Invited experts speaking at a meeting of the SEC’s Investor Advisory Committee (IAC) said the definition of materiality has by and large worked as intended, although company management and auditors might need to be better trained in applying the concept of materiality during financial reporting.
The definition of materiality is derived from Supreme Court decisions like TSC Industries v. Northway Inc. in 1976 and Basic Inc. v. Levinson in 1988. The high court’s decisions say that companies should disclose information that a reasonable person “would” find important in the total mix of information to make a voting or investing decision.
“I think it is fair to say that the Supreme Court definitions have stood the test of time; they’re clearly the law of the land today,” John White, former director of the SEC’s Division of Corporation Finance who is a partner with Cravath, Swaine & Moore LLP, said at the IAC meeting in Washington on March 7, 2024.
He said the materiality standard is objective and company-specific. White emphasized that this is a “would” standard, not a “could” standard. This is intended to help management avoid liability if it didn’t provide an avalanche of trivial information to shareholders.
25th Anniversary of Staff Accounting Bulletin 99
The SEC interpreted the meaning of materiality for financial statements when it published Staff Accounting Bulletin (SAB) No. 99, Materiality, (Topic 1.M) in 1999. And the IAC discussion comes as this year marks the 25th anniversary of SAB 99.
SAB 99 builds off the Supreme Court cases, and this, too, has fared well, according to experts, including the architect of the bulletin—former SEC Chief Accountant Lynn Turner who also spoke at the IAC meeting.
SEC officials, including Chief Accountant Paul Munter, in the past few years have been emphasizing that SAB 99 is not only about a quantitative analysis. Because it’s about a total mix of information, all relevant facts must be taken into account, which include qualitative factors. (See Top SEC Accountant Continues Focus on Materiality Assessment of Financial Reporting Errors in the March 10, 2022, edition of Accounting & Compliance Alert.)
White explained that SAB 99 gives a list of non-exclusive factors to look at, “I would say quite nicely it also stood the passage of time.”
In preparing for the panel discussion, White said he looked at the listed factors and asked a lot of people whether there are any missing or outdated factors. “And in all candor, I am not seeing or hearing suggestions that the guidance, the factors that are under SAB 99 came up short 25 years later.”
However, a couple of panelists said that management may not be appropriately applying SAB 99—intentionally or unintentionally.
Take for example, the fake accounts created by Wells Fargo employees, said former SEC commissioner Joseph Grundfest, a business law professor at Stanford University.
Sometimes some things that seem immaterial in the beginning can suddenly balloon to something quite material, he said.
“People find a problem, they go ‘oh, it’s sub-material. Let’s not worry about it.’ Big mistake,” Grundfest said. “Further, organizationally when bad things happen, employees sometimes hide the bad things from their superiors and from the board. And the rationalization is ‘this isn’t material; therefore, I don’t have to bring it to their attention.’”
With Wells Fargo, he said, “given our size, we are enormous, we are ginormous. You know, we only have like 1000s of these accounts, right?…and we have millions and millions of other accounts; therefore, it’s not material, we don’t have to bring it up to the board. Disastrous thinking.”
In another example, he said an employee embezzled $50,000. Management could see that as clearly immaterial because the company has $500 billion in assets.
But “what is it in the systems and procedures that would allow somebody in effect to steal $50,000 from the company. If they can steal $50,000? What couldn’t they steal?” he said.
Research Shows Opportunistic Interpretation of Materiality Concept
Preeti Choudhary, an accounting professor at the University of Arizona, who has done research on materiality said that materiality judgments are pervasive within financial reporting and vary substantially, which have important implications for the reliability of the financial statements.
Materiality largely stems from the notion that judgment requires context; thus, “it can be exercised opportunistically.”
Moreover, as Grundfest noted, small and immaterial errors do grow in significance over time, she said.
Also, “there’s an unfortunate common practice of managers not addressing immaterial errors ex-ante when identified, and these can come back to haunt them,” Choudhary said.
She said that cases like Wells Fargo are not that uncommon where immaterial errors related to fraud do not get elevated to higher-up in management or the board.
In addition, she found that managers are “pervasively waiving corrections to financial statements identified by the auditor” and “these errors tend to persist.”
Choudhary looked at filings from 2004 to 2015 and found that of the 2,500 audits of public companies, 18% had no errors while 41% of that sample waived all errors. Only 10% of the sample corrected all errors, and the remaining 30% corrected some but not all errors.
“There was a small number that waived errors in excess of materiality, less than 1% of the cases. But these resulted in restatements at the rate of 12%,” she said.
One possibility is that people are just misapplying the guidance. But another possibility is that they are opportunistically using contextual factors to justify leaving out quantitatively large amounts.
“I don’t know the answer to that because the study didn’t get into contextual factors,” she said.
Thus, in Turner’s view, there is no problem with the concept of materiality as laid out by the Supreme Court or with the interpretation that the SEC gave for financial reporting in SAB 99.
“Most of the issues with materiality, which I dealt with for the last 45 plus years, is an issue of oversight, governance, accountability, and enforcement,” he said.
This article originally appeared in the March 22, 2024, edition of Accounting & Compliance Alert, available on Checkpoint.
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