• Daniel Goelzer

SEC Acting Chief Accountant Warns Against Bias in Restatement Materiality Decisions

In Assessing Materiality: Focusing on the Reasonable Investor When Evaluating Errors, a statement issued on March 9, SEC Acting Chief Accountant Paul Munter discusses the concept of materiality and its application to financial statement errors. Mr. Munter asserts that materiality determinations should be made from the perspective of a reasonable investor and that the analysis “should put aside any potential bias of the registrant, auditor, or audit committee that would be inconsistent with” an investor perspective. His remarks signal that the SEC staff believes companies and their advisors have been taking an unduly narrow view of materiality and that many errors that have been treated as immaterial should have triggered restatement and reissuance of the affected financial statements. His comments also suggest that audit committees should play an active role in overseeing these decisions.

Background – Materiality and Error Correction

The Supreme Court has held that an omitted fact is material if there is a substantial likelihood that a reasonable investor would have viewed the fact “as having significantly altered the 'total mix' of information made available." In 1999, the SEC staff issued Staff Accounting Bulletin No. 99--Materiality (SAB No. 99) on the application of the concept of materiality to financial statement errors. SAB No. 99 takes the position that both quantitative and qualitative factors should be considered in evaluating materiality. For example, under SAB No. 99, a quantitatively small error may nonetheless be material based on qualitative factors, such as whether the error was intentional or whether the error caused the company to meet, rather than miss, earnings per share expectations.

The determination of whether an error in previously-issued financial statements is material affects the way in which the error must be corrected. Material errors must be corrected by restating and re-issuing the financial statements. If the error is not material to the affected financial statements, but either correcting the error or leaving the error uncorrected would be material to the current period, the error may be disclosed and corrected in the current period without restating the previous financial statements. A restatement of previously-issued financial statements is referred to as a reissuance or “Big R” restatement, while a correction in the current period is known as a revision or a "little r" restatement. Typically, a little r restatement attracts less attention than a Big R restatement. See Restatements Decline for the Sixth Straight Year, Notching a New Twenty-Year Low, November-December 2021 Update.

Applying Materiality to Errors

Materiality determinations are often not clear-cut and require an exercise of judgment. In close cases, there can be incentives to conclude that an error is not material. The Munter statement provides examples of these incentives: “[A] restatement of previously-issued financial statements may result in the clawback of executive compensation, reputational harm, a decrease in the registrant's share price, increased scrutiny by investors or regulators, litigation, or other impacts.” As noted by Mr. Munter and as discussed in prior Updates, the number of restatements has steadily declined in recent years and the percentage of little r restatements has increased. See Restatements Decline for the Sixth Straight Year, Notching a New Twenty-Year Low, above.

Mr. Munter warns that concerns about restatement impacts like reputational harm or share price declines should not be part of the analysis of the materiality of an error. “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.” Instead, in applying the TSC materiality definition to financial statement errors, “registrants, auditors, and audit committees need to thoroughly and objectively evaluate the total mix of information. Such an evaluation should take into consideration all relevant facts and circumstances surrounding the error, including both quantitative and qualitative factors, to determine whether an error is material to investors.”

Bias in Accounting Error Materiality Assessments

Based on the SEC staff’s interactions with companies and auditors, Mr. Munter describes several theories that are sometimes asserted to support of the view that a misstatement is not material. In his view, however, these theories “appear to be biased toward supporting an outcome that an error is not material to previously-issued financial statements, resulting in "little r" revision restatements.”

  • The error is irrelevant to investors. Companies sometimes contend that specific errors have no impact on investment decisions. They may argue that the misstated item is inherently not useful or that the passage of time has made it irrelevant to current investment decisions. “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.” Mr. Munter also points out that prior period errors could be material because they distort trend analysis.

  • The error is common in the industry and unintentional. Companies sometimes argue that an accounting error is not material because other companies made the same error and it “therefore reflects a widely-held view rather than an intention to misstate.” Under SAB No. 99, management intent may provide evidence of materiality. “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.”

  • The error is offset by other errors. Companies may argue that an error is not material because its effect is offset by other errors. Under SAB No. 99, companies and their auditors should consider both whether a misstatement is material, irrespective of its effect when combined with other mis-statements, and whether an otherwise immaterial error, when aggregated with other misstatements, renders the financial statements taken as a whole materially misleading. “However, we do not believe this analysis of the aggregate effects should serve as the basis for a conclusion that individual errors are immaterial.”

Accounting Errors and ICFR

The Munter statement also discusses the relationship between the determination of accounting error materiality and internal control over financial reporting (ICFR).

“[T]he principles mentioned here regarding an objective assessment similarly apply to the ICFR analysis as to the severity of the control deficiency. Management's ICFR effectiveness assessment must consider the magnitude of the potential misstatement that could result from a control deficiency, and we note that the actual error is only the starting point for determining the potential impact and severity of a deficiency. Therefore, while the existence of a material accounting error is an indicator of the existence of a material weakness, a material weakness may also exist without the existence of a material error.”

Mr. Munter emphasizes the audit committee’s role in identifying and communicating ICFR material weaknesses. “We encourage ongoing attention, including audit committee participation and training, as needed, regarding the adequacy of and basis for a registrant's ICFR effectiveness assessment---particularly where there are close calls in the assessment of whether a deficiency is a significant deficiency * * *.”

Comment: In several places, Mr. Munter refers explicitly to the role of the audit committee in assessing the materiality of errors. “When an error is identified, it is important for registrants, auditors, and audit committees to carefully assess whether the error is material by applying a well-reasoned, holistic, objective approach from a reasonable investor's perspective based on the total mix of information.” (This is consistent with Mr. Munter’s prior comments regarding the role of the audit committee in identifying threats to auditor independence. See Acting Chief Accountant Stresses Auditor Independence and Audit Committee Oversight, November-December 2021 Update.) Audit committees should take seriously Mr. Munter’s view of their responsibilities and make sure that they are informed of and involved in materiality determinations regarding errors. The SEC may inquire into the audit committee’s role in cases where it disagrees with a company’s determination regarding the handling of a financial statement error, and committees should be prepared to show that they provided active oversight.

In evaluating management’s views on the correction of errors in previously-issued financial statements, audit committees should keep in mind the potential for bias stemming from the impact on senior management compensation. Mr. Munter alludes to this in his statement. In addition, as discussed in SEC Revives a Proposal to Require Compensation Claw Backs After Restatements, September-October 2021 Update, a pending SEC rule proposal would compel listed companies to adopt policies requiring recovery, on a no-fault basis, of incentive compensation paid to executive officers on the basis of accounting measures that are subsequently restated. In its current form, the proposal (like many existing claw-back policies) would apply only to Big R restatements. If this rule is adopted, it will raise the stakes – and increase the scrutiny – around restatement decisions.

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