Magazine article The CPA Journal

Sec Issues SAB on Materiality

Magazine article The CPA Journal

Sec Issues SAB on Materiality

Article excerpt

A waived adjustment schedule can be seen on most audit engagements where each error found by the auditors is noted along with its estimated effect on the income statement and balance sheet. The net aggregate of the found errors is entered on the bottom of the schedule, which is then compared to five or 10% of income before taxes. If the net error amount is less than the calculated percentage amount, the audit is over.

While this scenario is an oversimplification of actual practice, it presents the essence of the way in which findings in an audit are evaluated. The recently issued SEC Staff Accounting Bulleting No. 99, Materiality, however, will make the process in whatever form it is presently practiced considerably more complex and analytical. The SAB was issued in response to a commitment made by SEC Chairman Arthur Levitt in his September 1998 speech, "The Numbers Game," (reprinted in its entirety in the December 1998 CPA Journal). Levitt, in attacking the practice of earnings management, noted how some companies abuse materiality by intentionally recording errors within a defined percentage ceiling and hiding behind the materiality shield when questioned why the errors were permitted to remain in their financials. He went on to commit the SEC to providing guidance for companies and their auditors on the role of materiality in evaluating misstatements in financial statements.

SAB No. 99 very carefuly defines that role using existing professional literature and securities laws and regulations. It sets forth a number of significant conclusions on the part of the staff of the SEC, without, in the opinion of SEC Chief Accountant Lynn Turner, "breaking new ground."

First, the SEC staff concludes that passing or waiving corrections to financial statements exclusively on the basis that they are below a percentage threshold (i.e., five percent of a financial statement item) "has no basis in the accounting literature or the law." The SAB states that use of riles of thumb are appropriate as an initial step in assessing materiality, but that identified misstatements must be subject to a qualitative analysis. To demonstrate the importance of evaluating misstatements in the light of all the relevant circumstances, the SAB gives a number of examples where a quantitatively small misstatement might very well be considered material, among them are as follows:

* 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 concerns a segment or other portion of the registrant's business that has been iden tified 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 has the effect of increasing management's compensation - for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation, and

* Whether the misstatement involves concealment of an unlawful transaction. …

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