Heads Up. When Small Looms Large SEC Staff Issues Materiality Guidance

Transcription

1 Heads Up Accounting, Tax, and Regulatory Developments Affecting Capital Markets Instruments and Strategies August 16, 1999; Volume 6; Issue 8 When Small Looms Large SEC Staff Issues Materiality Guidance W hen is a financial statement error significant enough to be material? Companies and their auditors have long looked to the size of the error as the key indicator. The bigger the error, the more likely it would be deemed material, especially in relation to key operating and balance sheet amounts (e.g. 3-5% of net income). Last week, the SEC staff issued SAB No. 99, Materiality, to help registrants and their auditors make appropriate materiality calls. Long concerned with earnings management, Chairman Levitt discussed materiality last fall: But some companies misuse the concept of materiality. They intentionally record errors within a defined percentage ceiling. Then they try to excuse the fib by arguing that the effect on the bottom line is too small to matter. If that s the case, why do they work so hard to create these errors? Maybe because the effect can matter, especially if it picks up that last penny of the consensus estimate. When either management or the outside auditors are questioned about these clear violations of GAAP, they answer sheepishly It doesn t matter. It s immaterial. Materiality is not a bright line cutoff of three to five percent. It requires consideration of all relevant factors that could impact an investor s decision. The questions below address the key topics of the SAB. Look to the attachment for details. As developments warrant, Heads Up is edited by Jim Johnson and published by Deloitte & Touche LLP s Capital Markets Group (New York). Heads Up contains general information only; it is not a substitute for consultation with a professional. To receive copies, contact Robert Canaan at (212) or visit our website at (Publications). Serving Financial Services Industries Globally

2 Topic May a registrant or its auditor assume the immateriality of items that fall below a percentage threshold? How does stock price volatility affect a materiality assessment? How do small intentional misstatements affect a materiality assessment? How does the location of a misstatement affect a materiality assessment? How should multiple misstatements be handled? May a registrant make intentional immaterial misstatements? What should be the auditor s response to intentional misstatements? What is the relationship of industry accounting practices to GAAP? How should transactions/disclosures not covered by literature be handled? Abbreviated Summary No, although the use of a percentage may provide the basis for a preliminary assessment. The SAB includes a nonexhaustive list of other considerations. An expected market reaction to the error is a factor when management or the auditor expects a reaction. They may provide evidence that the error is material (e.g. when used to manage earnings ). Location should be considered, e.g. segment information. Each must be considered individually and in the aggregate and in relation to line items, subtotals and totals. No. In certain circumstances intentional misstatements are unlawful. The auditor must take certain actions to respond to illegal acts including informing an appropriate level of management and ensuring that the audit committee is appropriately informed. GAAP takes precedence. The staff encourages registrants and auditors to discuss these with the staff on a timely basis. What are Staff Accounting Bulletins? They represent interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws. Two additional SABs are expected by Labor Day one dealing with revenue recognition, the other to cover restructuring charges. August 16, 1999 Page 2

3 Because of the significance of the topic, we urge you to read the actual guidance, easily downloadable from the SEC website ( In a Hurry? Heads Up Available on Y ou ll save better than a couple of days (and bring a big smile to our administrative budgeters) if you subscribe to Heads Up electronically. Just send your address to Robert Canaan (rcanaan@dttus.com). Please include the phrase Heads Up by in the subject area of your message. August 16, 1999 Page 3

4 Attachment SAB No. 99, Materiality Summary of Key Provisions Question 1 Answer Additional Guidance -No. The use of a percentage as a numerical threshold (e.g. 5%) may provide the basis for a preliminary assumption that a particular item is unlikely to be material. -Such quantification is only the beginning of an analysis of materiality rather than a substitute for a full analysis. -Materiality concerns the significance of an item to users of financial statements. -The staff believes that there are numerous circumstances in which misstatements below 5% could be material. May a registrant or its auditor assume the immateriality of items that fall below a percentage threshold? -Exclusive reliance on any percentage or numerical threshold has no basis in the accounting literature or the law. -Considerations that may render material a quantitatively small misstatement of a financial statement item include (the list is not exhaustive) 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 The misstatement masks a change in earnings or other trends The misstatement hides a failure to meet analysts' consensus expectations for the enterprise The misstatement changes a loss into income or vice versa 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 The misstatement affects the registrant's compliance with regulatory requirements The misstatement affects the registrant's compliance with loan covenants or other contractual requirements 1 Questions in bold are those specifically asked and answered in SAB No. 99

5 Question 1 Answer Additional Guidance 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 The misstatement involves concealment of an unlawful transaction. Additionally, how does the demonstrated volatility of a registrant s stock price in response to certain types of disclosures affect a materiality assessment? Additionally, how do small intentional misstatements (e.g those pursuant to earnings, management) affect a materiality assessment? (Also, see questions below) Additionally, how does the location of a misstatement in the financial statements affect a materiality assessment? The demonstrated volatility may provide guidance as to whether investors regard quantitatively small misstatements as material. The intent of management does not render a misstatement material but it may provide significant evidence of materiality. An example is segment information. In assessing materiality of a misstatement to the financial statements taken as a whole, registrants and auditors should consider not only the size of the misstatement, but also the significance of the segment information. -Consideration of potential market reaction to disclosure of a misstatement by itself is too blunt an instrument to be depended on in considering whether a fact is material. -However, when management or the auditor expects (based, for example, on a pattern of market performance) that a known misstatement may result in a significant positive or negative reaction, that expected reaction should be taken into account when considering whether a misstatement is material. -The evidence may be particularly compelling where management has intentionally misstated items to manage earnings. -Management presumably has done so believing that the resulting amounts and trends would be significant to financial statement users. -A misstatement of revenue and operating profit of a 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. Page 2

6 Question 1 Answer Additional Guidance Each misstatement separately and the aggregate should be evaluated for materiality in light of quantitative and qualitative factors. Additionally, how should multiple misstatements be treated the aggregating and netting issue? -Consider whether, in relation to individual line item amounts, subtotals or totals in the financial statements they materially misstate the financial statements taken as a whole. -If the misstatement of an individual amount causes the financial statements to be materially misstated, that effect cannot be eliminated by other misstatements whose effect may be to diminish the impact of the misstatement on other financial statement items. May a registrant make intentional immaterial misstatements in its financial statements? No. In certain circumstances intentional immaterial misstatements are unlawful. -The auditor should aggregate all misstatements that affect each subtotal or total and consider whether the misstatements in the aggregate affect the subtotal or total in a way that causes the registrants financial statements taken as a whole to be materially misleading. -Registrants and auditors should consider the appropriateness of offsetting a misstatement of an estimated amount with a misstatement of an item capable of precise estimation. -Registrants and auditors should consider the effect of misstatements from prior periods on the current financial statements, particularly the case where immaterial misstatements recur in several years and the cumulative effect becomes material in the current year. -The legal assessment is not materiality based; instead it is based on determinations of what constitutes reasonable assurance and reasonable detail as set forth in the Securities Exchange Act of 1934, 2 (regarding books, records, accounts and internal accounting controls). -Determinations are based on the level of detail and degree of 2 Sections 13(b)(2) (7) Page 3

7 Question 1 Answer Additional Guidance assurance that would satisfy prudent officials in the conduct of their own affairs. -In assessing whether a misstatement results in a violation of a registrant s obligation to keep books and records that are accurate in reasonable detail, registrants and their auditors should consider (in addition to potential materiality) these factors (there may be others): The significance of the misstatement. How the misstatement arose. It is unlikely that it is ever reasonable to record misstatements or not to correct known misstatements (even those that are immaterial) as part of an ongoing effort directed by or known to senior management for purposes of managing earnings. The cost of correcting the misstatement. The clarity of authoritative accounting guidance with respect to the misstatement. -Because the judgment is not mechanical, the staff will be inclined to continue to defer judgments that allow a business, acting in good faith, to comply with the Act s accounting provisions in an innovative and cost-effective way. What should be the auditor s response to intentional misstatements? Section 10A(b) of the Exchange Act requires auditors to take certain actions upon discovery of an illegal act whether or not the illegal act[s] are perceived to have a material effect. -Among other things, the auditor is required to inform the appropriate level of management of an illegal act (unless clearly inconsequential) and assure that the registrant s audit committee is adequately informed with respect to the illegal act. -Section 10A requirements echo auditing literature: SAS 54, Illegal Acts by Clients and SAS 82, Consideration of Fraud in a Financial Statement Audit. The clear implication of SAS 82 is that immaterial misstatements may be fraudulent financial Page 4

8 Question 1 Answer Additional Guidance reporting. -Intentional misstatements may also signal the existence of reportable conditions or material weaknesses in internal accounting control which must be reported to the audit committee. What is the relationship of industry accounting practices to GAAP? How should registrants handle proposed accounting treatments or disclosures about transactions or events that are not specifically covered by existing accounting literature? Authoritative literature takes precedence over industry practice that is contrary to GAAP. -Registrants may account for and disclose based on analogies to similar situations or other factors. -However, the staff may not be persuaded that a registrant s determination is the most appropriate. -The staff encourages registrants and auditors to discuss these items with the staff on a timely basis. -The staff has heard arguments that registrants should be permitted to follow an industry accounting practice that is inconsistent with GAAP. -The situation might occur if a practice is developed when there are few transactions and the accounting results are clearly inconsequential and that practice never changes despite a subsequent growth in the number or materiality of such transactions. When disagreements occur after a transaction or event has been reported, the consequences may be severe for registrants, auditors, and most importantly, the users of financial statements. Page 5