Materiality in financial statements

All too often the concept of materiality in the context of financial statements is not black and white, as some like to think.  Over and over again my experience has been that materiality is commonly misunderstood and misapplied.  Those dealing with disputes who don’t have a solid understanding of materiality can find themselves fighting a tough uphill battle.

Definition

So, to begin, what is “materiality”?

When I was a financial statement auditor, my engagement team would compute a quantitative threshold and call it overall materiality.  This was typically 5% of the audit client’s pre-tax income from continuing operations for profit-oriented entities, or, if pre-tax income from continuing operations was volatile or perhaps a loss was realized in one year and a gain in another year, we would sometimes compute an alternative materiality, taking into account other financial statement metrics (such as revenues, assets, equity, etc.) and apply judgment in deciding on a quantitative threshold (SAS No. 107 at ¶ 4).  This overall materiality calculation was the starting point in planning the audit, assessing risk, and performing audit testing.  Although qualitative factors are considered in audits, the quantitative threshold is often the primary tool to measure the significance of misstatements.

However, in the context of a litigation, contractual dispute, or other matter, materiality is more broad than a simple quantitative threshold.  The SEC Staff elaborated (in 1999) on this concept of materiality in Staff Accounting Bulletin No. 99, Materiality, stating:

The omission or misstatement of 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 inclusion or correction of the item.

This formulation in the accounting literature is in substance identical to the formulation used by the courts in interpreting the federal securities laws. 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.

Under the governing principles, an assessment of materiality requires that one views the facts in the context of the “surrounding circumstances,” as the accounting literature puts it, or the “total mix” of information, in the words of the Supreme Court. In the context of a misstatement of a financial statement item, while the “total mix” includes the size in numerical or percentage terms of the misstatement, it also includes the factual context in which the user of financial statements would view the financial statement item…

The FASB has long emphasized that materiality cannot be reduced to a numerical formula.

Rules of Thumb

The SEC Staff also weighed in on the common 5% threshold that many market participants applied in the past.  Although this SEC Staff guidance has been publicly known and relied upon for over 16 years, I still find this mentality:

The staff is aware that certain registrants, over time, have developed quantitative thresholds as “rules of thumb” to assist in the preparation of their financial statements, and that auditors also have used these thresholds in their evaluation of whether items might be considered material to users of a registrant’s financial statements. One rule of thumb in particular suggests that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances, such as self-dealing or misappropriation by senior management. The staff reminds registrants and the auditors of their financial statements that exclusive reliance on this or any percentage or numerical threshold has no basis in the accounting literature or the law.

The SEC also acknowledged widespread use of a 5% – 10% threshold range, which was referenced to FASB’s Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, at paragraph 167.

Deeper Understanding

There are some key phrases in SAB No. 99, namely “surrounding circumstances” and “total mix of information.”  I’d like to touch upon these key phrases next.

Although something may be perceived as immaterial on the surface, particularly quantitatively small misstatements, the following, at a minimum, should be considered:

• whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate
• whether the misstatement masks a change in earnings or other trends
• whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise
• whether the misstatement changes a loss into income or vice versa
• whether the misstatement concerns a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operations or profitability
• whether the misstatement affects the registrant’s compliance with regulatory requirements
• whether the misstatement affects the registrant’s compliance with loan covenants or other contractual requirements
• whether the misstatement has the effect of increasing management’s compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation
• whether the misstatement involves concealment of an unlawful transaction.

The Staff made sure that users of this guidance understood that this above list “is not an exhaustive list…”  All relevant facts and circumstances should be considered.  By the way, I want to mention that a key criticism of SAB No. 99 is that it does not clearly define what is not considered to be material.  This “gap,” of course, can be an area of frustration for registrants.

Applicability

Another thing I want to make clear is that all of this talk about materiality is, unless specific contractual terms dictate otherwise, in the context of “the financial statements taken as a whole.”  Further, the same context applies to auditors when they plan and perform audits (SAS No. 107 at ¶ 7 and 11d).  For those who like to refer to the “old school” auditing standards, SAS No. 47, which was superseded by SAS No. 107, has similar language (see ¶ 3, 8).

Recently I assisted an expert take a firm, reliable position that materiality must be considered in the context of the financial statements taken as a whole and not on a subset of a subset of the financial statements.   The litigation I refer to involved allegations that the defendant client materially misstated its financial statements such that one of its primary users relied on allegedly materially misstated information.  Having a strong grasp of materiality and how to assess specific transactions, disclosures, or business segments for materiality is a game changer for clients involved in disputes or investigations.  Attorneys should seek out practitioners that have a solid understanding of these materiality concepts.

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