SEC, PCAOB Pushed to Define Materiality

The PCAOB acknowledges that those groups that want a bright-line materiality standard saw the rewrite of AS2 as an opportunity, but has been leery about addressing such a weighty topic. In the staff's notes about the proposal before the SEC, the PCAOB said its new standard is "an inappropriate place to redefine or refine the meaning of materiality, which is a long-established concept in the federal securities laws." The board wanted to create a standard that "relies more on general principles than detailed requirements."

Ironically, that's exactly what corporate critics of Sarbox's Section 404 have been begging for over the past few years. Indeed, the push for a bright-line definition highlights a fundamental conundrum in financial regulation: companies consistently claim to want less prescriptive, principles-based rules, but then tend to balk at the lack of clear, rules-based guidance out of fear of regulatory actions or legal liability.

The PCAOB's intent with AS5 is a less prescriptive standard that's risk-based and focuses auditors' attention on only those areas that could potentially lead to a material misstatement. The regulator did redefine a "material weakness" as having a reasonable possibility of leading to a material misstatement that will not be prevented or detected on a timely basis. The previous PCAOB standard said there had to be "more than a remote likelihood" of a material misstatement. Yet in the past, the auditing profession has tended to assign specific numbers or percentages to what constitutes a material misstatement and such phrases "reasonable possibility" or "remote likelihood." And, in fact, AS5 tells auditors to use same materiality measures that they use to plan and perform the audits of financial statements.

For now, however, both the SEC and PCAOB continue to avoid being pinned down to a particular number. Assigning a quantitative measurement for materiality could leave out information that could be crucial to investors, says Gerald White, president of investment adviser Grace & White. "Material to me means something that will affect my view of a company," he says. "It's not whether something is bigger than a breadbox."

Still, he acknowledges it's a topic that just won't go away. As chairman of the CFA Centre for Financial Market Integrity's Corporate Disclosure Policy Council, he was asked for his views on materiality by the SEC during an informal meeting in April. And about 20 years ago, he worked on a Financial Accounting Standards Board task force that ultimately decided a materiality standard could not be quantified.

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