By Thomas A. Ratcliffe
Deciding What Is Material
It makes so much sense. So why wasn't it thought of before? Place the responsibility for not making proposed audit adjustments where it clearly belongs, on client management, and, in the case of public companies, bubble-up the knowledge of any adjustments management chooses not to make to the audit committee.
That is exactly what SAS No. 89, Audit Adjustments, does through its amendments to SAS No. 1, Codification of Auditing Standards and Procedures, SAS No. 85, Management Representations, and SAS No. 61, Communication with Audit Committees. The impetus for SAS No. 89 came from the SEC. It can be traced back to SEC Chair Arthur Levitt's September 1998 speech, "The Numbers Game," and clearly has been influenced by SEC Staff Accounting Bulletin No. 99 on materiality.
The author concludes that the number of proposed audit adjustments not booked--especially for public companies--will surely decline, if not disappear, because of SAS No. 89.
In December 1999, the Auditing Standards Board (ASB) issued Statement on Auditing Standards (SAS) No. 89, Audit Adjustments. The new auditing guidance contained in SAS No. 89 will probably not be apparent to external users of financial statements; however, the new pronouncement, through its amendments to three other SASs, will impact engagement letters, management representation letters, and audit committee communications.
The issuance of SAS No. 89 follows on the heels of the SEC's August 1999 issuance of Staff Accounting Bulletin (SAB) No. 99, Materiality. Applicable to SEC registrants, SAB No. 99 provides guidance in applying materiality thresholds to the preparation (and audit) of financial statements filed with the SEC. The combined requirements of SAB No. 99 (applicable only to publicly traded entities) and SAS No. 89 (applicable to audits of all entities) will probably result in more companies "booking" audit adjustments.
SAB No. 99, Materiality
While SABs are not official SEC rules or interpretations, they do represent interpretations and practices followed by the Office of the Chief Accountant and the Division of Corporation Finance in administering disclosure requirements under Federal securities laws. The issuance of SAB No. 99 fulfilled a promise made by SEC Chair Arthur Levitt that the staff would clarify its views on materiality thresholds.
SAB No. 99 represents a restatement of existing concepts of materiality contained in the accounting and auditing literature. Particularly, SEC registrants and their auditors are warned not to rely exclusively on quantitative benchmarks to determine whether an item is material to the financial statements. In SAS No. 47, Audit Risk and Materiality in Conducting an Audit, as that document is amended by SAS No. 82, Consideration of Fraud in a Financial Statement Audit, the ASB had already reached the conclusion that qualitative considerations (not just a quantitative threshold) are important in concluding whether financial statement misstatements are material. Therefore, it would seem that determining whether items, events, and transactions are material to financial statements never should have been based simply on a "bright-line" quantitative (amount or percentage) materiality threshold.
SAB No. 99 consists of two parts. The first part stipulates that it is not appropriate to rely solely upon a percentage ceiling test to make materiality determinations. While the SEC has no objection to using quantitative thresholds as an initial assessment, using them exclusively has no basis in the accounting literature or law. The staff emphasizes that evaluation of materiality requires registrants and their auditors to consider all relevant circumstances, both quantitative and qualitative, surrounding an issue. Exhibit 1 summarizes some of the qualitative factors discussed in SAB No. 99 that should be considered by auditors in determining whether a misstatement is material to the financial statements.
The second part of SAB No. 99 serves as a reminder that the Securities Exchange Act of 1934 requires registrants to make and keep books, records, and accounts that (in reasonable detail) accurately and fairly reflect transactions and disposition of assets. SAB No. 99 specifically stipulates that managers should not direct or acquiesce in immaterial misstatements in the financial statements for the purpose of managing earnings. Furthermore, the SAB indicates that, above and beyond issues directly associated with amounts in the financial statements, the very practice of managing earnings might be a material fact that must be disclosed. As an example, the SAB indicates that the ongoing practice to over- or understate earnings up to an amount just below a defined percentage threshold in order to manage earnings would generally be considered significant to investors.
The SAB also states that making intentional misstatements, even if immaterial, may be a violation of the securities laws. Auditors encountering intentional misstatements should consider the guidance in SAS No. 54, Illegal Acts, and SAS No. 82, Consideration of Fraud in a Financial Statement Audit. They should also consider section 10(A)(b) of the Exchange Act.
As amended by SAS No. 83, Establishing an Understanding with the Client, SAS No. 1/AU section 310, "Appointment of the Independent Auditor," requires auditors to establish an understanding of the audit engagement with the client. While the technical literature does not require the use of engagement letters, it does stipulate that the understanding with the client be documented, preferably in an engagement letter or other written communication.
Paragraph 6 of AU section 310 specifies various matters that are generally addressed in establishing an understanding of an audit engagement with the client. Omitted from this literature is specific mention of management's responsibility for determining the appropriate disposition of financial statement misstatements determined to exist by the auditor. SAS No. 89 fixes this by amending AU section 310 to require management to acknowledge its responsibility for adjusting the financial statements to correct material misstatements. The statement also establishes management's responsibility to affirm to the auditor in the management representation letter that the effects of any uncorrected misstatements aggregated by the auditor during the current engagement and pertaining to the latest period presented are immaterial, both individually and in the aggregate, to the financial statements taken as a whole.
Pursuant to the guidance in SAS No. 47, financial statements are considered to be materially misstated when they contain misstatements where the effect (individually or in the aggregate) is important enough to cause the statements not to be presented fairly in conformity with generally accepted accounting principles (GAAP) or an other comprehensive basis of accounting (OCBOA). The misstatements contemplated in SAS No. 47 (as amended by SAS No. 82) can result from either errors or fraud. Importantly, auditors have no responsibility to plan and perform an audit to obtain reasonable assurance that immaterial misstatements resulting from error or fraud will be detected. However, the primary issue addressed in both SAB No. 99 and SAS No. 89 is the use of materiality thresholds in evaluating audit findings.
In making the determination as to whether financial statements are presented fairly in all material respects and conform to GAAP or OCBOA, the auditor should aggregate misstatements that the entity has not corrected in a way that enables the auditor to consider whether (when compared to amounts, subtotals, or totals in the financial statements) the financial statements taken as a whole are materially misstated. Qualitative considerations must be utilized in making the decision as to whether misstatements are material.
Based on the accumulation of audit evidence, when the auditor concludes that the aggregation of likely misstatements causes financial statements to be materially misstated, the auditor should request that management eliminate these misstatements. While aggregating the misstatements, consideration should be given to SAB No. 99, especially with respect to netting misstatements with offsetting effect. The SAB takes the position that it is not appropriate to offset a material misstatement going in one direction with a material misstatement in the other direction that results in a net immaterial effect. Each must be considered individually.
Even though management will have acknowledged its responsibility to record material adjustments and to conclude that uncorrected misstatements are immaterial to the financial statements in the engagement letter, the auditor is not relieved of the duty to objectively assess and evaluate management's conclusions on materiality.
Management Representation Letters
The amendment to AU section 310 establishes the understanding that the client will be expected to address unadjusted known misstatements in a representation letter. To complete the process, SAS No. 89 also amends SAS No. 85, Management Representations, which requires that the auditor obtain written representations from management as part of a financial statement audit. These recommendations are typically obtained in a representation letter at the conclusion of the audit engagement.
SAS No. 89 requires that the management representation letter include an acknowledgement by management that it has considered the financial statement misstatements aggregated by the auditor and has concluded that uncorrected misstatements are immaterial, both individually and in the aggregate, to the financial statements taken as a whole. The amendment also requires that a summary of uncorrected misstatements be included in or attached to the representation
letter. This summary parallels the workpaper documentation currently used in practice and referred to in a variety of different ways, such as a summary of audit differences, a summary of unadjusted differences, or an audit difference evaluation form.
The following is an example representation that may be utilized to accomplish the SAS No. 89 objective:
We believe that the effects of the uncorrected financial statement misstatements, summarized in the accompanying schedule, are immaterial (both individually and in the aggregate) to the financial statements taken as a whole.
In those circumstances where management believes that certain of the identified items are not misstatements, management's belief may be acknowledged by adding language to the representation, such as, "We do not agree that items AA and BB constitute misstatements because [description of reasons]."
The amendment notes that the communication to management of immaterial misstatements aggregated by the auditor as part of the representation
letter does not satisfy the auditor's responsibilities to communicate illegal acts. Guidance in SAS Nos. 54 and 82 and the Exchange Act should be followed in those cases where the auditor believes the failure to adjust for intentional misstatements rises to the level of a potential unlawful act.
Audit Committee Communications
Pursuant to the provisions of SAS No. 61, Communication with Audit Committees, auditors are required to determine that certain matters related to the conduct of an audit are communicated to those that have responsibility for oversight of the financial reporting process (i.e., the audit committee). The communication requirements in SAS No. 61 are applicable only in SEC engagements and non-SEC engagements where the reporting entity has an audit committee (or another formally designated body serving that purpose). As such, the provisions of SAS No. 61 are not applicable to the majority of small business engagement audits. One of the requirements in SAS No. 61 is that the auditor inform the audit committee about adjustments arising from the audit (whether recorded by the entity or not) that could, in the auditor's judgment, have a significant effect on the reporting entity's financial reporting process.
SAS No. 89 amends SAS No. 61 by requiring the auditor to inform the audit committee about uncorrected misstatements aggregated by the auditor during the current engagement and pertaining to the latest period presented, where management believes the effects of the
misstatements are immaterial (both individually and in the aggregate) to the financial statements taken as a whole. The presentation to the audit committee should be similar to the summary of uncorrected misstatements included in or attached to the management representation letter.
SAB No. 99's Guidance Filters Down to All Audits Through SAS No. 89
SAB No. 99 has already modified how auditors and their clients analyze uncorrected misstatements in financial statements of publicly traded entities. For these entities, and for entities that are not publicly traded, SAS No. 89 significantly amends current authoritative literature related to communications with the client at the beginning and end of audit engagements.
Perhaps one of the shortest standards issued, SAS No. 89 is nonetheless the first time the ASB has articulated a position on perhaps the most important aspect of an audit engagement. It should put appropriate pressure on management to record all but the most trivial adjustment.
Exhibit 2 summarizes the significant changes that must be implemented by auditors performing financial statement audits for periods beginning on or after December 15, 1999. Early adoption of the provisions of SAS No. 89 is permitted. *
Thomas A. Ratcliffe, PhD, CPA, is dean of the Sorrell College of Business and Eminent Scholar in Accounting and Finance, Troy State University, Troy, Ala.
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