Reconciling Materiality Standards for SEC's FinancialDocumentation
The Securities and Exchange Commission (SEC) has been emphasising the importance of materiality in federal securities laws, a topic that has not yet achieved complete clarity. This focus on materiality is crucial for SEC registrants, auditors, and audit committees, as it plays a significant role in determining the accuracy of financial statements.
Paul Munter, the acting Chief Accountant of the SEC, recently highlighted the significance of materiality in the context of errors in financial statements. According to Munter, a fact is material if it has a substantial likelihood of being viewed by the reasonable investor as having significantly altered the 'total mix' of information made available.
Registrants should expect that their materiality judgments will be stress-tested by the SEC staff. To determine the materiality of an identified error, registrants should evaluate all relevant facts and circumstances, following the principle-based standard of materiality. This analysis takes into account both quantitative and qualitative factors.
When a material accounting error has been identified, it must be corrected by restating prior-period financial statements, known as a Big R restatement. However, if an error is not material to previously-issued financial statements, it may be corrected in the current period by correcting the prior period information (little r restatement).
Auditors use materiality to determine which classes of accounts and disclosures should be subject to audit procedures. It also helps auditors decide whether a control deficiency is a material weakness for purposes of the audit of management's assessment on the effectiveness of the company's internal control over financial reporting.
The Office of the Chief Accountant (OCA) has expressed concern about a trend of "little r" restatements dominating recent restatements, suggesting a bias toward concluding that an error is not material. The OCA has also noted that parties have asserted that a quantitatively significant error is not material due to qualitative factors, which stands in contrast to SAB No. 99.
The OCA has encountered unpersuasive arguments regarding materiality, such as investors not caring about identified errors, other filers making the same innocent mistake, and all identified errors zeroing each other out. The OCA has stated that each individual error stands on its own and cannot be judged to be immaterial by aggregating it with other errors.
In the context of a restatement, the materiality discussions between the audit committee and auditor are likely to be more involved. Audit committees should discuss materiality thresholds with the outside auditors and appreciate how the auditors assess materiality in the context of financial reporting and disclosure issues. They should also understand how management applies materiality to decide whether to restate previously-issued financial statements.
It is particularly important that any SAB No. 99 analysis has documented support for its conclusions. If the company does not record those adjustments, the auditor is required to discuss with the audit committee, or confirm that management has addressed with the audit committee, the basis for concluding that the uncorrected misstatements were immaterial.
The total number of restatements by registrants declined each year from 2013 to 2020, but "little r" restatements as a percentage of total restatements rose to nearly 76% in 2020. This trend has raised concerns about a potential bias towards concluding that errors are not material.
In conclusion, the SEC's focus on materiality underscores the importance of accurate and transparent financial reporting. Registrants, auditors, and audit committees must ensure they are applying the principle-based standard of materiality consistently and appropriately to maintain investor confidence and comply with federal securities laws.
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