[Federal Register Volume 64, Number 160 (Thursday, August 19, 1999)]
[Rules and Regulations]
[Pages 45150-45155]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-21484]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 211
[Release No. SAB 99]
Staff Accounting Bulletin No. 99
AGENCY: Securities and Exchange Commission.
ACTION: Publication of Staff Accounting Bulletin.
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SUMMARY: This staff accounting bulletin expresses the views of the
staff that exclusive reliance on certain quantitative benchmarks to
assess materiality in preparing financial statements and performing
audits of those financial statements is inappropriate; misstatements
are not immaterial simply because they fall beneath a numerical
threshold.
DATES: Effective August 12, 1999.
FOR FURTHER INFORMATION CONTACT: W. Scott Bayless, Associate Chief
Accountant, or Robert E. Burns, Chief Counsel, Office of the Chief
Accountant (202-942-4400), or David R. Fredrickson, Office of General
Counsel (202-942-0900), Securities and Exchange Commission, 450 Fifth
Street, NW, Washington, DC 20549-1103; electronic addresses:
[email protected]; [email protected]; [email protected]
SUPPLEMENTARY INFORMATION: The statements in the staff accounting
bulletins are not rules or interpretations of the Commission, nor are
they published as bearing the Commission's official approval. They
represent interpretations and practices followed by the Division of
Corporation Finance and the Office of the Chief Accountant in
administering the disclosure requirements of the Federal securities
laws.
Dated: August 12, 1999.
Margaret H. McFarland,
Deputy Secretary.
PART 211--[AMENDED]
Accordingly, Part 211 of Title 17 of the Code of Federal
Regulations is amended by adding Staff Accounting Bulletin No. 99 to
the table found in Subpart B.
Staff Accounting Bulletin No. 99
The staff hereby adds Section M to Topic 1 of the Staff Accounting
Bulletin Series. Section M, entitled ``Materiality,'' provides guidance
in applying materiality thresholds to the preparation of financial
statements filed with the Commission and the performance of audits of
those financial statements.
Staff Accounting Bulletins
Topic 1: Financial Statements
* * * * *
[[Page 45151]]
M. Materiality
1. Assessing Materiality
Facts: During the course of preparing or auditing year-end
financial statements, financial management or the registrant's
independent auditor becomes aware of misstatements in a registrant's
financial statements. When combined, the misstatements result in a 4%
overstatement of net income and a $.02 (4%) overstatement of earnings
per share. Because no item in the registrant's consolidated financial
statements is misstated by more than 5%, management and the independent
auditor conclude that the deviation from generally accepted accounting
principles (``GAAP'') is immaterial and that the accounting is
permissible.\1\
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\1\ American Institute of Certified Public Accountants
(``AICPA''), Codification of Statements on Auditing Standards
(``AU'') Sec. 312, ``Audit Risk and Materiality in Conducting an
Audit,'' states that the auditor should consider audit risk and
materiality both in (a) planning and setting the scope for the audit
and (b) evaluating whether the financial statements taken as a whole
are fairly presented in all material respects in conformity with
generally accepted accounting principles. The purpose of this Staff
Accounting Bulletin (``SAB'') is to provide guidance to financial
management and independent auditors with respect to the evaluation
of the materiality of misstatements that are identified in the audit
process or preparation of the financial statements (i.e., (b)
above). This SAB is not intended to provide definitive guidance for
assessing ``materiality'' in other contexts, such as evaluations of
auditor independence, as other factors may apply. There may be other
rules that address financial presentation. See, e.g., Rule 2a-4, 17
CFR 270.2a-4, under the Investment Company Act of 1940.
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Question: Each Statement of Financial Accounting Standards adopted
by the Financial Accounting Standards Board (``FASB'') states, ``The
provisions of this Statement need not be applied to immaterial items.''
In the staff's view, may a registrant or the auditor of its financial
statements assume the immateriality of items that fall below a
percentage threshold set by management or the auditor to determine
whether amounts and items are material to the financial statements?
Interpretive Response: No. The staff is aware that certain
registrants, over time, have developed quantitative thresholds as
``rules of thumb'' to assist in the preparation of their financial
statements, and that auditors also have used these thresholds in their
evaluation of whether items might be considered material to users of a
registrant's financial statements. One rule of thumb in particular
suggests that the misstatement or omission \2\ of an item that falls
under a 5% threshold is not material in the absence of particularly
egregious circumstances, such as self-dealing or misappropriation by
senior management. The staff reminds registrants and the auditors of
their financial statements that exclusive reliance on this or any
percentage or numerical threshold has no basis in the accounting
literature or the law.
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\2\ As used in this SAB, ``misstatement'' or ``omission'' refers
to a financial statement assertion that would not be in conformity
with GAAP.
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The use of a percentage as a numerical threshold, such as 5%, may
provide the basis for a preliminary assumption that--without
considering all relevant circumstances--a deviation of less than the
specified percentage with respect to a particular item on the
registrant's financial statements is unlikely to be material. The staff
has no objection to such a ``rule of thumb'' as an initial step in
assessing materiality. But quantifying, in percentage terms, the
magnitude of a misstatement is only the beginning of an analysis of
materiality; it cannot appropriately be used as a substitute for a full
analysis of all relevant considerations.
Materiality concerns the significance of an item to users of a
registrant's financial statements. A matter is ``material'' if there is
a substantial likelihood that a reasonable person would consider it
important. In its Statement of Financial Accounting Concepts No. 2, the
FASB stated the essence of the concept of materiality as follows:
The omission or misstatement of an item in a financial report is
material if, in the light of surrounding circumstances, 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.\3\
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\3\ FASB, Statement of Financial Accounting Concepts No. 2,
Qualitative Characteristics of Accounting Information (``Concepts
Statement No. 2''), para. 132 (1980). See also Concepts Statement
No. 2, Glossary of Terms--Materiality.
This formulation in the accounting literature is in substance
identical to the formulation used by the courts in interpreting the
federal securities laws. The Supreme Court has held that a fact is
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material if there is--
a substantial likelihood that the . . . fact would have been
viewed by the reasonable investor as having significantly altered
the ``total mix'' of information made available.\4\
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\4\ TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976).
See also Basic, Inc. v. Levinson, 485 U.S. 224 (1988). As the
Supreme Court has noted, determinations of materiality require
``delicate assessments of the inferences a `reasonable shareholder'
would draw from a given set of facts and the significance of those
inferences to him. . . . .'' TSC Industries, 426 U.S. at 450.
Under the governing principles, an assessment of materiality
requires that one views the facts in the context of the ``surrounding
circumstances,'' as the accounting literature puts it, or the ``total
mix'' of information, in the words of the Supreme Court. In the context
of a misstatement of a financial statement item, while the ``total
mix'' includes the size in numerical or percentage terms of the
misstatement, it also includes the factual context in which the user of
financial statements would view the financial statement item. The
shorthand in the accounting and auditing literature for this analysis
is that financial management and the auditor must consider both
``quantitative'' and ``qualitative'' factors in assessing an item's
materiality.\5\ Court decisions, Commission rules and enforcement
actions, and accounting and auditing literature \6\ have all considered
``qualitative'' factors in various contexts.
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\5\ See, e.g., Concepts Statement No. 2, Paras. 123-124; AU
Sec. 312.10 (`` . . . materiality judgments are made in light of
surrounding circumstances and necessarily involve both quantitative
and qualitative considerations.''); AU Sec. 312.34 (``Qualitative
considerations also influence the auditor in reaching a conclusion
as to whether misstatements are material.''). As used in the
accounting literature and in this SAB, ``qualitative'' materiality
refers to the surrounding circumstances that inform an investor's
evaluation of financial statement entries. Whether events may be
material to investors for non-financial reasons is a matter not
addressed by this SAB.
\6\ See, e.g., Rule 1-02(o) of Regulation S-X, 17 CFR 210.1-
02(o), Rule 405 of Regulation C, 17 CFR 230.405, and Rule 12b-2, 17
CFR 240.12b-2; AU Sec. Sec. 312.10--.11, 317.13, 411.04 n. 1, and
508.36; In re Kidder Peabody Securities Litigation, 10 F. Supp. 2d
398 (S.D.N.Y. 1998); Parnes v. Gateway 2000, Inc., 122 F.3d 539 (8th
Cir. 1997); In re Westinghouse Securities Litigation, 90 F.3d 696
(3d Cir. 1996); In the Matter of W.R. Grace & Co., Accounting and
Auditing Enforcement Release No. (``AAER'') 1140 (June 30, 1999); In
the Matter of Eugene Gaughan, AAER 1141 (June 30, 1999); In the
Matter of Thomas Scanlon, AAER 1142 (June 30, 1999); and In re
Sensormatic Electronics Corporation, Sec. Act Rel. No. 7518 (March
25, 1998).
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The FASB has long emphasized that materiality cannot be reduced to
a numerical formula. In its Concepts Statement No. 2, the FASB noted
that some had urged it to promulgate quantitative materiality guides
for use in a variety of situations. The FASB rejected such an approach
as representing only a ``minority view,'' stating--
The predominant view is that materiality judgments can properly
be made only by those who have all the facts. The Board's present
position is that no general standards of materiality could be
formulated to take into account all the considerations that enter
into an experienced human judgment.\7\
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\7\ Concepts Statement No. 2, para. 131 (1980).
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The FASB noted that, in certain limited circumstances, the
Commission and other authoritative bodies had issued quantitative
materiality guidance, citing as examples guidelines ranging from one to
ten percent with
[[Page 45152]]
respect to a variety of disclosures.\8\ And it took account of
contradictory studies, one showing a lack of uniformity among auditors
on materiality judgments, and another suggesting widespread use of a
``rule of thumb'' of five to ten percent of net income.\9\ The FASB
also considered whether an evaluation of materiality could be based
solely on anticipating the market's reaction to accounting
information.\10\
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\8\ Concepts Statement No. 2, Paras. 131 and 166.
\9\ Concepts Statement No. 2, para. 167.
\10\ Concepts Statement No. 2, Paras. 168-69.
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The FASB rejected a formulaic approach to discharging ``the onerous
duty of making materiality decisions'' \11\ in favor of an approach
that takes into account all the relevant considerations. In so doing,
it made clear that--
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\11\ Concepts Statement No. 2, para. 170.
[M]agnitude by itself, without regard to the nature of the item
and the circumstances in which the judgment has to be made, will not
generally be a sufficient basis for a materiality judgment.\12\
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\12\ Concepts Statement No. 2, Paras. 125.
Evaluation of materiality requires a registrant and its auditor to
consider all the relevant circumstances, and the staff believes that
there are numerous circumstances in which misstatements below 5% could
well be material. Qualitative factors may cause misstatements of
quantitatively small amounts to be material; as stated in the auditing
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literature:
As a result of the interaction of quantitative and qualitative
considerations in materiality judgments, misstatements of relatively
small amounts that come to the auditor's attention could have a
material effect on the financial statements.\13\
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\13\AU Sec. 312.11.
Among the considerations that may well render material a
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quantitatively small misstatement of a financial statement item are--
Whether the misstatement arises from an item capable of
precise measurement or whether it arises from an estimate and, if
so, the degree of imprecision inherent in the estimate \14\
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\14\ As stated in Concepts Statement No. 2, Paras. 130:
Another factor in materiality judgments is the degree of
precision that is attainable in estimating the judgment item. The
amount of deviation that is considered immaterial may increase as
the attainable degree of precision decreases. For example, accounts
payable usually can be estimated more accurately than can contingent
liabilities arising from litigation or threats of it, and a
deviation considered to be material in the first case may be quite
trivial in the second.
This SAB is not intended to change current law or guidance in
the accounting literature regarding accounting estimates. See, e.g.,
Accounting Principles Board Opinion No. 20, Accounting Changes
Paras. 10, 11, 31-33 (July 1971).
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Whether the misstatement masks a change in earnings or
other trends.
Whether the misstatement hides a failure to meet
analysts' consensus expectations for the enterprise.
Whether the misstatement changes a loss into income or
vice versa.
Whether the misstatement concerns a segment or other
portion of the registrant's business that has been identified as
playing a significant role in the registrant's operations or
profitability.
Whether the misstatement affects the registrant's
compliance with regulatory requirements.
Whether the misstatement affects the registrant's
compliance with loan covenants or other contractual requirements.
Whether the misstatement has the effect of increasing
management's compensation--for example, by satisfying requirements
for the award of bonuses or other forms of incentive compensation.
Whether the misstatement involves concealment of an
unlawful transaction.
This is not an exhaustive list of the circumstances that may affect
the materiality of a quantitatively small misstatement.\15\ Among other
factors, the demonstrated volatility of the price of a registrant's
securities in response to certain types of disclosures may provide
guidance as to whether investors regard quantitatively small
misstatements as material. Consideration of potential market reaction
to disclosure of a misstatement is by itself ``too blunt an instrument
to be depended on'' in considering whether a fact is material.\16\
When, however, management or the independent auditor expects (based,
for example, on a pattern of market performance) that a known
misstatement may result in a significant positive or negative market
reaction, that expected reaction should be taken into account when
considering whether a misstatement is material.\17\
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\15\ The staff understands that the Big Five Audit Materiality
Task Force (``Task Force'') was convened in March of 1998 and has
made recommendations to the Auditing Standards Board including
suggestions regarding communications with audit committees about
unadjusted misstatements. See generally Big Five Audit Materiality
Task Force, ``Materiality in a Financial Statement Audit--
Considering Qualitative Factors When Evaluating Audit Findings''
(August 1998). The Task Force memorandum is available at
www.aicpa.org.
\16\ See Concepts Statement No. 2, para. 169.
\17\ If management does not expect a significant market
reaction, a misstatement still may be material and should be
evaluated under the criteria discussed in this SAB.
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For the reasons noted above, the staff believes that a registrant
and the auditors of its financial statements should not assume that
even small intentional misstatements in financial statements, for
example those pursuant to actions to ``manage'' earnings, are
immaterial.\18\ While the intent of management does not render a
misstatement material, it may provide significant evidence of
materiality. The evidence may be particularly compelling where
management has intentionally misstated items in the financial
statements to ``manage'' reported earnings. In that instance, it
presumably has done so believing that the resulting amounts and trends
would be significant to users of the registrant's financial
statements.\19\ The staff believes that investors generally would
regard as significant a management practice to over- or under-state
earnings up to an amount just short of a percentage threshold in order
to ``manage'' earnings. Investors presumably also would regard as
significant an accounting practice that, in essence, rendered all
earnings figures subject to a management-directed margin of
misstatement.
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\18\ Intentional management of earnings and intentional
misstatements, as used in this SAB, do not include insignificant
errors and omissions that may occur in systems and recurring
processes in the normal course of business. See notes 38 and 50
infra.
\19\ Assessments of materiality should occur not only at year-
end, but also during the preparation of each quarterly or interim
financial statement. See, e.g., In the Matter of Venator Group,
Inc., AAER 1049 (June 29, 1998).
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The materiality of a misstatement may turn on where it appears in
the financial statements. For example, a misstatement may involve a
segment of the registrant's operations. In that instance, in assessing
materiality of a misstatement to the financial statements taken as a
whole, registrants and their auditors should consider not only the size
of the misstatement but also the significance of the segment
information to the financial statements taken as a whole.\20\ ``A
misstatement of the revenue and operating profit of a relatively small
segment that is represented by management to be important to the future
profitability of the entity'' \21\ is more likely to be material to
investors than a misstatement in a segment that management has not
identified as especially important. In assessing the materiality of
misstatements in segment information--as with materiality generally--
\20\ See, e.g., In the Matter of W.R. Grace & Co., AAER 1140
(June 30, 1999).
\21\ AUI Sec. 326.33.
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situations may arise in practice where the auditor will conclude
that a matter relating to segment information is qualitatively
material even though, in his or her judgment, it is quantitatively
immaterial to the financial statements taken as a whole.\22\
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\22\ Id.
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[[Page 45153]]
Aggregating and Netting Misstatements
In determining whether multiple misstatements cause the financial
statements to be materially misstated, registrants and the auditors of
their financial statements should consider each misstatement separately
and the aggregate effect of all misstatements.\23\ A registrant and its
auditor should evaluate misstatements in light of quantitative and
qualitative factors and ``consider whether, in relation to individual
line item amounts, subtotals, or totals in the financial statements,
they materially misstate the financial statements taken as a whole.''
\24\ This requires consideration of--
\23\ The auditing literature notes that the ``concept of
materiality recognizes that some matters, either individually or in
the aggregate, are important for fair presentation of financial
statements in conformity with generally accepted accounting
principles.'' AU Sec. 312.03. See also AU Sec. 312.04.
\24\ AU Sec. 312.34. Quantitative materiality assessments often
are made by comparing adjustments to revenues, gross profit, pretax
and net income, total assets, stockholders' equity, or individual
line items in the financial statements. The particular items in the
financial statements to be considered as a basis for the materiality
determination depend on the proposed adjustment to be made and other
factors, such as those identified in this SAB. For example, an
adjustment to inventory that is immaterial to pretax income or net
income may be material to the financial statements because it may
affect a working capital ratio or cause the registrant to be in
default of loan covenants.
the significance of an item to a particular entity (for example,
inventories to a manufacturing company), the pervasiveness of the
misstatement (such as whether it affects the presentation of
numerous financial statement items), and the effect of the
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misstatement on the financial statements taken as a whole. . . .\25\
\25\ AU Sec. 508.36.
Registrants and their auditors first should consider whether each
misstatement is material, irrespective of its effect when combined with
other misstatements. The literature notes that the analysis should
consider whether the misstatement of ``individual amounts'' causes a
material misstatement of the financial statements taken as a whole. As
with materiality generally, this analysis requires consideration of
both quantitative and qualitative factors.
If the misstatement of an individual amount causes the financial
statements as a whole to be materially misstated, that effect cannot be
eliminated by other misstatements whose effect may be to diminish the
impact of the misstatement on other financial statement items. To take
an obvious example, if a registrant's revenues are a material financial
statement item and if they are materially overstated, the financial
statements taken as a whole will be materially misleading even if the
effect on earnings is completely offset by an equivalent overstatement
of expenses.
Even though a misstatement of an individual amount may not cause
the financial statements taken as a whole to be materially misstated,
it may nonetheless, when aggregated with other misstatements, render
the financial statements taken as a whole to be materially misleading.
Registrants and the auditors of their financial statements accordingly
should consider the effect of the misstatement on subtotals or totals.
The auditor should aggregate all misstatements that affect each
subtotal or total and consider whether the misstatements in the
aggregate affect the subtotal or total in a way that causes the
registrant's financial statements taken as a whole to be materially
misleading.\26\
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\26\ AU Sec. 312.34.
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The staff believes that, in considering the aggregate effect of
multiple misstatements on a subtotal or total, registrants and the
auditors of their financial statements should exercise particular care
when considering whether to offset (or the appropriateness of
offsetting) a misstatement of an estimated amount with a misstatement
of an item capable of precise measurement. As noted above, assessments
of materiality should never be purely mechanical; given the imprecision
inherent in estimates, there is by definition a corresponding
imprecision in the aggregation of misstatements involving estimates
with those that do not involve an estimate.
Registrants and auditors also should consider the effect of
misstatements from prior periods on the current financial statements.
For example, the auditing literature states,
Matters underlying adjustments proposed by the auditor but not
recorded by the entity could potentially cause future financial
statements to be materially misstated, even though the auditor has
concluded that the adjustments are not material to the current
financial statements.\27\
\27\ AU Sec. 380.09.
This may be particularly the case where immaterial misstatements
recur in several years and the cumulative effect becomes material in
the current year.
2. Immaterial Misstatements That are Intentional
Facts: A registrant's management intentionally has made adjustments
to various financial statement items in a manner inconsistent with
GAAP. In each accounting period in which such actions were taken, none
of the individual adjustments is by itself material, nor is the
aggregate effect on the financial statements taken as a whole material
for the period. The registrant's earnings ``management'' has been
effected at the direction or acquiescence of management in the belief
that any deviations from GAAP have been immaterial and that accordingly
the accounting is permissible.
Question: In the staff's view, may a registrant make intentional
immaterial misstatements in its financial statements?
Interpretive Response: No. In certain circumstances, intentional
immaterial misstatements are unlawful.
Considerations of the Books and Records Provisions Under the Exchange
Act
Even if misstatements are immaterial,28 registrants must
comply with Sections 13(b)(2)-(7) of the Securities Exchange Act of
1934 (the ``Exchange Act'').29 Under these provisions, each
registrant with securities registered pursuant to Section 12 of the
Exchange Act,30 or required to file reports pursuant to
Section 15(d),31 must make and keep books, records, and
accounts, which, in reasonable detail, accurately and fairly reflect
the transactions and dispositions of assets of the registrant and must
maintain internal accounting controls that are sufficient to provide
reasonable assurances that, among other things, transactions are
recorded as necessary to permit the preparation of financial statements
in conformity with GAAP.32 In this context, determinations
of what constitutes ``reasonable assurance'' and ``reasonable detail''
are based not on a ``materiality'' analysis but on the level
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of detail and degree of assurance that would satisfy prudent officials
in the conduct of their own affairs.33 Accordingly, failure
to record accurately immaterial items, in some instances, may result in
violations of the securities laws.
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\28\ FASB Statements of Financial Accounting Standards
(``Standards'' or ``Statements'') generally provide that ``[t]he
provisions of this Statement need not be applied to immaterial
items.'' This SAB is consistent with that provision of the
Statements. In theory, this language is subject to the
interpretation that the registrant is free intentionally to set
forth immaterial items in financial statements in a manner that
plainly would be contrary to GAAP if the misstatement were material.
The staff believes that the FASB did not intend this result.
\29\ 15 U.S.C. Sec. Sec. 78m(b)(2)-(7).
\30\ 15 U.S.C. Sec. 78l.
\31\ 15 U.S.C. Sec. 78o(d).
\32\ Criminal liability may be imposed if a person knowingly
circumvents or knowingly fails to implement a system of internal
accounting controls or knowingly falsifies books, records or
accounts. 15 U.S.C. 78m(4) and (5). See also Rule 13b2-1 under the
Exchange Act, 17 CFR 240.13b2-1, which states, ``No person shall,
directly or indirectly, falsify or cause to be falsified, any book,
record or account subject to Section 13(b)(2)(A) of the Securities
Exchange Act.''
\33\ 15 U.S.C. Sec. 78m(b)(7). The books and records provisions
of section 13(b) of the Exchange Act originally were passed as part
of the Foreign Corrupt Practices Act (``FCPA''). In the conference
committee report regarding the 1988 amendments to the FCPA, the
committee stated, ``The conference committee adopted the prudent man
qualification in order to clarify that the current standard does not
connote an unrealistic degree of exactitude or precision. The
concept of reasonableness of necessity contemplates the weighing of
a number of relevant factors, including the costs of compliance.''
Cong. Rec. H2116 (daily ed. April 20, 1988).
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The staff recognizes that there is limited authoritative guidance
34 regarding the ``reasonableness'' standard in Section
13(b)(2) of the Exchange Act. A principal statement of the Commission's
policy in this area is set forth in an address given in 1981 by then
Chairman Harold M. Williams.35 In his address, Chairman
Williams noted that, like materiality, ``reasonableness'' is not an
``absolute standard of exactitude for corporate records.''
36 Unlike materiality, however, ``reasonableness'' is not
solely a measure of the significance of a financial statement item to
investors. ``Reasonableness,'' in this context, reflects a judgment as
to whether an issuer's failure to correct a known misstatement
implicates the purposes underlying the accounting provisions of
Sections 13(b)(2)-(7) of the Exchange Act.37
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\34\ So far as the staff is aware, there is only one judicial
decision that discusses Section 13(b)(2) of the Exchange Act in any
detail, SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724
(N.D. Ga. 1983), and the courts generally have found that no private
right of action exists under the accounting and books and records
provisions of the Exchange Act. See e.g., Lamb v. Phillip Morris
Inc., 915 F.2d 1024 (6th Cir. 1990) and JS Service Center
Corporation v. General Electric Technical Services Company, 937 F.
Supp. 216 (S.D.N.Y. 1996).
\35\ The Commission adopted the address as a formal statement of
policy in Securities Exchange Act Release No. 17500 (January 29,
1981), 46 FR 11544 (February 9, 1981), 21 SEC Docket 1466 (February
10, 1981).
\36\ Id. at 46 FR 11546.
\37\ Id.
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In assessing whether a misstatement results in a violation of a
registrant's obligation to keep books and records that are accurate
``in reasonable detail,'' registrants and their auditors should
consider, in addition to the factors discussed above concerning an
evaluation of a misstatement's potential materiality, the factors set
forth below.
The significance of the misstatement. Though the staff
does not believe that registrants need to make finely calibrated
determinations of significance with respect to immaterial items,
plainly it is ``reasonable'' to treat misstatements whose effects are
clearly inconsequential differently than more significant ones.
How the misstatement arose. It is unlikely that it is ever
``reasonable'' for registrants to record misstatements or not to
correct known misstatements--even immaterial ones--as part of an
ongoing effort directed by or known to senior management for the
purposes of ``managing'' earnings. On the other hand, insignificant
misstatements that arise from the operation of systems or recurring
processes in the normal course of business generally will not cause a
registrant's books to be inaccurate ``in reasonable detail.''
38
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\38\ For example, the conference report regarding the 1988
amendments to the FCPA stated, ``The Conferees intend to codify
current Securities and Exchange Commission (SEC) enforcement policy
that penalties not be imposed for insignificant or technical
infractions or inadvertent conduct. The amendment adopted by the
Conferees [Section 13(b)(4)] accomplishes this by providing that
criminal penalties shall not be imposed for failing to comply with
the FCPA's books and records or accounting provisions. This
provision [Section 13(b)(5)] is meant to ensure that criminal
penalties would be imposed where acts of commission or omission in
keeping books or records or administering accounting controls have
the purpose of falsifying books, records or accounts, or of
circumventing the accounting controls set forth in the Act. This
would include the deliberate falsification of books and records and
other conduct calculated to evade the internal accounting controls
requirement.'' Cong. Rec. H2115 (daily ed. April 20, 1988).
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The cost of correcting the misstatement. The books and
records provisions of the Exchange Act do not require registrants to
make major expenditures to correct small misstatements.39
Conversely, where there is little cost or delay involved in correcting
a misstatement, failing to do so is unlikely to be ``reasonable.''
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\39\ As Chairman Williams noted with respect to the internal
control provisions of the FCPA, ``[t]housands of dollars ordinarily
should not be spent conserving hundreds.'' 46 FR 11546.
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The clarity of authoritative accounting guidance with
respect to the misstatement. Where reasonable minds may differ about
the appropriate accounting treatment of a financial statement item, a
failure to correct it may not render the registrant's financial
statements inaccurate ``in reasonable detail.'' Where, however, there
is little ground for reasonable disagreement, the case for leaving a
misstatement uncorrected is correspondingly weaker.
There may be other indicators of ``reasonableness'' that
registrants and their auditors may ordinarily consider. Because the
judgment is not mechanical, the staff will be inclined to continue to
defer to judgments that ``allow a business, acting in good faith, to
comply with the Act's accounting provisions in an innovative and cost-
effective way.'' 40
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\40\ Id., at 11547.
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The Auditor's Response to Intentional Misstatements
Section 10A(b) of the Exchange Act requires auditors to take
certain actions upon discovery of an ``illegal act.'' 41 The
statute specifies that these obligations are triggered ``whether or not
[the illegal acts are] perceived to have a material effect on the
financial statements of the issuer. . . .'' Among other things, Section
10A(b)(1) requires the auditor to inform the appropriate level of
management of an illegal act (unless clearly inconsequential) and
assure that the registrant's audit committee is ``adequately informed''
with respect to the illegal act.
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\41\ Section 10A(f) defines, for purposes of Section 10A, an
illegal act as ``an act or omission that violates any law, or any
rule or regulation having the force of law.'' This is broader than
the definition of an ``illegal act'' in AU Sec. 317.02, which
states, ``Illegal acts'' by clients do not include personal
misconduct by the entity's personnel unrelated to their business
activities.''
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As noted, an intentional misstatement of immaterial items in a
registrant's financial statements may violate Section 13(b)(2) of the
Exchange Act and thus be an illegal act. When such a violation occurs,
an auditor must take steps to see that the registrant's audit committee
is ``adequately informed'' about the illegal act. Because Section
10A(b)(1) is triggered regardless of whether an illegal act has a
material effect on the registrant's financial statements, where the
illegal act consists of a misstatement in the registrant's financial
statements, the auditor will be required to report that illegal act to
the audit committee irrespective of any ``netting'' of the
misstatements with other financial statement items.
The requirements of Section 10A echo the auditing literature. See,
for example, Statement on Auditing Standards No. (``SAS'') 54,
``Illegal Acts by Clients,'' and SAS 82, ``Consideration of Fraud in a
Financial Statement Audit.'' Pursuant to paragraph 38 of SAS 82, if the
auditor determines there is evidence that fraud may exist, the auditor
must discuss the matter with the appropriate level of management. The
auditor must report directly to the audit committee fraud involving
senior management and fraud that causes a material misstatement of the
financial statements. Paragraph 4 of SAS 82 states that ``misstatements
arising from fraudulent financial reporting are intentional
misstatements or omissions of amounts or disclosures
[[Page 45155]]
in financial statements to deceive financial statement users.'' \42\
SAS 82 further states that fraudulent financial reporting may involve
falsification or alteration of accounting records; misrepresenting or
omitting events, transactions or other information in the financial
statements; and the intentional misapplication of accounting principles
relating to amounts, classifications, the manner of presentation, or
disclosures in the financial statements.\43\ The clear implication of
SAS 82 is that immaterial misstatements may be fraudulent financial
reporting.\44\
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\42\ AU Sec. 316.04. See also AU Sec. 316.03. An unintentional
illegal act triggers the same procedures and considerations by the
auditor as a fraudulent misstatement if the illegal act has a direct
and material effect on the financial statements. See AU
Sec. Sec. 110 n. 1, 316 n. 1, 317.05 and 317.07. Although
distinguishing between intentional and unintentional misstatements
is often difficult, the auditor must plan and perform the audit to
obtain reasonable assurance that the financial statements are free
of material misstatements in either case. See AU Sec. 316 note 3.
\43\ AU Sec. 316.04. Although the auditor is not required to
plan or perform the audit to detect misstatements that are
immaterial to the financial statements, SAS 82 requires the auditor
to evaluate several fraud ``risk factors'' that may bring such
misstatements to his or her attention. For example, an analysis of
fraud risk factors under SAS 82 must include, among other things,
consideration of management's interest in maintaining or increasing
the registrant's stock price or earnings trend through the use of
unusually aggressive accounting practices, whether management has a
practice of committing to analysts or others that it will achieve
unduly aggressive or clearly unrealistic forecasts, and the
existence of assets, liabilities, revenues, or expenses based on
significant estimates that involve unusually subjective judgments or
uncertainties. See AU Sec. Sec. 316.17a and .17c.
\44\ AU Secs. 316.34 and 316.35, in requiring the auditor to
consider whether fraudulent misstatements are material, and in
requiring differing responses depending on whether the misstatement
is material, make clear that fraud can involve immaterial
misstatements. Indeed, a misstatement can be ``inconsequential'' and
still involve fraud.
Under SAS 82, assessing whether misstatements due to fraud are
material to the financial statements is a ``cumulative process''
that should occur both during and at the completion of the audit.
SAS 82 further states that this accumulation is primarily a
``qualitative matter'' based on the auditor's judgment. AU
Sec. 316.33. The staff believes that in making these assessments,
management and auditors should refer to the discussion in Part 1 of
this SAB.
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Auditors that learn of intentional misstatements may also be
required to (1) re-evaluate the degree of audit risk involved in the
audit engagement, (2) determine whether to revise the nature, timing,
and extent of audit procedures accordingly, and (3) consider whether to
resign.\45\
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\45\ AU Secs. 316.34 and 316.36. Auditors should document their
determinations in accordance with AU Sec. Sec. 316.37, 319.57, 339,
and other appropriate sections.
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Intentional misstatements also may signal the existence of
reportable conditions or material weaknesses in the registrant's system
of internal accounting control designed to detect and deter improper
accounting and financial reporting.\46\ As stated by the National
Commission on Fraudulent Financial Reporting, also known as the
Treadway Commission, in its 1987 report,
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\46\ See, e.g., AU Sec. 316.39.
The tone set by top management--the corporate environment or
culture within which financial reporting occurs--is the most
important factor contributing to the integrity of the financial
reporting process. Notwithstanding an impressive set of written
rules and procedures, if the tone set by management is lax,
fraudulent financial reporting is more likely to occur.\47\
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\47\ Report of the National Commission on Fraudulent Financial
Reporting at 32 (October 1987). See also Report and Recommendations
of the Blue Ribbon Committee on Improving the Effectiveness of
Corporate Audit Committees (February 8, 1999).
An auditor is required to report to a registrant's audit committee
any reportable conditions or material weaknesses in a registrant's
system of internal accounting control that the auditor discovers in the
course of the examination of the registrant's financial statements.\48\
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\48\ AU Sec. 325.02. See also AU Sec. 380.09, which, in
discussing matters to be communicated by the auditor to the audit
committee, states, ``The auditor should inform the audit committee
about adjustments arising from the audit that could, in his
judgment, either individually or in the aggregate, have a
significant effect on the entity's financial reporting process. For
purposes of this section, an audit adjustment, whether or not
recorded by the entity, is a proposed correction of the financial
statements. . . .''
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GAAP Precedence Over Industry Practice
Some have argued to the staff that registrants should be permitted
to follow an industry accounting practice even though that practice is
inconsistent with authoritative accounting literature. This situation
might occur if a practice is developed when there are few transactions
and the accounting results are clearly inconsequential, and that
practice never changes despite a subsequent growth in the number or
materiality of such transactions. The staff disagrees with this
argument. Authoritative literature takes precedence over industry
practice that is contrary to GAAP.\49\
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\49\ See AU Sec. 411.05.
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General Comments
This SAB is not intended to change current law or guidance in the
accounting or auditing literature.\50\ This SAB and the authoritative
accounting literature cannot specifically address all of the novel and
complex business transactions and events that may occur. Accordingly,
registrants may account for, and make disclosures about, these
transactions and events based on analogies to similar situations or
other factors. The staff may not, however, always be persuaded that a
registrant's determination is the most appropriate under the
circumstances. When disagreements occur after a transaction or an event
has been reported, the consequences may be severe for registrants,
auditors, and, most importantly, the users of financial statements who
have a right to expect consistent accounting and reporting for, and
disclosure of, similar transactions and events. The staff, therefore,
encourages registrants and auditors to discuss on a timely basis with
the staff proposed accounting treatments for, or disclosures about,
transactions or events that are not specifically covered by the
existing accounting literature.
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\50\ The FASB Discussion Memorandum, Criteria for Determining
Materiality, states that the financial accounting and reporting
process considers that ``a great deal of the time might be spent
during the accounting process considering insignificant matters . .
. . If presentations of financial information are to be prepared
economically on a timely basis and presented in a concise
intelligible form, the concept of materiality is crucial.''
This SAB is not intended to require that misstatements arising
from insignificant errors and omissions (individually and in the
aggregate) arising from the normal recurring accounting close
processes, such as a clerical error or an adjustment for a missed
accounts payable invoice, always be corrected, even if the error is
identified in the audit process and known to management. Management
and the auditor would need to consider the various factors described
elsewhere in this SAB in assessing whether such misstatements are
material, need to be corrected to comply with the FCPA, or trigger
procedures under Section 10A of the Exchange Act. Because this SAB
does not change current law or guidance in the accounting or
auditing literature, adherence to the principles described in this
SAB should not raise the costs associated with recordkeeping or with
audits of financial statements.
[FR Doc. 99-21484 Filed 8-18-99; 8:45 am]
BILLING CODE 8010-01-P
