Whose Business Is It?
Edward A. Weinstein
- It has long been established in the professional literature that
financial statements are the responsibility of management. That
responsibility includes establishing and maintaining accounting
systems that record, process, summarize, organize, and control the
myriad transactions that flow through businesses. Included in this
mandate is maintenance of the integrity of the accounting system
that summarizes the transactions into periodic financial statements.
statements are supposed to be representations of what has transpired
in the business and of its financial condition as of a certain
date. The assignment of this responsibility to management is also
set forth in engagement letters, representation letters, and in
the auditor’s opinion for each audit engagement.
have a secondary responsibility for clients’ financial statements:
obtaining reasonable assurance as to their fairness, as expressed
in the auditor’s opinion. This is done after an examination
of records, review and test of transactions, and outside verification
of both balances and transactions. The audit also requires many
estimates and judgments. In this process, auditors are required
to evaluate evidence and to determine the materiality of information
uncovered by the audit. The process of assessing materiality is
not precisely defined in professional literature, although the
responsibility for this judgment is clearly the auditor’s.
however, when the responsibilities of management and the auditor
conflict or are confused?
management, having primary responsibility for the financial statements,
knows of the auditor’s responsibility to express his opinion
and make materiality judgments. Suppose management decides to
“game” the system. What are the consequences?
After a 40-year
auditing career, and having served as an expert witness in several
legal controversies (including engagements on behalf of the SEC
Enforcement Division), the author has seen the consequences. The
distortion of financial statements can be subtle or substantial.
The results can be damaging to those who must rely upon financial
statements that are flawed as a result of a system gone awry.
decisions involve the following issues:
errors found during the course of an audit or review. These
are mispostings, or computational or similar errors.
“mistakes” caused by management that produce distortion
in the financial statements.
regarding an estimate (e.g., adequacy of bad-debt reserves)
or the application of GAAP (e.g., whether cash flow is generated
by operations or financing).
design of the extent and breadth of systems of internal control.
scope determinations. These are affected by risk tolerance and
are often expressed as a materiality percentage.
will discuss the first two issues in greater depth.
when this author entered the auditing profession, financial systems
were at the beginning of the computer age. Even in 1963, the treasurer
of one large client expressed dismay that the leather-bound ledgers
that his company had been using for decades were no longer available.
While filing deadlines in those years were more lenient (120 days
for 10-Ks; 60 days for 10-Qs), the pressure to complete an audit
within the filing timeframe was severe.
completion of adjusted trial balances, consolidations, financial
statements, and audits, and ultimately publish the financial statements,
auditors developed a protocol to avoid posting late, but arguably
unimportant, entries to financial statements. This protocol evolved
into what has for at least the last 50 years been referred to
as “materiality.” Accountants and auditors always
recognized that financial statements, which summarized thousands
and, in many instances, millions of transactions, were bound to
contain small errors.
in the protocol was the understanding that the errors were inadvertent,
the result of an incorrect posting, an omission, a mathematical
error, or a faulty judgment. The protocol did not encompass deliberate
error. Most auditors viewed materiality in quantitative terms;
that is, in relation to the amounts in the financial statements,
principally net income or earnings per share.
the professional literature never explicitly defined a “normal”
materiality limit, many auditors considered it to be 5% of net
income. For higher-risk situations or clients, the limit was reduced
to 3%. In situations judged as low-risk, the materiality tolerance
could be as high as 10%.
which originated as a protocol to enable auditors to complete
audits of financial statements, has evolved in unintended ways.
It has been used by management to excuse inadvertent errors as
well as those deliberately made, both of which can alter reported
financial results. This evolution has not been particularly good
for the auditing profession.
In the 1960s,
’70s, and ’80s, auditors made materiality decisions.
Then, gradually, management began to assert that it too could
make such decisions. Instead of focusing on the need for all transactions
to be recorded properly and in the right period, company management
encroached on the auditors’ domain. In doing this, management
began to lose focus regarding its own responsibilities and to
limit auditor judgmental responsibility. Many auditors did not
has not been thought of only in quantitative terms. Nor were individual
errors to be measured only separately; they were to be grouped
and measured. Certain errors were to be considered in terms of
their qualitative effect on financial statements. These concepts
are discussed in accounting and auditing literature published
by the SEC, FASB, and the auditing profession itself, most recently
in SEC Staff Accounting Bulletins (SAB) 108 and 99, the latter
of which identifies some qualitative misstatements.
these concepts are expressed in the auditing guidelines and programs
published internally and used by accounting and auditing firms.
These guidelines also define how the auditor is to assess risk,
and the relationship of this assessment to the quantitative materiality.
If the quantitative
total of the errors discovered by the audit exceeds the auditor’s
planned limit, the auditor should first consider the appropriateness
of planning materiality in relation to the final financial statements.
The auditor should then consider whether his scope was sufficient
to flush out all errors. Assuming that the auditor concludes positively
on both, or makes appropriate adjustment to scope while the gross
error still exceeds limits, what happens next?
the auditor cannot express an opinion on the financial statements
absent correction of the errors. In practice, one of two scenarios
develops, only rarely leading to the theoretical result: In scenario
one, auditor and management have an iterative discussion resulting
in the client accepting all or some of the auditor’s suggested
error corrections. In scenario two, management rejects all suggested
corrections and the auditor is left to again reassess the original
planning limit of materiality, taking into consideration the financial
and operational circumstances of the client and other matters
revealed by the audit. These may affect the materiality metrics
originally scoped or modified. This additional modification is
considered an acceptable result in an audit.
the case in audits of Waste Management Corporation (WM) from 1992
through 1996. Each year, the total of errors exceeded the planning
limit (many times by a multiple of it). Each year, management
and the auditor discussed the result and management “passed”
the auditor’s proposed adjusting journal entries (PAJEs);
that is, rejected them. The auditor then reconsidered the 3% limit,
and issued an unqualified opinion on WM’s financial statements.
entries were not recorded in the first period of the succeeding
year. (In the author’s experience, virtually every audit
client had posted passed adjusting journal entries in the first
quarter of the succeeding year because they were deemed immaterial
to either period.) Instead, the entries at WM were suspended.
of the publication of WM’s financial statements, a new audit
planning cycle began and the same risk-assessment and materiality
limits were adopted. This pattern continued each year, from 1992
to 1996. The auditor had been prevented from making the appropriate
correcting entries because management asserted primacy regarding
the financial statements. The auditor could have refused to provide
assurance on these financial statements through his opinion, but
did not choose this course of action.
due to increasing auditor discomfort, WM management adopted strategies
for eliminating the errors, including netting them against nonrecurring
gains on the disposition of subsidiaries or divisions. Although
this practice had the salutary effect of reducing the carryover
amount of these entries, it was not in accordance with GAAP. Thus,
one error was fixed with another.
same five-year period, WM management caused a series of entries
to be made in 14 consecutive quarters. These entries reclassified
amounts that were accumulated in certain expense categories to
other, presumably less-significant expense categories. With one
exception, these entries distorted the relationship between selling
and administrative expenses, or operating expenses, and total
revenue. These entries had no effect on net income, because the
offsetting debits or credits were to interest, taxes, or other
expense accounts. None of these entries reflected any business
transaction. No support or audit evidence could be found for any
created by these entries were for amounts as small as 0.7% of
the related line item. Obvious questions included the following:
Were these items “errors” as contemplated by materiality
protocols? How should they have been viewed by the auditor? How
should they be viewed in terms of qualitative materiality?
were clearly material (qualitatively). Otherwise, why were
they made? Not entered in the transactional record of WM,
their only purpose could have been to affect the financial statements.
They were designed to deceive readers of the financial statements.
And they effectively destroyed the representational faithfulness
of the financial statement in which they were made. These were
not inadvertent errors as contemplated by materiality protocols.
They were deliberately created “errors.” It appeared
that the auditor, considering solely the quantitative effect,
ignored management’s actions in creating these entries.
present an interesting perspective on the entire WM matter. On
the one hand, WM management was consistently refusing to correct
errors found by its auditor in five successive years, the amounts
of which significantly exceeded the auditor’s judgment of
what was quantitatively material. On the other hand, WM management
was simultaneously and deliberately altering the results produced
by the transactional record in amounts that were, by comparison,
infinitesimal. Taken together, these two positions are contradictory
and SEC pronouncements address this kind of deception. FASB’s
Statement of Financial Concepts 2 states that a misstatement is
material if “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.” SAB 99 states that auditors
“should not assume that even small intentional misstatements
in financial statements … are immaterial. While the intent
of management does not render a misstatement material, it may
provide significant evidence of materiality.”
case known to the author, a company’s management created
entries that had no substance to serve its purposes. These entries
were justified to the auditor as immaterial.
involved the disposition of trade accounts receivable that had
arisen from sales of dubious origin. Because the receivables were
not collectable, management had to remove them from the accounts.
To have written them off as bad debts would have aroused the suspicions
of analysts and required response to inevitable questions. What
was to be done?
determined to establish unrelated “reserves” in connection
with the acquisition of purchased companies. The reserves were
established at slightly less than 5% of the purchase price of
the acquired companies. The company used these reserves as repositories
for the bad receivables.
also asserted its primacy over the financial statements. The auditor
was allegedly told that because the “error” was less
than 5%, the amounts were not material. The auditor reluctantly
accepted this explanation, ignoring the issue of qualitative materiality.
Change in Climate
the audit landscape has changed as a result of the Sarbanes-Oxley
Act (SOX). Audit committees have begun to assert themselves and
are increasingly populated by more knowledgeable, independent
individuals. The fact that PAJEs must be disclosed to the audit
committee has begun to act as a countervailing force to managements’
reluctance to accept these adjustments. The author has been told
that some audit committees, concerned with their own liability,
have instructed management to book all PAJEs.
The SOX requirement
that CEOs and CFOs sign off on company financial statements has
also had a sobering effect on some individuals’ thinking.
Executives who might otherwise be inclined to ignore auditor attempts
to correct errors, or even to cause such errors, must now think
twice. Auditors, facing sharp questioning from audit committees,
are more focused and less willing to be malleable. The possibility
of being second-guessed by the Public Company Accounting Oversight
Board’s (PCAOB) inspection process has also affected the
thinking of auditors.
much progress has been made, this writer suspects that there remain
some companies with executives who haven’t gotten the message,
some audit committees whose members are ill suited to the task,
and some auditors who still believe that client service means
accommodation of bad practices. In other words, the temptations
remain. It is important that recent improvements become universal
and part of the institutional memory of the financial reporting
of roles regarding materiality decisions and the ceding of responsibility
by some auditors must not be allowed to happen again. It is disappointing
that SAB 99, an important step forward, does not assign clear
responsibility to the auditor for materiality decisions. It perpetuates
management’s making materiality decisions having to do with
financial statement errors, arguably on a co-equal basis with
auditors. SAB 99 thus continues the confusion regarding materiality
Materiality: A New ‘Fuzzy Logic’ Approach” (The
CPA Journal, June 2006), authors Rebecca L. Rosner, Christie
L. Comunale, and Thomas R. Sexton suggest that the assessment
of qualitative materiality factors is difficult and would be furthered
by using “fuzzy logic” techniques.
In the author’s
experience, such an approach is not necessary. What is necessary
is for auditors to use keener judgment and avoid doing what is
plainly wrong with an overly quantitative approach. This keener
judgment needs to be accompanied by a strong measure of auditor
resolve if challenged by management over materiality decisions.
is some simple advice for auditors on materiality:
management should not be making materiality decisions having
to do with financial statement error.
- Any outright
error created deliberately by management is, by definition,
qualitatively material and must be corrected.
- In today’s
era of computers, there is little justification for any but
the most insignificant (note: not “immaterial”)
error corrections not to be entered in the books and records
before publication of financial statements.
- Any insignificant
error not corrected at a closing must be immediately booked
into the first quarter of the next year. There should be no
reason to carry over such entries from year to year or period
to period. (See Lee J. Seidler, “Materiality Decisions
in the Computer Age,” The CPA Journal, May 1999.)
This requirement will improve the client’s judgment as
to what is “insignificant,” providing incentive
to record all but truly insignificant corrections in the correct
the Auditor’s Role
When a company’s
management asserts its primacy regarding financial statements,
including the right to make all materiality judgments that also
must be evaluated by the auditor, it is time for the auditor to
leave. This is especially so when the errors are deliberate, not
supported by the transactional record, and acknowledged as such
by the client.
client is never easy. In the Waste Management case, jurors were
permitted to ask questions of witnesses after direct examination,
cross-examination, and redirect. One juror observed that resigning
from a client had to be a very difficult action to take and asked
this witness whether he knew of any such resignation. Acknowledging
the difficulty of resigning from a client, I described having
done so about 30 years ago, with a then–very significant
client, over the initial objections of more-senior partners in
the office. The reasons for the resignation involved a dispute
over materiality and client integrity. That revelation helped
the jurors to understand the concept of “materiality.”
A. Weinstein, CPA, a consultant and advisor to businesses
and other organizations, and an arbitrator, is currently serving
as an expert witness for both the SEC and the U.S. Attorney for
the Southern District of California. Prior to his retirement in
1998, he was a senior partner in the New York office of Deloitte
& Touche LLP. He is also a past president (1981–1982)
of the NYSSCPA, which in May 2007 presented him with its Distinguished
Service Award. In 1975, his article “A Time of Travail and
Challenge” (December 1974) won The CPA Journal’s
first Max Block Distinguished Article Award.