On August 13, 1999, the Staff of the Securities and Exchange Commission's Office of the Chief Accountant (the "Staff") issued Staff Accounting Bulletin No. 99 (the "Bulletin") concerning the assessment of "materiality" in preparing and auditing financial statements. The Bulletin focused on: (i) determining the materiality of misstated accounting items; (ii) the aggregate and netting effect of misstatements on a registrant's financial statements; (iii) the consequences of intentional misstatements by a registrant; and (iv) the auditor's response to such intentional acts.
Materiality
According to the Staff, a registrant or the auditor of its financial statements may not "assume the immateriality of misstated items that fall below a percentage threshold set by management or the auditor to determine whether amounts and items are material to the financial statements." The Staff stated that exclusive reliance on quantitative measures for determining the materiality of an accounting item in preparing financial statements and performing audits of those financial statements is inappropriate because there is no basis for such reliance in either the accounting literature or the law. The Staff noted that while it was not opposed to the use of a numerical threshold, such as 5%, as a "rule of thumb" as an initial step in assessing materiality, it cautioned that financial management and auditors must also consider qualitative measures in determining an accounting item's materiality. The Staff then set forth a non-exclusive list of qualitative measures that should be examined in determining the materiality of a misstated accounting item. See inset box.
Aggregating and Netting Misstatements
In determining the materiality of multiple misstatements, the Staff stated that registrants and auditing professionals must analyze the materiality of each accounting item separately and must determine the aggregate effect of all misstated accounting items on the registrant's financial statements as a whole. The Staff recommended that a quantitative and qualitative materiality analysis should be conducted for each specific accounting item and cautioned against curing the material effect of any misstated accounting item with offsetting misstatements.
Intentional, Immaterial Misstatements
The Staff opined that a registrant may not make intentional immaterial misstatements in its financial statements because such misstatements nevertheless may be illegal under Sections 13(b)(2)-(7) of the Securities Exchange Act of 1934 (the "Exchange Act"). These provisions require a registrant to make and keep books, records and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the registrant, and to maintain adequate internal accounting controls to ensure a registrant's ability to produce GAAP financial statements. In determining whether a misstatement results in a violation of a registrant's obligation to keep books and records that are accurate "in reasonable detail," the Staff stated that registrants and their auditors should consider both the materiality of the misstatement and the following factors:
- the significance of the misstatement;
- how the misstatement arose, including whether the intentional misstatement is part of a pattern of "managing" earnings;
- the cost of correcting the misstatement, including whether correcting an inconsequential misstatement would require unjustified major expenditures; and
- the clarity of authoritative accounting guidance with respect to the misstatement.
After noting that there may be other indicators of reasonableness, and that the judgment of "reasonableness" is not "mechanical," the Staff stated that it "will be inclined to continue to defer to judgments that 'allow a business, acting in good faith, to comply with the Act's accounting provisions in an innovative and cost-effective way.'"
The Auditor's Response to Intentional Misstatements
The Staff also stated that under Section 10A(b) of the Exchange Act, auditing professionals are required to take affirmative action upon the discovery of any intentional misstatement contained in a registrant's financial statements if such misstatement is illegal, even if not "material." Such affirmative action, the Staff noted, would include disclosing the intentional misstatement to the appropriate level of management, including the audit committee. *
SEC Staff Accounting Bulletin No. 99, SEC Release No. SAB 99, 64 Fed. Reg. 45150 (Aug. 19, 1999) (to be codified at 17 C.F.R. Part 211).
Qualitatively Assessing "Materiality"
In Staff Accounting Bulletin No. 99, the Staff of Securities and Exchange Commission's Office of the Chief Accountant (the "Staff") stated that both quantitative and qualitative factors must be considered in determining the materiality of a misstated item for financial reporting and auditing purposes. The Staff suggested that some of the qualitative measures, though not exclusive, to be examined in determining materiality include:
- Whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate;
- 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 changes a loss into income or vice versa;
- 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 affects the registrant's compliance with loan covenants or other contractual 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.
In addition, the Staff stated that price volatility of the registrant's securities and general market reaction to past accounting disclosures could also provide a framework for conducting a qualitative analysis. Further, the Staff stated that where intentional misstatements are made to "manage" earnings, the intent of management "may provide significant evidence of materiality." Finally, the Staff stated that materiality may turn on where the misstatements appear in the financial statements.