September 1999

SEC Delivers Message on Materiality

Requires Companies and Auditors to Scrutinize Misstatements

By James L. Craig, Jr., CPA

On August 12, the Securities and Exchange Commission released Staff Accounting Bulletin 99--Materiality, that sets forth the SEC's views on when and how corporate management and independent auditors should determine whether or not information is material. As a result, CPAs must now examine financial statements more closely and evaluate misstatements against criteria that previously was not considered significant.

The bulletin fulfills a commitment made last September by SEC Chairman Arthur Levitt when he announced that the commission would take action to address his criticisms of accounting practices that companies undertake to "make the numbers."

SAB 99 states 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." While the use of rules of thumb is appropriate as an initial step in assessing materiality, the SEC asserts that it cannot be used "as a substitute for a full analysis of all relevant considerations." The staff bulletin gives examples where a quantitatively small misstatement might well be considered material, including situations that hide an enterprise's failure to meet analysts' expectations.

In addition, SAB 99 states that each misstatement must be considered separately and then aggregated with other misstatements in determining whether adjustments are required. The SEC believes that it is inappropriate to offset a misstatement that on its own is material by another unadjusted misstatement that has an offsetting effect.

The SAB also concludes that intentional immaterial misstatements are never appropriate and in fact may be unlawful.

SEC Chief Accountant Lynn Turner said that staff accounting bulletin does not break new ground, but it reminds companies to carefully weigh the impact on investors when considering materiality.

"It is a needed reminder to both registrants and auditors that they have to consider carefully the impact of an item on investors before deciding that it is immaterial," Turner said. "Decisions on materiality often are not easy. The SAB points out some key factors that should be taken into account when making those decisions."

The SEC sets forth in detail references to professional standards and securities law that forms the basis of its conclusions. Accounting firms that audit public companies will want to review their administrative practices to assure that they carefully follow the SAB's specifics in evaluating misstatements for possible adjustment.