The SEC has issued its long-awaited Staff Accounting Bulletin on materiality (S.A.B. 99), a project that Chairman Levitt instructed the SEC staff to undertake as part of the SEC's attack on "managed earnings." The 18-page release is available at the SEC's website.
First, the staff bulletin states that the use of a percentage test alone to determine materiality is not acceptable. Although a quantitative test can be used as an initial assessment, all "facts and circumstances" must be evaluated to determine materiality. Thus, there is no "safe harbor" for materiality if a misstatement or omission of a financial statement item falls under a 5% of earnings or income threshold.
Second, the staff bulletin sets forth the types of "facts and circumstances" that may render a quantitatively small misstatement of a financial statement item material. They are:
- whether the misstatement masks a change in earnings or other trends;
- whether it hides a failure to meet analysts' consensus expectations for the company;
- whether it changes a loss into income or the other way around;
- whether it concerns a business segment or division that plays a significant role in the company's operations or profitability;
- whether it affects the company's compliance with regulatory requirements, loan agreements or other contractual obligations;
- whether it results in increasing management's compensation; or
- whether it conceals an unlawful transaction.
Third, the staff bulletin states that companies and their auditors must consider each misstatement separately and also the aggregate effect of all misstatements. Thus, if a single misstatement has a material impact on the financial statements as a whole, it cannot be "cured" by another misstatement which "cancels out" the impact of the first item. Further, while a single misstatement by itself may not be material, the effect may be material when the misstatement is combined with others. This includes looking at the effect of a current misstatement in light of misstatements from prior reporting periods.
Fourth, the staff bulletin states that even immaterial misstatements (immaterial under the new view this staff bulletin articulates) if made intentionally may violate sections 13(b)(2)-(7) of the Securities Exchange Act. These provisions require that a public company (1) maintain and keep books and records which in "reasonable detail" accurately reflect the company's financial operations and results; and (2) maintain internal accounting controls which provide "reasonable assurance" that transactions are recorded to permit preparation of financial statements in accordance with GAAP.
To prove a violation of either of these provisions, the SEC does not need to prove that the errors in the company's books and records or internal controls are material. Instead, it only needs to prove a lack of "reasonable assurance" that the books and records are accurate or that they reflect the company's operations in "reasonable detail." Proving a lack of reasonableness is, of course, much easier than proving non-materiality. The bulletin states that the factors determining whether an intentional but non-material misstatement results in these violations should focus on the significance of the misstatement (which is apparently different from materiality), the costs of correcting the misstatement, and the clarity of the accounting literature guidance as to the misstatement.
Fifth, the staff bulletin states that an auditor's obligation under section 10A of the Exchange Act to inform management (and, if ignored, the SEC) of an illegal act is triggered by a violation of the books and records or internal controls requirement--which, as just noted, can be violated regardless of materiality.
Finally, the staff bulletin states the SEC's view that GAAP takes precedence over industry practice.
The staff bulletin concludes that it is not intended to change the current law or guidance in the accounting or auditing literature--a point surely open to dispute. Regardless, this staff bulletin is required reading for all financial executives and auditors.