With the SEC’s focus on the needs of investors under the leadership of Gary Gensler, two agency accountants emphasized that public companies must determine materiality through the lens of a reasonable investor based on the Supreme Court’s decisions when figuring out whether there was an accounting error.
They made the remarks because some companies may have been biased when making materiality determination.
The concept of materiality came up during a conference panel discussion about the SEC’s Office of Chief Accountant’s (OCA) recent push on little r and big R restatements.
“The materiality evaluation needs to be an objective assessment and an impartial evaluation that takes into consideration all facts and circumstances with respect to the error,” Jonathan Wiggins, senior associate chief accountant in OCA, said during the 20th Annual Financial Reporting Conference hosted virtually by Baruch College on May 4, 2022.
“When I think about what that means, I consider the large number of different types of experts that might participate in any materiality assessment. So that could include both accountants and non-accountants and a company’s management. It could include in-house counsel, outside counsel, audit committee members, auditors and others. And each of those individuals or experts may bring a very valuable unique skill set and knowledge base to that evaluation,” he said. “However, I think it’s critical that we all remember that the concept of materiality is focused on a total mix of information from the perspective of reasonable investor.”
The current definition of materiality is derived from Supreme Court decisions like TSC Industries v. Northway Inc. in 1976 and Basic Inc. v. Levinson in 1988.
The SEC interpreted the meaning of materiality for regulatory filings when it published Staff Accounting Bulletin (SAB) No. 99, Materiality, (Topic 1.M). SAB No. 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements when assessing materiality.
Thus, Wiggins said the experts he mentioned should assess the materiality of errors from the point of view of a reasonable investor to “eliminate any of their own biases, or perspectives that would be inconsistent with that reasonable investor’s view.”
He explained that the SEC staff uses the same standard when it thinks about materiality, whether it is for an accounting consultation in OCA or work that is done by the Divisions of Corporation Finance (CorpFin) and Enforcement.
First, she said that the staff is not creating new guidance on materiality or developing a bright-line threshold, as some may have suggested.
“In the past, when CorpFin has talked about materiality, we then in our comment process may receive responses citing our remarks at various panels or whatever suggesting there was bright-line threshold,” McCord said. “So, just to be clear, there is no bright-line thresholds. We simply are trying to be very transparent with the external parties of what are some fact patterns we see and how do we think about that, so you can think about that as you go along with your day-to-day work.”
The first example she gave was about an accounting error related to the calculation of loss on a sale of a business, and the error led to an understated loss. The impact of the error was more than 20% of net income and more than 50% of loss in discontinued operations.
Some of the qualitative factors the company cited in their comment letter response were:
“So, definitely appreciated the qualitative factors cited by the company, and they were weighted heavier or more than the quantitative in their analysis,” McCord said. “But that being said, I do think when the staff looked at these qualitative factors, there were a few things we noted and ultimately came to the conclusion that the qualitative factors were not enough to overcome the magnitude of the quantitative error to net income, a line item that is important to investors.”
The staff noted that the materiality analysis is carried out to determine how to correct a known error. Thus, the fact that the error is being, was, or is going to be corrected should not be a factor in the materiality analysis.
The staff also noted that several qualitative factors cited could broadly be categorized as passage of time concept, and that the errors in previously issued financial statements are no longer material once either more recent financial statements are issued, or there is no reoccurring impact on the year. In this case, she said, the misstatements are still required in Form 10-K. This is because investors value trends in financials, which is why comparative financial information is required in current period filings.
“As a consequence, I just personally struggle with the view that investors are focused only on current financial results, and not on any of those historical periods,” McCord said. “Investors have shared with the staff and there is academic research to support that investors consider the registrants’ past history of accounting as an indicator of the reliability of the current financial results.”
For the second example, she discussed an error related to equity classification, special-purpose acquisition company (SPAC) shares and the consideration of the unit of account in relation to that error. In this case, the error was more than 100% of total shareholders’ equity, and it changed the earnings per share (EPS) by more than 50%.
The company considered the following primary qualitative factors:
The staff disagreed that those qualitative factors would overcome the magnitude of the quantitative error to determine it was a little r, and the staff determined that this was a big R restatement.
“Again, we did not focus on the fact that the passage of time where the error will be corrected due to the passage of time or change..., that’s not sufficient to overcome the significance of a quantitative error,” she said. “Also, the fact that there is a single group of factors for an entire group of registrants, which in this case was SPACs, is so determined that every accounting error discovered would never or would not change or influence the judgment of a reasonable person relying upon the report by inclusion or correction of the error. That also was something that we didn’t agree with.”
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