A waived adjustment schedule can be seen on most audit engagements where each error found by the auditors is noted along with its estimated effect on the income statement and balance sheet. The net aggregate of the found errors is entered on the bottom of the schedule, which is then compared to five or 10% of income before taxes. If the net error amount is less than the calculated percentage amount, the audit is over.
While this scenario is an oversimplification of actual practice, it presents the essence of the way in which findings in an audit are evaluated. The recently issued SEC Staff Accounting Bulleting No. 99, Materiality, however, will make the process in whatever form it is presently practiced considerably more complex and analytical. The SAB was issued in response to a commitment made by SEC Chairman Arthur Levitt in his September 1998 speech, "The Numbers Game," (reprinted in its entirety in the December 1998 CPA Journal). Levitt, in attacking the practice of earnings management, noted how some companies abuse materiality by intentionally recording errors within a defined percentage ceiling and hiding behind the materiality shield when questioned why the errors were permitted to remain in their financials. He went on to commit the SEC to providing guidance for companies and their auditors on the role of materiality in evaluating misstatements in financial statements.
SAB No. 99 very carefully defines that role using existing professional literature and securities laws and regulations. It sets forth a number of significant conclusions on the part of the staff of the SEC, without, in the opinion of SEC Chief Accountant Lynn Turner, "breaking new ground."
First, the SEC staff concludes that passing or waiving corrections to financial statements exclusively on the basis that they are below a percentage threshold (i.e., five percent of a financial statement item) "has no basis in the accounting literature or the law." The SAB states that use of rules of thumb are appropriate as an initial step in assessing materiality, but that identified misstatements must be subject to a qualitative analysis. To demonstrate the importance of evaluating misstatements in the light of all the relevant circumstances, the SAB gives a number of examples where a quantitatively small misstatement might very well be considered material, among them are as follows:
* 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 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 has the effect of increasing management's compensation for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation, and
* Whether the misstatement involves concealment of an unlawful transaction.
These examples will place previously unsuspected burdens upon the auditors of public companies to learn about what market analysts are expecting of the company and to evaluate misstatements relative to particular industry segments that may be of interest to analysts.
The SAB also discusses aggregating and netting misstatements and presents the SEC staff's view that each misstatement must be considered separately and then aggregated with other misstatements when determining whether adjustments are required. The staff believes it is inappropriate to offset a material misstatement with another, unadjusted misstatement.
The SAB concludes by developing the argument that companies have a statutory requirement to maintain their books and records "in reasonable detail" and that therefore recording intentional immaterial misstatements may be unlawful.
In turning to the auditor's responsibility, the SAB says that intentional immaterial misstatements may represent fraudulent financial reporting as contemplated in SAS No. 82.
The complete text of SAB 99, Materiality, is available at the www.sec.gov/rules/acctreps/sab99.htm.
The SEC staff has met Chairman Levitt's commitment to deliver guidance on materiality in financial reporting. The seriousness with which the staff of the SEC views intentional misstatement of financial statements is abundantly clear. The SAB plainly sounds the death knell for the passed adjustment worksheet.
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