SEC Ponders Update On Materiality Standard

The staff of the Securities and Exchange Commission is considering an update to its views on materiality, especially the qualitative factors surrounding large versus small errors and the effect of quarterly materiality considerations.

Conrad Hewitt, the Commission’s chief accountant, met last month with the SEC Regulations Committee of the American Institute of Certified Public Accountants, and told the committee that staff members from his office are working with their counterparts in the SEC Division of Corporation Finance to review Staff Accounting Bulletin No. 99, Materiality. While it was issued in 1999, the bulletin remains the SEC’s most current and comprehensive view on how companies should assess materiality.

According to a brief Deloitte & Touche account of Hewitt’s meeting with the AICPA committee, he told the group that SEC staff is reviewing how SAB 99 treats items that are “qualitatively material and quantitatively immaterial, or qualitatively immaterial and quantitatively material.” That means the SEC is trying to address how companies should look at mistakes where the numbers are small but the impact is significant, or where the numbers are big but the impact is not significant.

Hewitt said the project also is exploring issues related to interim or quarterly materiality, according to the Deloitte summary.

SEC spokesman John Heine says no formal proposal is pending before the Commission, nor is there any specific initiative under way regarding materiality. “I don’t know what [Deloitte] meant by a ‘project,’ but we haven’t announced any kind of initiative or task force,” he says. “We’re always listening to what people have to say and we’re always happy to get input from the outside.”

The AICPA and Deloitte declined further comment, deferring to the SEC. A source close to the SEC who is familiar with the work says the initiative likely is meant to clarify confusion that has become apparent since SEC associate chief accountant Todd Hardiman delivered a speech at the AICPA conference in December addressing quantitative versus qualitative aspects of materiality and quarterly materiality.

In his speech, Hardiman discussed scenarios where a company might discover an error where the numbers are small but the effect on previously reported numbers is significant enough that they must be corrected. The inverse, he said, is also true: that the error could be large but the impact to previously reported numbers could be insignificant enough that the company could find the error immaterial. That concept was explored last week in a Compliance Week column by former SEC deputy chief accounting Scott Taub. (See box above, right, for Hardiman’s speech and Taub’s column).

Hardiman went on to say the SEC staff bristles when it digs into a materiality analysis and finds the company’s approach looks solely at the principled guidance of SAB 99, without looking more comprehensively at the company’s own fact patterns to reach a decision about whether an error is material.

RULE EXCERPT

Below is a portion of Staff Accounting Bulletin No. 99, Materiality, from the Securities and Exchange Commission.

Evaluation of materiality requires a registrant and its auditor to consider allthe relevant circumstances, and the staff believes that there are numerous circumstances in which misstatements below 5 percent could well be material. Qualitative factors may cause misstatements of quantitatively small amounts to be material; as stated in the auditing literature:

As a result of the interaction of quantitative and qualitative considerations in materiality judgments, misstatements of relatively small amounts that come to the auditor's attention could have a material effect on the financial statements.

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;

whether the misstatement masks a change in earnings or other trends;

whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise;

whether the misstatement changes a loss into income or vice versa;

whether the misstatement 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;

whether the misstatement affects the registrant's compliance with regulatory requirements;

whether the misstatement affects the registrant's compliance with loan covenants or other contractual requirements;

whether the misstatement has the effect of increasing management's compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation;

whether the misstatement involves concealment of an unlawful transaction.

This is not an exhaustive list of the circumstances that may affect the materiality of a quantitatively small misstatement. Among other factors, the demonstrated volatility of the price of a registrant's securities in response to certain types of disclosures may provide guidance as to whether investors regard quantitatively small misstatements as material. Consideration of potential market reaction to disclosure of a misstatement is by itself "too blunt an instrument to be depended on" in considering whether a fact is material. When, however, management or the independent auditor expects (based, for example, on a pattern of market performance) that a known misstatement may result in a significant positive or negative market reaction, that expected reaction should be taken into account when considering whether a misstatement is material.

For the reasons noted above, the staff believes that a registrant and the auditors of its financial statements should not assume that even small intentional misstatements in financial statements, for example those pursuant to actions to "manage" earnings, are immaterial. While the intent of management does not render a misstatement material, it may provide significant evidence of materiality. The evidence may be particularly compelling where management has intentionally misstated items in the financial statements to "manage" reported earnings. In that instance, it presumably has done so believing that the resulting amounts and trends would be significant to users of the registrant's financial statements. The staff believes that investors generally would regard as significant a management practice to over- or under-state earnings up to an amount just short of a percentage threshold in order to "manage" earnings. Investors presumably also would regard as significant an accounting practice that, in essence, rendered all earnings figures subject to a management-directed margin of misstatement.

Source

Securities and Exchange Commission (August 1999)

“To support an assertion that a large error is immaterial, registrants need to look beyond the qualitative considerations listed in the SAB that identify when a small error may be material,” Hardiman said at the time. “They need to identify the considerations that cause the financial statements to be reliable notwithstanding the large error.”

Regarding quarterly materiality, Hardiman explored the different views on how often an error in a quarterly report would be seen as material if it is not material to the annual period. “Simple math says the sum of the four quarters must equal the year,” he said. “But the fact remains that materiality judgments of annual financial statements do not consider quarterly effects. And so long as they don’t, it seems like we'll struggle with the mechanics of how to account for errors that are immaterial to an annual period, but may be material to a quarterly period.”

Hardiman said the staff has debated quarterly materiality for some time, especially since the issuance last fall of Staff Accounting Bulletin No. 108, which takes a more comprehensive view of how errors in financial statements should be viewed and corrected. He called on financial reporting experts to continue dialogue on the quarterly materiality issue, “so that we can all come to an understanding of how to think about materiality in quarterly financial statements in a way that best meets the needs of investors and the capital markets.”

Materiality Questions

Ten Eyck

Ernie Ten Eyck, a senior managing director at FTI Consulting who attended the conference at which Hardiman spoke, says he understood the speech to mean that the SEC wants companies to pay more attention to issues that are material to a quarterly period. “The accounting literature says you view a quarter primarily in the context of the year,” he says. “[Hardiman] said a couple things that would suggest the staff didn't agree with—that if you’re going to have to make a materiality judgment for something that happened in a quarter, you should look at just that quarter as at least one of the considerations.”

A source familiar with the SEC’s current initiative to offer new staff views says the staff wants to establish some common understanding around continuing questions about how qualitative issues affect a materiality assessment, and how quarterly materiality fits into an annual period materiality assessment.

The rules around materiality—highly principled with few prescriptive thresholds—have long been a source of tension in the financial reporting world. Companies generally want a bright line, “so you can walk right up to it without stepping over it,” Ten Eyck says.

Regulators, however, have long resisted, saying every company has too many unique facts and circumstances to draw such bright lines. SAB 99 itself says “a matter is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important.”

SAB 99 raises a number of factors to consider in deciding whether a quantitatively small misstatement might be considered material: whether it arises from estimates or precise measurements, whether it moves earnings or stock price, whether it hides a failure to meet analysts’ expectations, whether it affects core business or a side operation, whether it sweetens management compensation, and whether it affects loan covenants, regulatory compliance, or other contractual obligations.

Connors

Thomas Connors, an audit partner with Deloitte & Touche, says a number of quantitative thresholds have been used over the years to assess materiality, such as 5 percent of net income or 1 percent of net assets. SAB 99 makes clear, however, that such ratios should be regarded as only a starting point in a materiality assessment.

Connors also says Sarbanes-Oxley has played a role in heightening the debate over materiality. “In the past, if you asked people about materiality, it was focused more on a quantitative analysis,” he says. “In light of SOX, the qualitative is now as important if not more important.”

Connors said calls for bright lines around materiality should be countered with reminders about what happens when rules become overly prescriptive. “People would love for there to be very specific rules defining materiality, but as we learned from Sarbanes-Oxley, being prescriptive has unintended consequences: inefficiency and ineffectiveness,” he says, as demonstrated by the current effort to rewrite SOX-related rules to reduce overzealous implementation. “The lessons we’ve learned from SOX is that we have to be more principles based.”

Neri Bukspan, managing director and chief accountant at Standard & Poor’s, says materiality has been tough to pin down because it means different things to different readers of financial statements. “Not all users of financial statements are created alike,” he says. “Large groups of constituencies have different thresholds: investors, regulators, creditors, analysts …”

Bukspan says some of the tension around materiality decisions might be relieved if the correction process—that is, issuing a restatement—were less onerous. “Every restatement is costly; some take a lot of time, and that creates uncertainty in the financial markets,” he says. Bukspan believes the market might welcome some kind of regulatory solution that would allow a company to make corrections and fully explain them without the burden and consequences of the restatement process.