC’s primary target with settlements like this is earnings management, a nuisance for investors that became common in the 1990s boom. According to Mande, executives could goose earnings a penny or two per share to meet expectations while the accounting maneuver itself might not be quantitatively material. A crackdown on qualitative grounds “would make that behavior go away,” he said.
Packard at Davis Munck, meanwhile, worries that qualitative materiality can curb disclosure about a company’s new lines of business. There, executives tread a fine line between puffery and legitimate growth expectations. With auditors investigating claims about growth more aggressively, Packard wonders whether executives will simply remain silent and let analysts gauge growth expectations themselves. “I think it will be more likely to see no-comments on new side businesses,” he says, “and that’s worse for the investing public.”
The KPMG judgment also increases pressure for corporate executives to remain on their best behavior. Qualitative judgments go to the heart of management integrity and intentions.
According to Hartig at PwC, once a company runs afoul of SEC investigators on those grounds, “that makes it very difficult for the agency to take any of your statements at face value.”
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