VideoWhen W. R. Grace used a $60 million cookie-jar reserve to smooth fluctuations in its earnings from 1991 to 1995, the outside auditor knew all about it, according to the Securities and Exchange Commission. But the SEC says Brian J. Smith, Grace's chief financial officer at the time, convinced the auditor, Price Waterhouse (as PricewaterhouseCoopers was then known), that the effect of this violation of generally accepted accounting principles was immaterial. And that helped the company stay out of trouble, until a former chief of internal audit blew the whistle, sparking a lawsuit by the SEC last December.
In its defense, Grace contended that Price Waterhouse's seal of approval of its financial reports for all five years was a sign of the company's innocence. Yet the Boca Raton, Florida-based chemical company eventually agreed to settle, offering to establish for the SEC a $1 million fund to "further awareness relating to financial reporting," without actually admitting to wrongdoing. Two Price Waterhouse auditors agreed to cease-and- desist orders, and former CFO Smith, along with five others, faces civil charges. (Grace declined comment.)
But the case shows why the SEC has produced new guidelines for what constitutes materiality--the point at which company information must be publicly disclosed. The commission is convinced, and many accounting observers agree, that some companies hide their efforts to manipulate earnings from public view by claiming that the effects are immaterial.
Intentional Mistakes
The problem, according to the SEC, isn't definitional. According to the Financial Accounting Standards Board, an item is material if "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." Clear enough? Not, evidently, to many finance executives, who have adopted their own arbitrary thresholds, such as 5 percent of earnings, for what constitutes an item important enough to require disclosure. With the acquiescence of auditors, these executives have then been able to hide earnings management simply by keeping the amounts in question below that threshold.
But the SEC is determined to end the practice. With its "Staff Accounting Bulletin No. 99: Materiality," issued in August and based on existing accounting standards, the SEC emphasizes that any misstatement, even if it involves a seemingly immaterial amount, may be material if it is intentional. And SAB 99 specifically warns that numerical thresholds alone are unacceptable. Management should weigh qualitative issues as well, the SEC guidelines say, including whether the misstatement "masks a change in earnings" or concerns a vital business segment.
"To the people who are intentionally playing the game, the SEC says loud and clear you can't intentionally misstate your numbers when you know what you're doing is wrong," says Daniel Noll, manager of accounting standards at the American Institute of Certified Public Accountants, in New York.
Not surprisingly, SAB 99 has upset finance executives. They worry that the bulletin will increase the burden of the financial-reporting process, adding significantly to the cost of audits. They also predict that the SEC's guidelines will encourage frivolous shareholder lawsuits.
"I would fear that in-house and outside counsel would become much more involved in the financial process than they have been historically, because the judgments have legal implications," says Robert Dixon, vice president and treasurer of Carpenter Technology, a specialty steel maker based in Reading, Pennsylvania.
Although he thinks the SEC essentially "reached the correct conclusion," Dixon also worries that the guidelines will lead to more restatements. Historically, a company may have bitten the bullet on an item and corrected it the next quarter, says Dixon. Now it may "feel compelled to restate, so it opens up the door to second-guessers."
But the SEC's general counsel, Harvey J. Goldschmid, says such concerns may be overblown. "My hope would be that this provides the kind of in-depth analysis and framework that will allow CFOs and others to [conduct financial reporting] more easily and effectively -- and be less legally vulnerable."
Forget Thresholds
In any case, the SEC found that corporate abuse of FASB's definition of materiality was significant enough to justify action. The goal, as Lynn Turner, the SEC's chief accountant, explained in a conference call organized by the Financial Executives Institute in August, was to create "a level playing field."
The alternative -- simply going after offenders -- was rejected, says Goldschmid, because numerical thresholds were all over the map, and it was time to restore more-rigorous thinking to the question. "I've had accounting firms use 7 percent, 9 percent, 3 percent [of earnings]," he says. "Anyone with sophistication knew you had to dig deeper."
But exactly what does the SEC find wrong with numerical thresholds? At some level, after all, the market can be expected to shrug off a misstatement's impact. Perhaps, Goldschmid responds, but investors often deserve information that may be denied through formulaic assumptions. More to the point, even a small amount of earnings management may be significant. "If they're going through all that trouble, there is at least an implication that they must think it's going to influence people out there," says Goldschmid.
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