This is the second of three academic papers which I wrote this past semester while pursuing my Masters in Accounting about forensic accounting concepts. While this is especially pertinent for accounting professionals, I am a strong believer that all finance and investing professionals should at least be familiar with the procedures that are employed in preparing and auditing financial statements. This paper was prepared on November 9, 2009.
SEC Staff Accounting Bulletin Number 99 – Materiality (“SAB 99”) was released in August 1999 with the primary objective of communicating the SEC’s displeasure with the overreliance placed on quantitative thresholds in determining the materiality for attestation services, specifically “reporting” materiality for known errors or misstatements. The precise intent of the bulletin was to “provide guidance in applying materiality thresholds to the preparation of financial statements.” As with most regulation, there is a direct catalyst and SAB 99 is no exception. In September 1998, SEC Chairmen Arthur Levitt gave a speech in which he characterized financial reporting as a “game of nods and winks” between auditors and management which causes “earnings reports [to] reflect the desires of management rather than the underlying financial performance of the company.” Levitt was directing his criticism at a relatively widespread tactic of earnings management in which companies would “smooth” earnings in order to meet Wall Street analysts’ expectations via “immaterial” adjustments.
Two notable SEC earnings management investigations of 1998 and 1999 were Sensormatic Electronics Corp. (“Sensormatic”) and W.R. Grace Co. (“Grace”), respectively. Sensormatic was a high-tech company; therefore, it is unfortunately unsurprising that the company engaged in premature revenue recognition practices to achieve analysts’ expectations in seasonally weak quarters. Grace utilized “cookie-jar” reserve accounting to defer profits into the future. Grace’s auditor’s Price Waterhouse knew that management’s conduct was not in conformance with GAAP but permitted it because they deemed it to be immaterial. While these are only examples of two SEC investigations relating to “immaterial” fraudulent activities, these are representative of the type of conduct that was relatively common due to the evolution of materiality application. Even more notorious was the SEC’s investigation of Waste Management which focused on the issue of “netting” and focused the spotlight back on to materiality. This enforcement release will be discussed extensively after laying the framework of SAB 99.
With this historical context in mind, it is important to understand the traditional definition of materiality and how it was commonly being applied during this time. It is important to remember that ultimately materiality is a legal concept rather than an accounting one. In general, an item or event is material “if there is a substantial likelihood that a reasonable person would consider it important.” FASB Concept No. 2 further clarifies whether an item is material: “an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced … by the item.” This is a slight deviation from the Supreme Court’s interpretation of materiality which utilizes the phrase “the total mix.” The underlying intent behind both definitions is to ensure that both numerical magnitude and factual circumstances are taken into account when determining materiality. In other words, both quantitative and qualitative factors must be considered. FASB Concept Summary No. 2 makes it very clear that the Board does not believe that materiality considerations can “be reduced to a numerical formula” as it would be “discharging the onerous duty of making materiality decisions” by considering all relevant facts. Nevertheless, there was no clear SEC guidance on materiality before SAB 99.
The quantitative measurements referred to by the FASB include common “rules of thumb” such as declaring five percent of net income to be a materiality threshold. The Board reaffirms that it does not object to such rules of thumb as initial steps; however, these type of guideline should not “be used as substitutes for a full analysis of all relevant considerations.” For example, if Price Waterhouse had looked beyond the pure quantitative magnitude of the cookie-jar adjustments but instead focused on the implications for earnings targets, it is likely that the two lead auditor partners would have concluded that the adjustments were material in nature.
After stressing why purely numerical thresholds are inappropriate when assessing materiality and the importance of considering other factors, SAB 99 lists other considerations that auditors should reflect upon when determining the appropriate materiality threshold for an engagement. The nine factors presented can be divided into three broad categories:
- Wall Street analyst expectations and key performance indicators
- External compliance requirements
- Personal considerations
As mentioned above, Wall Street estimates can place tremendous pressure on management to engage in aggressive or unscrupulous conduct to meet targets. Not only must management concentrate on absolute estimates but they need to consider a gain changing to a loss as well as the trends over time. Even if a company manages to meet the analysts’ consensus expectations for the period the firm can suffer in the market if the performance of a key business segment does not perform up to expectations. It is plain to see that these factors would influence a reasonable person because they provide insight about management as well as performance.
In addition to operating the business profitably and beating Wall Street expectations, management also needs to be mindful of compliance requirements. For example, management must prevent violating the terms of debt covenants, which would cause the debt to become immediately callable and likely increase the cost of capital. Another critical concern is conforming to exchange listing requirements that can cripple market capitalization if breached.
The last class of conditions relates more to individual’s reasons for adjusting financial data than the corporate-wide reasons detailed in the first two groupings; however, they are not mutually exclusive. Management compensation commonly includes bonuses and incentive based compensation that is tied to financial metrics such as net income or the performance of a specific group. Bridging these conditions to the financial statement ones above is the fact that key employees often receive stock options that allow the individuals to share in the company’s success. At a more insidious level managers may take actions to manipulate the financial records to conceal defalcation or other illegal activities. Intentional “immaterial” misstatements will be further addressed in a subsequent discussion. Any of the errors or misstatements in these categories could be deemed immaterial under a strict adherence to quantitative benchmarks but it is unmistakable that they all can have impacts on investors, creditors, and stakeholders.
All of the examples presented elaborate on why it is impossible to determine materiality based solely upon quantitative factors. Management may manage earnings or engage in fraudulent activities that may equate to one or two percent of earnings to beat expectations or to avoid violating a debt covenant, both of which would influence the “judgment of a reasonable person.” Another qualitative factor that should be considered is the potential market reaction to the disclosure of the restatement. It is difficult to predict market reaction but this is yet another aspect of the complex issue that must be taken into account.
Another prime materiality concern addressed in SAB 99 is the potential for materiality to be deceptive due to the aggregation and netting of misstatements. The aggregation effect is addressed by SAB 99’s hierarchy of testing: after identifying all misstatements, even those that are deemed to be immaterial in light of all available circumstances can still cause the financial statements to be misstated if the aggregate amount crossed the predetermined materiality threshold. The SEC has already clearly stated its position that material misstatements require adjustment but poses a twist: what if a material misstatement is “eliminated by other misstatements?” In such an example, SAB 99 states that the effect of one misstatement cannot be to offset that of another misstatement. If such treatment were allowed, the effect would certainly not be clean financial statements as at least two accounts would contain material misstatements. To borrow an axiom, two wrongs don’t make a right. The discrepancy is exaggerated when a critical account such as revenue is overstated at the same time that an overlooked expense is inflated.
Perhaps the best example of this was the conduct of CEOs Dean Buntrock and Philip Rooney, in conjunction with other senior managers at Waste Management (“WM”) from 1992 to 1997. Waste Management always had a reputation for aggressive accounting practices but it was not until the early 1990s that that the firm fell down the slippery slope of “earnings magic” into fraud. WM’s senior management engaged in a systematic fraud to achieve its aggressive earnings targets. The primary method employed involved deferring current period expenses such as depreciation and amortization into future periods by extending useful lives and increasing salvage value. Other corresponding aspects of the fraud included fraudulently capitalized expenses and manipulated reserves. When all else failed, management conspired together and made “top-level adjustments” to achieve desired earnings.
To conceal the fraud, management “netted” operating expenses against one-time gains on sales of assets. This was communicated to the public via misleading financial statements and other releases. In the words of CFO Koenig, the objective was to “make the financials look the way we want to show them.” All executives received stock options and directly profited from their conduct: Buntrock was the mastermind who “earned” almost $17 million from the fraud but every executive involved reaped at least $400,000 from his conduct. As with the Sensormatic and Grace frauds discussed above, it is likely that SAB 99 was in response to the egregious conduct at those firms.
Unfortunately it appears that even SAB 99 would have been insufficient to prevent the misconduct at Waste Management because WM’s auditor, Arthur Anderson, was compromised. Anderson had proposed adjusting entries but never forced management to actually book them because management was able to convince them that netting caused the items to be immaterial. The primary reason for this was that Anderson’s independence was impaired because Anderson received $17.8 million from non-audit fees versus $7.5 million from capped audit fees. Even precise materiality rules would not have prevented the fraud: WM’s management clearly sent the signal to Anderson that audit quality was not a prime concern.
A related point concerns materiality changing over time and the importance of “considering the effect of misstatements from prior periods on the current financial statements.” An auditor may waive identified misstatements that are immaterial; however, if net income or the other base used to determine materiality shrinks in subsequent years and materiality decreases, the previously immaterial items could become material. In general, the objective of SAB 99 is to help orient auditors towards considering more factors related to materiality and this is yet another factor that must be considered.
The last major area addressed in SAB 99 centers on immaterial misstatements that are intentional. Thus far, SAB 99 is very clear that material misstatements are unacceptable but fraudsters may also make immaterial and unlawful adjustments for other reasons than the ones presented above. Once the auditor has identified that fraudulent activities are likely the auditor must employ the tactics of SAS 99, mainly continuing to gather evidence discretely, determining whether management can be relied up, notifying the audit committee or other sufficient level of management, and suggesting that outside counsel be engaged. The conclusion that can be drawn from this provision in SAB 99 is that materiality is irrelevant when assessing whether fraud has occurred. SAB 99 also briefly addresses the use of industry specific accounting practices rather than GAAP when the results would be “inconsequential” and is firm in stating that “authoritative literature takes precedence over industry practice that is contrary to GAAP.”
Taken as a whole SAB No. 99 provides an adequate basis for helping companies and auditors make judgments about materiality. In its general comments the SEC states “SAB is not intended to change current law or guidance in the accounting or auditing literature”; therefore, the suggestions and factors included in SAB 99 do not form new regulation for auditors. It is critical to realize that there was no SEC guidance on materiality before SAB 99. Despite the fact that the qualitative factors can be somewhat vague, they serve as a useful starting point for auditors when assessing materiality. Determining materiality is a very delicate issue that requires professional care and judgment so it is unreasonable to expect for the SEC to be able to issue definitive standards for materiality. In other words, the SEC could not author a rules-based materiality “cookbook” like it could for other topics. Short of requiring strict documentation rules, it is difficult to think of practical and significant improvements to the bulletin.
In closing, the main point of SAB 99 is that auditors should not rely solely on arbitrary quantitative thresholds to measure materiality. Qualitative factors and other external considerations are equally as important. Materiality is a fluid concept that commonly changes between years. Items must also be aggregated and cannot be netted when making the final assessment about materiality. Lastly, materiality is irrelevant when fraud is involved.
 Zabel, Richard M., and James J. Benjamin. “Reviewing Materiality in Accounting Fraud.” New York Law Journal (2002). Akin, Gump, Strauss, Hauer & Feld, L.L.P., 15 Jan. 2002. Web. 28 Oct. 2009. <www.akingump.com/>;.
 Huber, John J., and Thomas J. Kim. SAB 99: Materiality As We Know It Or Brave New World For Securities Law. Northwestern University Law School/Latham & Watkins, 19 Nov. 2001. Web. 28 Oct. 2009. <www.law.northwestern.edu/contexec/docume...;.
Disclosure: No positions