May 1999 Issue

The old ways don't hold water.

Decisions in the
Computer age.
By Lee J. Seidler

In Brief

No More Excuses

Often, misstatements found by auditors are not recorded by the client on the basis that they are not material to the financial statements. Such materiality decisions are usually based on arbitrary percentages rather than definitional guidelines contained in standards. This practice has come under criticism, most recently from the chair of the SEC.

One factor that traditionally supported not recording misstatements detected by auditors was the difficulty and time involved in their recording. With the application of computer technology, this reason is no longer valid. As a result, the author proposes that a new standard be established to require that all but inconsequential detected errors be corrected.

onsider the following exchange: Auditor: We believe you should book this adjustment, reducing revenue. Client: You're right, theoretically, but I would rather not. The consolidation is almost finished. Auditor: We still think you should adjust. Client: No. Besides, your adjustment is only two percent of net income for the period. It's not material.

Hypothetical? Uncommon? No. Most experienced auditors have encountered this situation. So has the SEC. On September 28, 1998, SEC Chairman Arthur Levitt gave a speech at New York University, noting the following:

Some companies abuse 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. 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."

Whether many auditors are quite as pliable as the chairman implies is questionable. In practice, the outcome of such confrontations varies depending upon many factors, not the least of which are the personalities involved and the character of the relationship between auditor and client. One fact is certain, however: The auditor gets little help in dealing with this problem from our profession's authoritative literature.

There is a simple, straightforward standard that I believe would provide guidance in many of the situations described above. The substance of the proposed standard is that detected misstatements must be corrected. The standard would apply to all but inconsequential detected misstatements.

"Misstatements" in this context refers to those that would normally be corrected by a journal or adjusting entry. The new standard could be promulgated as either an accounting or auditing standard (or both). Its rationale is simple: In the computer age recording an audit adjustment is virtually cost free in terms of both time and effort. So why not do it?

Materiality: All Powerful

Materiality pervades accounting and auditing. Indeed, the process of summarizing, classifying, and communicating financial information involves a series of materiality decisions. However, materiality is not only pervasive, it is also the most powerful of all elements in GAAP. Every statement issued by FASB (and its predecessors) includes, "The provisions of this statement need not be applied to immaterial items." In effect, a materiality decision--or more precisely, a decision that a matter is not material--may outweigh the most authoritative accounting standard. If the client successfully contends that an adjustment is not material, many auditors believe they cannot force the client to book it, although both may agree the proposed accounting is correct.

The next question is obvious: What determines whether an item is material? The following definition is offered by FASB in Concepts Statement No. 2 (also cited by the AICPA in SAS No. 47 and by the Canadian Institute of Chartered Accountants):

The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

The SEC, in Regulation S-X, says the same thing, albeit more succinctly. A material matter is one--

about which an average prudent investor ought reasonably to be informed (Rule 1-02).

The courts have applied similar materiality tests in attempting to determine if users would consider an item material. (See, for example, Escott et al v. BarChris and Mitchell v. Texas Gulf Sulphur Co.)

These definitions, however, are less than useful in actual application. That something is material if a user would consider it to be material is clearly not a complete guide for deciding whether to make a client book an adjustment. Auditors know little about the identity of users, much less how and why they make decisions.

The profession might ask users what they consider to be material. James Patillo conducted what appears to be the most extensive such survey for the Financial Executives Research Foundation in 1976. Utilizing a variety of case studies, users (and others) were asked for their views on materiality thresholds. Patillo found wide variation in user perceptions, depending particularly upon the nature of the matter in question. He concluded that no general purpose single dollar amount or percentage relationship could be derived that would be appropriate for all situations.

The Traditional Definitions

Accountants and auditors must produce financial statements; that is why they are paid. Thus, they cannot avoid making decisions as to what is and is not material. In response to this decision imperative, accountants and auditors resort mainly to arbitrary percentage measures.

When I started in public accounting (in the late 1950s) a senior whispered in my ear, "Materiality is 10% of net income." In 1985, Montgomery's Auditing concluded that five percent of the base (probably net income) is a commonly used figure. Recent conversations with several auditors suggest flirtations with even lower levels, such as three percent of net income.

However, these arbitrary percentages are not derived in any logical way from the definitions of materiality that focus on what is important to the user. Indeed, it is common to see share prices drop precipitously when companies fail to meet market expectations for earnings by as little as a penny a share. In these instances, user notions of materiality might be far narrower than those commonly employed by the profession.

Auditors are cautioned in SAS No. 21, for example, to consider qualitative as well as quantitative factors in materiality decisions. However, the nature of the qualitative factors to be considered is accorded little specificity. In particular, there is no mention that a known, uncorrected error has any particular qualitative significance. The only such allusion I have been able to find is a footnote in Donald Leslie's 1985 materiality research study, performed for the Canadian Institute of Chartered Accountants. It indicated that some (Canadian) practitioners believed that once management was informed of the existence of errors and refused to correct them, they became intentional errors, even if they originally occurred accidentally. Unfortunately, Leslie failed to elaborate on the point.

Another problem with prevailing materiality definitions stems from their origins. They were not developed within the accounting or auditing context. Instead, they evolved from an adversarial legal structure, from situations when a company omitted or misstated some financial information and (frequently) an auditor failed to find or correct it. In much current litigation, when such a misstatement has occurred, the guilt or innocence of the defendants (company or auditor) depends principally on whether "an average prudent investor ought reasonably to have been informed" about the particular matter. Was it material?

When the auditor stands accused in court there is no choice; the legal standard will be applied. However, it does not follow that the legal standard should be the basis for decisions required by the normal accounting process. Accountants do not record and deal only with those transactions significant enough to influence investors' decisions. They record virtually all transactions, no matter how small. The significance of a recorded transaction then determines how it will be analyzed, summarized, and presented in the financial statements.

This concept is not new. In the first accounting textbook, written more than 500 years ago, Luca Pacioli insisted that the results of all transactions must be recorded. However, he noted some examples when further analysis or detail would be unrewarding. For example, freight-in need not be allocated to each item of merchandise. "If you kept separate accounts, it would be too lengthy and not worth the expense."

For small expenses, Pacioli counseled, "Set aside one or two ducats in a little bag, and make small payments out of this amount." He then gave the entry to establish a petty cash fund.

Obviously, modern accounting retains these ideas. Accountants still require the results of every transaction be recorded. They routinely book numerous, often small, adjusting entries to preserve the accuracy of individual accounts. They do not subject this activity to the legal materiality test: would an investor's decision be affected if I did not record this transaction or make this adjustment? Why then should the recording of an adjusting entry arising from the audit be subject to a different test?

It has always been logical to raise cost-benefit considerations in the application of accounting principles and practices. Pacioli was doing just that when he decided that the cost of allocating freight-in to individual products was greater than the benefit of more accurate costs for each product.

Technology Has Made the Costs Negligible

When I practiced public accounting, enormous hand-posted columnar worksheets were often necessary for the consolidation and as a basis for the financial statements. Recording an adjusting entry near the end of the process could involve hours of work. "Immaterial" adjustments were often passed because of time pressures.

Today, there is negligible incremental cost--in terms of time or money--associated with making an audit adjustment anytime before the financial statements are printed. In the computer age, those worksheets and statements reside in computers. The $149 accounting program on my laptop computer will, when given a journal entry, instantly and completely revise all the resulting financial statements. The software used by large corporations and their auditors is certainly no less versatile.

Thus, arguments that it is too difficult or too late to record audit adjustments have vanished in the computer age. It is time to promulgate a materiality standard that reflects this reality.

Impacts of the Proposal

The main advantage of this proposal would be to eliminate the demeaning dialogue that opened this article, at least when client and auditor agree that the adjustment represents correct accounting. On the other hand, it would likely increase arguments over debatable items, arguments that are now often resolved, as the SEC chairman suggests, by labeling the item as not material. It would also eliminate the bizarre (to the author) but common practice wherein auditors maintain a list of detected but uncorrected misstatements to determine if their cumulative value exceeds some materiality threshold.

Offsetting Misstatements

It is quite conceivable under present standards that if an auditor finds errors that are individually material but offset each other to create a net immaterial amount, the client could successfully argue that the action was immaterial and did not require correction.

For example, assume it is agreed that $1 million is the quantitative materiality threshold with respect to the net income of Company X. At the end of year one, an error is discovered which has the effect of accelerating $500,000 of income from year two into year one. This amount, however, is deemed not material, and the auditor does not require a correction. However, the $500,000 diverted into year one reduced year two income by the same amount. At the end of year two, the auditor notes another error which accelerates $1.2 million from year three into year two, an amount which individually exceeds the $1 million materiality threshold.

Is the $1.2 million acceleration at the end of year two material? No, argue Montgomery's Auditing and Donald Leslie in the Canadian Institute research study, because the two similar year two items--the $500,000 reversal and the $1.2 million acceleration--can be netted to produce an immaterial misstatement of only $700,000. I disagree with that logic, but I will not belabor the point. It will suffice to note that this issue would disappear if all detected misstatements had to be corrected.

What Is Inconsequential? I suspect that a definition of inconsequential will be far less elusive than that of materiality. For example, in published financial statements, figures are typically rounded to the nearest thousand or, in the case of large entities, to the nearest million dollars. The rounding is done because the numbers are more easily read; any resulting imprecision is inconsequential. Alternatively, one might decide that the magnitude of the smallest adjusting journal entry recorded during the period defines inconsequential.

Materiality Issues Will Not Disappear

The proposed standard would apply only to detected misstatements, that is, incorrect numbers. The import of undetected misstatements would continue to be measured by the current, ephemeral, and legally oriented standards of materiality. Similarly, the issue of materiality in the disclosure or, more precisely, of failure to disclose or incorrectly disclosing material information would remain in all its complexity. *

Lee J. Seidler, CPA, was formerly senior managing director at Bear, Stearns & Co. and the Price Waterhouse Professor of Auditing at New York University.


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