December 1999


By Gary Illiano, CPA,
Grant Thornton LLP

"The provisions of this Statement need not be applied to immaterial items." How many FASB statements have we read that contain that boxed, final assertion? Some have said they would overlook a bogus entry, although contrary to the statement, because it is immaterial. Of course, if it were material, they would have followed the guidance to the letter.

Well, that kind of hare-brained logic has finally got the SEC up in arms. Last fall SEC Chair Arthur Levitt began a speaking, writing, cajoling crusade against "earnings management." Chief Accountant Lynn Turner called for three related staff accounting bulletins (SAB). The first one is SAB 99, Materiality, available at It is short enough, understandable enough, and important enough to be downloaded for immediate perusal.

The Specifics

The SEC's guidance in SAB 99 expresses a number of main themes.

Nothin' new here. The staff didn't want SAB 99 to change current law or accounting or auditing literature. The new SAB reiterates, emphasizes, prods, and clarifies--using only what's out there now. SAB 99 springs forth from concepts statements, statements on auditing standards, Supreme Court decisions, the Foreign Corrupt Practices Act, and the Private Securities Litigation Reform Act. And it's indicative of a new tone at 450 Fifth Street. The view in Washington is that accountants and auditors have too often become reluctant to do their jobs. Here, in black and white, are the arguments necessary to convince the recalcitrant. Ordinarily, unjustified departures from this sort of staff guidance do not result in pleasant interactions with the various divisions of the SEC.

Materiality is what's important to the reader, a reasonable sort. Materiality--the concept--relates to the significance of an item to financial statement users. For FASB Concepts Statement No. 2, "material" in magnitude is defined as the point where the judgment of a reasonable person would be influenced. With its mandate--the protection of those reasonable users known as investors--the SEC considers something material if it would have influenced an investor in his or her decision to buy, sell, or hold a security. This concept is rooted in the securities laws and runs through the history of SEC rulemaking. Despite objection, many a comment letter from the Division of Corporation Finance has required additional disclosure, disaggregation, or clarification on the basis that the archetypal reasonable investor would need that additional detail.

Quantitative thresholds are useful, but only as a first step. Cost-benefit analyses tell us that it doesn't pay to look at every single item, whether we are preparing or auditing financial statements. Setting your scope of work or filter for finding errors at some percentage threshold, say five percent of income before taxes, or the like, is a reasonable approach to obtaining the level of assurance for which society is willing to pay. The SEC staff does not object to this as an initial step. The staff does object if it is "used as a substitute for a full analysis of all relevant considerations." There is, they point out, no basis in the entire accounting literature or the law for the notion of immateriality below a quantitative threshold. Were I a betting man, I would bet they checked.

If it's material to the piece, it's material to the whole. What about the argument that the small amount, albeit wrong, surely is not material to the financial statements taken as a whole? Not so fast. SAB 99 provides a list of factors that make quantitatively small misstatements material. One of those is the impact of a misstatement on a portion of the business, for example, a significant segment. But what if the segment is too small to be "significant"? Slow down again! If the segment is likely to be important to future profitability, it could be a significant segment for the purposes of looking at misstatements. And so, the tiny misstatement, while only material to the tiny segment, could be material to the financial statements taken as a whole from the investor's perspective.

Similarly, each misstatement must be evaluated in terms of its related individual line item amount. The misstatements are aggregated to see if together they are material to a subtotal, with similar aggregation and comparison up through other subtotals to the total total. Prior year misstatements must also be considered. They may have been building and suddenly become material, or there may have been a change in circumstances, like the drop in net income from $50 million last year to break even this year.

Be careful in offsetting, because you cannot really offset a precise, hard number against a softer estimate. Also consider the pervasiveness and the significance of the item being misstated. Tucked away in footnote 19 is the reminder that these determinations are made on a quarterly as well as an annual basis. I suspect that some may not be looking at their passed adjustments quite this way.

Intentional misstatements could be illegal. Intentional misstatements, even small ones, are by definition material. What earnings management scheme misstates (or omits) information that nobody cares about? Absent psychotic management, these adjustments must be something the reasonable investor would want to know. Furthermore, engaging in earnings management is inherently material--another item of interest to our reasonable investor. Failure to disclose that fact becomes its own material omission. Also, the Foreign Corrupt Practices Act requires that companies keep sufficient books and records to be able to prepare GAAP financial statements. Intentional misstatements could violate the books and records provisions, an illegal act.

Illegal acts invoke auditor whistleblowing. One result of the Private Securities Litigation Reform Act of 1995 is a fairly stringent set of auditor reporting obligations. With limited exception, auditors must report illegal acts they discover to the appropriate parties within the company and, if satisfactory action is not taken, to the SEC. In some cases, reporting requirements are compressed into a one-day time frame. Auditing standards require communication of potential fraud to management or the board. Beheading the auditor won't help: When a company changes auditors, the terminated one tells the anointed one of various events she uncovered. If the company doesn't then tell the public, the auditor must.

Unintentional misstatements cannot be swept under the rug, either. Unintentional errors will arise in the normal accounting process. The simplest example is clerical error. Nevertheless, companies and their auditors must consider whether the discovered unintentional error is material. Assuming it is not, then they must consider what corrective action to take. They may conclude that, although known, the error is insignificant, or could not be fixed without unreasonable cost or delay, or would not prevent the company's books from being reasonably accurate. On the other hand, they may conclude that it should be corrected in order to satisfy the requirement to maintain adequate books and records and that their failure to do so could put them on the roller-coaster ride of having to notify the right persons or regulators regarding illegal acts.

It doesn't matter if others are doing it. Periodically, a contingent from my firm treks to Washington to discuss unique accounting issues with a contingent from the chief accountant's office. At our last session, Lynn Turner made clear that anyone arguing for a particular accounting treatment should not provide as her sole support the fact that others in the industry are accounting for the transaction that way. It could be mentioned, of course, but there had better be some basis in the accounting literature for the proposed accounting. SAB 99 reiterates that, even where the accounting result is clearly inconsequential, the argument for non-GAAP accounting treatment won't fly just because others in the industry practice it.

Consult with the SEC staff sooner rather than later. Not every situation is covered in the accounting literature, nor could it be. Companies may analogize to existing GAAP for their unique transactions or circumstances. Very often they are right, "right" being defined as having a position with which the SEC staff agrees. Occasionally they are not. When the guys and gals of Corporation Finance disagree with your accounting treatment after the financial statements are filed, the consequences quickly shift to somewhere between undesirable and severely painful. Either you must call forth your powers of persuasion or acquiesce to a position contrary to that previously reported. In the first instance, you will have made an expensive and time-consuming investment, one undertaken without any guarantee of success; in the second, revised financial restatements are de facto an admission that previously "true and correct" assertions were not so. That fact alone is enough to whet the appetite of the SEC's enforcement folks, not to mention produce difficulties with lawyers, shareholders, and creditors.

Our regulatory brethren encourage consultations on novel and unique transactions prior to reporting them. In contrast to ex post facto discussions, these chats have, in my experience, been comparatively pleasant, even intellectually stimulating. A word of caution: Do your homework first. Do not bring a stickball bat into Yankee Stadium. Unfortunately, time constraints and misguided (as to the accounting) operations and salespeople sometimes take away preclearance as an option. Accountants and auditors together must be vigilant to identify early those issues that may need advance consultation with the staff.

Study the Commandment

The latest tablet to make its way down the mountain is worth checking out. It may cause some to rethink what had previously been internalized: what makes an item material, how to analyze adjustments, and whether to ask first or just let the chips fall. The SEC staff has thought through the myriad ways something small comes to have large consequences. So too, perhaps, should we all. *

Gary Illiano, CPA
Grant Thornton LLP

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