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US Securities and Exchange Commission

Top SEC Accountant Continues Focus on Materiality Assessment of Financial Reporting Errors

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

· 5 minute read

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

· 5 minute read

In a March 9, 2022, statement, the SEC’s Acting Chief Accountant Paul Munter described in greater detail about the assessment of materiality as it relates to financial reporting errors.

This statement continues his ongoing focus on the topic started last year when he discussed “Big R” and “little r” restatements.

“It looks like he is trying to ‘codify’ the guidance that was given in various presentations during the AICPA conference in December,” said former FASB chairman Dennis Beresford. “This has obviously been a hot topic for the SEC for some time.”

With Gary Gensler serving as chair of the SEC, Munter has also been putting a greater focus on providing useful information related to financial reporting to investors.

The Supreme Court has held that a fact is material if there is “a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

When management finds a material error in a previous financial statement, then it must promptly notify investors of the error and correct it.

“The determination of whether an error is material is an objective assessment focused on whether there is a substantial likelihood it is important to the reasonable investor,” he said.

When an error is material to previously-issued financials, then a restatement is necessary—Big R. If the error is not material to previous financials, but either correcting the error or leaving the error uncorrected would be material to the current period financial statements, then the company must correct the error. But the company is not precluded from doing so in the current period comparative financials by restating the prior period information and disclosing the error—little r.

In either case, Munter said such errors must be clearly disclosed to investors.

Materiality Assessment is ‘Not a Mechanical Exercise’

In Munter’s view, the assessment of materiality is not a mechanical exercise.

Moreover, he stressed that the evaluation should not be based solely on quantitative analysis in emphasizing the “total mix” of information. This means all relevant facts must be taken into account, which include qualitative factors, he said.

Moreover, he said any potential bias in the analysis must be set aside.

He gave an example of a restatement that may result in the clawback of executive compensation, reputational harm, a drop in stock price, increased scrutiny by regulators or investors, litigation, or other effects.

“An assessment where a registrant’s, auditor’s, or audit committee’s biases based on such impacts influenced a determination that an error is not material to previously-issued financial statements so as to avoid a Big R restatement would not be objective and would be inconsistent with the concept of materiality,” he said.

Are Companies Biased Towards Little R?

The staff in the Office of the Chief Accountant (OCA) has observed an increased need for objectivity when assessing qualitative factors.

Staff Accounting Bulletin (SAB) No. 99Materiality, (Topic 1.M), provides situations where a quantitatively small error could be material because of qualitative factors.

“However, we are often involved in discussions where the reverse is argued—that is, a quantitatively significant error is nevertheless immaterial because of qualitative considerations,” Munter said. “We believe, however, that as the quantitative magnitude of the error increases, it becomes increasingly difficult for qualitative factors to overcome the quantitative significance of the error.”

He said that the qualitative factors that may be relevant in assessing the materiality of a quantitatively significant error would not necessarily be the same qualitative factors in SAB No. 99 when considering whether a numerically small error is material.

“So, it might be inappropriate for a registrant to simply assess those qualitative factors in reverse when evaluating the materiality of a quantitatively significant error,” he said. “Such a scenario highlights the importance of a holistic and objective assessment from a reasonable investor’s perspective.”

The OCA’s views come as little r has gone up as a percentage of total restatements each year from 2013 to 2020. Little r was 35 percent in 2005 but 76 percent in 2020. Some say that this may primarily be due to improvements in internal control over financial reporting (ICFR) and audit quality. But Munter said that the staff is continuing to monitor this trend to better understand it.

This is especially a cause for concern because recent discussions with companies and auditors indicated that some materiality analyses seemed to be biased toward a preferable outcome—little r.

He said OCA staff has “not infrequently” been presented with arguments that financial statements or specific line items are not relevant to investment decisions. Some also argue that historical financials or specific line items in those are irrelevant.

“We have not found these types of arguments to be persuasive because such views could be used to justify a position that many errors in previously-issued financial statements could never be material regardless of their quantitative significance or other qualitative factors,” Munter stated.

While the starting point is official GAAP, he said an analysis of key non-GAAP measures must be also be done.

‘But Others Are Doing it, Too’ Does Not Cut It

Another problematic argument that companies use, Munter said is: others are doing it, too; thus, this just reflects a widely-held view, not an intention to misstate.

“SAB No. 99 states that while the intent of management does not render a misstatement material, it may provide significant evidence of materiality,” he said. “We have not found persuasive, however, arguments that attempt to apply that SAB No. 99 premise in reverse—that is, that the lack of intentional misstatement is viewed as providing evidence that the error is not material.”


This article originally appeared in the March 10, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.

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