SEC ADVISOR

April 2002

Materiality and Audit Adjustments

By Mary B. Curtis and Thomas Hayes

Perhaps the most authoritative definition of materiality is found in Financial Accounting Concepts Statement 2, Qualitative Characteristics of Accounting Information: “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.”

Because materiality is the foundation of almost all judgments made during an audit and because it is so vaguely defined, there is enormous latitude and variation in its application. On September 28, 1998, Arthur Levitt, then chair of the SEC, delivered what was the shot heard around the world with respect to materiality issues in his “Numbers Game” speech. Levitt described the abuse of materiality as “another way we build flexibility into financial reporting” and said that materiality should no longer be used to hide or disregard “deliberate misstatements of performance.” Shortly thereafter, both the SEC and the Auditing Standards Boards issued standards addressing problems related to materiality judgments in financial statement audits.

External auditors consider materiality at three points in their audit of financial statements: during planning, while evaluating audit differences in the field, and during review of the audit (AU 312). During the planning phase, auditors determine a quantitative materiality level that is used in several ways, including to calculate sampling precision levels and to stratify populations. The initial planning for materiality is fairly structured and, in most firms, prescribed. In the field, individual items that fail an audit test are evaluated for their impact on the account and the financial statements as a whole. During review, items classified material are reviewed again from a big-picture perspective. The materiality judgments made in the field are the most relevant to the new auditing standards.

To better understand the importance and impact of these new standards, the authors interviewed 10 SEC practice audit partners from the largest international audit firms. Recent changes in their audit practices were discussed, with an emphasis on materiality.

Staff Accounting Bulletin 99

Staff Accounting Bulletin (SAB) 99, Materiality, addresses evaluations of audit differences for materiality. Issued on August 12, 1999, the bulletin is a reminder that qualitative factors should be considered in the determination of materiality, in addition to the more common quantitative relationship to financial accounts (see “Size Doesn’t Matter: SEC Releases SAB 99 on Materiality, December 1999). Although it has always been accepted audit practice to consider both qualitative and quantitative factors in determining materiality, the ease of applying quantitative rules of thumb may overshadow qualitative factors. Interviews with audit partners suggest that SAB 99’s re-emphasis of qualitative characteristics has been effective in encouraging professionals to broaden their perspective. While only one firm has modified audit workpaper procedures to specifically address the evaluation of qualitative characteristics for audit differences, all firms appear to have a heightened awareness of their importance.

In the evaluation of audit evidence, results different from those expected by the auditor become “audit differences” that are then subjected to materiality evaluations. There are essentially two types of audit differences:

• Hard differences are misstatements that can be proved, evidenced, or calculated. They may be intentional or unintentional. Examples include unrecorded liabilities or miscounts of inventory.
• Soft differences are based on differences in estimates between the auditor and client. These differences could be due to timing, such as the determination of when an event is essentially complete and should be booked, or due to the duration of an event, such as the determination of how many periods an item should be recognized, amortized, or accrued.

Different estimates may also be due to different assumptions in measurement, such as the appropriate number of periods or discount rate for present value calculations, the current market value of assets, or the collectability of receivables and notes. SAB 99 recognizes that materiality judgments are influenced by the “imprecision inherent in the estimate.”

The two approaches to auditing estimates are making independent estimates for comparison to client accounts, and reviewing client procedures for arriving at estimates. The latter method, sanctioned by auditing standards, is employed by the interviewees’ firms. In this way, formulas or bases for estimates are reviewed for reasonableness, and then estimates are recalculated with the client’s formula for testing accuracy. In a reference to Concepts Statement 2, SAB 99 recognizes that “The amount of deviation that is considered immaterial may increase as the attainable degree of precision decreases.”

Although most firms still initially screen audit differences by comparison to a preset percentage of planning materiality threshold, SAB 99 requires further evaluation of any misstatements that are intentional or illegal. One partner suggested that intentional errors, by definition, must be material, because a company would not make intentional misstatements if it did not feel they could influence someone’s judgment. Most interviewees said that the booking of corrections for intentional misstatements was absolutely required. Many of them also suggested that intentional errors are indicators of internal control problems, which can have a major impact on detection risk and thus the nature, timing, and extent of planned evidence.

In the last few years, capital markets have paid significant attention to whether quarterly and annual earnings announcements meet analysts’ forecasts. Stock prices have been known to drop precipitously after missing earnings per share (EPS) projections by two or three cents. SAB 99 suggests that an important qualitative evaluation is “whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise.” This is a relatively new dimension for materiality, and the interviewees varied considerably in the extent they considered analyst forecasts and statements made by management to analysts. In fact, one respondent suggested that it is a contradiction to define materiality as any factor that influences “reasonable” investors while also claiming that a very slight failure to meet analysts’ forecasts should signal materiality.

The “new economy” marketplace forced auditors to adjust to the notion that companies can lose money quarter after quarter yet continue to be considered viable investments. When a company has no net income and is highly leveraged, initial materiality levels and misstatement evaluations must be based on less traditional bases. Auditors today use many different indicators, including total revenue; earnings before interest, taxes, depreciation, and amortization (EDITDA); and EPS. The recent trend of firms to release pro forma earnings numbers based on other-than-GAAP net income has further complicated materiality judgments. Because the pro-forma results often represent EPS based on operating income and similar bases, companies may prefer to push all possible expenses and losses below this line. Thus, the placement of an item or suggested correction has become of major significance, and misplacement must be considered a trigger for potential misstatement.

SAB 99 requires the aggregation of audit differences not individually material and prohibits the canceling out of offsetting items. Companies can no longer assert that misstatements need not be booked because they have no net effect. The interviews suggest that firms record most audit differences that pass their initial materiality threshold but do not pass other tests of materiality on their schedules of audit differences, then evaluate these items later in the audit for their impact individually and in the aggregate.

SAS 89

SAS 89, Audit Adjustments, issued December 1999 and effective for audits after December 15, 1999, has two primary purposes: to make management acknowledge responsibility for uncorrected misstatements, and to ensure that audit committees are informed of these uncorrected adjustments.

As an amendment to SAS 85 (AU 333.06), auditors are now required to attach a summary of uncorrected misstatements to the management letter of representation, and include a statement that management has concluded that the listed uncorrected misstatements are immaterial to the financial statements. The engagement letter should forewarn management of this requirement. In interviews with audit partners, we found that this had been done occasionally but is now uniformly followed without exception. Although this requirement could potentially increase litigation by bringing uncorrected misstatements into the open, auditors appear to have very positive attitudes toward it. The fact that management now must acknowledge the misstatements they have chosen not to correct has given auditors more influence in getting misstatements booked. This summary makes auditor-client disagreements with regard to materiality public knowledge—within the organization, at least. Management at every level, including the CEO who must sign the letter, is now aware of the disagreements that occurred between management and the auditors.

As an amendment to SAS 61 (AU 380), SAS 89 requires that auditors add the summary of uncorrected misstatements to their list of items discussed with the audit committee. This appears to also be uniformly followed by audit firms and is applauded by auditors and audit committees alike. One interviewee said that audit committees are now more aware of their responsibilities, and access to the summary encourages the committees to take a stronger oversight role and provides the information for it. This increased insight into management’s accounting methods and attitudes gives audit committees a clearer picture of management performance.

In response to our inquiry as to whether audit committees understood the importance of this communication, interviewees told us that while some committees educated themselves on these issues, partners have invested significant time educating audit committees as to the meaning of the summary. Overall communications between auditors and audit committees may have also changed as a result of recent standards, and some firms have developed more formal processes for reporting to the committees.

The general opinion among the partners we interviewed seems to be that SAB 99 and SAS 89 have had a major positive impact on the audit process. Although in most cases changes have not been reflected in current workpaper procedures, the culture of the audit has changed through firm training, discussion, and supervision.

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