SEC Issues SAB 99 on Materiality
In August, the SEC issued Staff Accounting Bulletin (SAB) 99 to clarify principles of materiality for those who prepare or audit financial statements filed with the SEC. SAB 99 does not present new materiality standards but, instead, reaffirms long-accepted concepts expressed in auditing and accounting literature. It also provides interpretive guidance to ensure those concepts are applied properly in today’s complex reporting environment.
The bulletin’s most important points are that
- Registrants and auditors may not rely solely on quantitative criteria to evaluate an item’s materiality.
- The materiality of items can be determined reliably only if they are evaluated both individually and collectively.
- An intentional misstatement may be illegal even if the item it concerns is immaterial.
According to the bulletin, “Quantifying in percentage terms the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations. Materiality concerns the significance of an item to users of a registrant’s financial statements. A matter is ’material’ if there is substantial likelihood that a reasonable person would consider it important.”
In addition, the SAB says there are several ways in which a “quantitatively small” misstatement may be material. For example, it may conceal a failure to meet analysts’ expectations or it may convert a loss into a profit. In fact, one of the more widespread abuses the SAB addresses is the intentional recording of immaterial errors in a registrant’s financial statements in order to smooth earnings artificially and give a false impression of their stability.
The concern over misstatements that affect earnings directly arises out of the SEC’s vision of itself as the “investor’s advocate.” SAB 99 thus fulfills a pledge Chairman Arthur Levitt made last fall to clarify the SEC’s views on the criteria for evaluating materiality.
At that time, Levitt said he had difficulty accepting that some so-called nonevents simply don’t matter “in markets where missing an earnings projection by a penny can result in a loss of millions of dollars in market capitalization.”
Toward that end, SAB 99 establishes as an important materiality criterion the effect misstatements can have on investors. SEC Chief Accountant Lynn Turner said the SAB is “a needed reminder to both registrants and auditors that they have to consider carefully the impact of an item on investors before deciding it is immaterial.”
The bulletin also emphasizes the need to evaluate items on individual and collective bases: “If a registrant’s revenues are a material financial statement item and if they are materially overstated, the financial statements taken as a whole will be materially misleading even if the effect on earnings is completely offset by an equivalent overstatement of expenses.”
To the extent that registrants intentionally misstate immaterial items, they potentially violate provisions of the Securities Exchange Act of 1934, which mandates the use of accurate and reasonably detailed records as the basis for financial statements.
Although the SAB provides advice on how to judge misstatements discovered during the course of preparing or auditing financial reports, it does not address how an auditor should assess materiality when planning an audit.
Besides requiring management to keep accurate and complete records, the bulletin says auditors must inform management, and sometimes audit committees, if they become aware of illegal acts.
The SEC recommends that registrants and auditors allow sufficient time to discuss with its staff the treatment of, or disclosures about, transactions or events not specifically addressed in the bulletin or other existing literature.