SEC Acting Chief Accountant Discusses Materiality Assessments in Restatements | Cooley LLP
In this statement from the SEC’s Office of the Chief Accountant, Acting Chief Accountant Paul Munter discusses materiality assessments in the context of errors in financial statements. As he summarizes the issue, “determining whether an error is material is a objective assessment focused on whether there is a substantial likelihood that it is material to the reasonable investor. And when an error in the historical financial statements is deemed material, a “Big R” restatement of the prior period financial statements is required. On the other hand, if the error is not material, “but correcting the error or not correcting the error would be material to the current period’s financial statements, a registrant should still correct the error, but is not precluded from doing so in the current period’s comparative financial statements by restating prior period information and disclosing the error”, known as a revision or restatement of the “small r”. In either case, observes Munter, “these two methods – reissue and revision, or ‘Big R’ and ‘little r’ – constitute restatements to correct errors in previously issued financial statements, as those terms are defined in the United States GAAP”. According to a study by Audit Analytics, “While the total number of reprocessings by enrollees decreased each year from 2013 to 2020, ‘small r’ reprocessings as a percentage of total reprocessings reached almost 76% in 2020, compared to about 35% in 2005.” Should we attribute this change to improvements in audit quality or internal control over financial reporting, or could it be that some companies are not entirely objective in their materiality determinations? If there is an error in the financial statements, Munter emphasizes, companies, auditors and audit committees should “carefully assess whether the error is material by applying a reasoned, holistic and objective from the perspective of a reasonable investor based on the total combination of information.”
Munter reminded readers that the materiality standard adopted by SCOTUS is that information is material if there is: “a substantial probability that the … fact would have been considered by the reasonable investor to have materially altered the ‘mix’. total” information made available. In light of this definition, Munter insists that assessments of the materiality of errors be made “through the prism of the reasonable investor. To be consistent with the concept of materiality, this assessment must be objective. A materiality analysis is not a mechanical exercise, nor should it be based solely on a quantitative analysis. Rather, registrants, auditors and audit committees should thoroughly and objectively assess the total mix of information. Such an evaluation should consider all relevant facts and circumstances surrounding the error, including both quantitative and qualitative factors, in order to determine whether an error is material to investors. An objective analysis would “set aside any potential bias”, such as “potential clawback of executive compensation, reputational damage, decline in the registrant’s stock price, increased scrutiny by investors or regulators, litigation or other impacts”.
Munter highlights in particular an increased need for objectivity on qualitative factors. Under SAB 99, qualitative factors could make a quantitatively small error significant, but more often than not companies argue the opposite, an argument that seems like a pretty steep climb: for the OCA, “as the quantitative magnitude of the error increases, it becomes more and more difficult for the qualitative factors to overcome the quantitative significance of the error.In addition, different qualitative factors may be relevant to a quantitatively significant error relative to an error quantitatively weak.
Through staff monitoring and business interactions, notwithstanding all previous statements by staff, staff have “observed that some materiality analyzes appear to be biased towards a result that an error is not material to the previously published financial statements, resulting in ‘small r’ revisions. When it comes to accounting errors, companies have tried to sell staff on a number of theories: that financial statements or financial statement line items are not relevant or not useful to investors’ decision-making or too old to be important for current decisions. But these arguments have found no buyer at OCA: Munter argues that these arguments “could be used to justify a position that many errors in previously issued financial statements could never be material, regardless of their quantitative importance or other qualitative factors”. Rather, the OCA considers “financial statements prepared in accordance with US GAAP or IFRS, as required by the Commission’s rules, to be the starting point for any objective materiality analysis.” But errors in non-GAAP financial measures should not be ignored; “Analysis of key non-GAAP measures, if any, should be performed in addition to, but not as a substitute for, financial statement materiality analysis.”
Other flimsy arguments presented by the companies were that the errors are just common errors that others have also made, reflecting “widespread opinion rather than intent to misrepresent”. But lack of intent, advises Munter, does not make a trivial mistake. Compensation errors also do not eliminate materiality. Instead, the materiality of each misstatement should be considered separately, and also on an aggregate basis “to determine whether an otherwise immaterial error, when aggregated with other misstatements, renders the financial statements together as being significantly misleading. However, we do not believe that this analysis of aggregate effects should serve as the basis for a conclusion that individual errors are not significant.
Munter also observes that accounting errors raise questions about the effectiveness of ICFR, and the same principles apply in this context. In particular, management’s analysis of ICFR
“must take into account the magnitude of the potential misstatement that could result from a control failure, and we note that the actual error is only the starting point for determining the potential impact and severity of a defect. Therefore, while the existence of a material accounting error is an indicator of the existence of a material weakness, a material weakness can also exist without the existence of a material error. Management’s assessment of the effectiveness of ICFR should therefore focus on a holistic and objective analysis of what could occur in the context of current and evolving financial reporting risks.
Munter emphasizes the need for the audit committee to pay close attention to the relevance and basis for evaluating the effectiveness of a company’s ICFR – “particularly when there are close calls in the assessment to determine whether a deficiency is a material deficiency (and should only be reported to the audit committee) or a material weakness (which should be disclosed to investors).
Munter also stresses the importance for audit firms to have “policies and processes in place to ensure that the appropriate people are involved in oversight and review in evaluating significant judgments made on the audit. materiality and effects of identified accounting errors”.