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If the SEC has its way, it will be harder to hide earnings management by calling the impact immaterial.
George Donnelly, CFO Magazine
October 1, 1999
When 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.
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."
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.
Again, Grace is a case in point. In establishing the reserve by tapping excess profits from its medical subsidiary, the firm was not altering overall earnings by more than 5 percent. However, because Grace had stated that the subsidiary was a key to its future, Goldschmid says, "surely a reasonable shareholder would have been concerned."
That helps explain why the SAB also specifies that the materiality of a misstatement depends on where it appears in the financial statement. "Registrants and their auditors should consider not only the size of the misstatement," the SAB says, "but also the significance of the segment information to the financial statement taken as a whole."
The SAB also says that the volatility of a company's stock must be considered. When management expects a market reaction, based on experience, to certain misstatements, "that expected reaction should be taken into account."
In other words, a penny of earnings may indeed be material if management has reason to believe it will cause a much sharper swing in a stock's price.
"Their mention of market impact was significant," says Amy L. Goodman, a securities attorney with Gibson Dunn and Crutcher LLP, in Washington, D.C. "What the SEC is saying is that companies know which items the market is particularly sensitive to, and don't try to use the 5 percent test on an item you know is very significant to the market."
The SAB also takes aim at a loophole that some companies use to avoid materiality. This is done by "netting out" misstatements. Say that a misstatement of an individual amount causes a company's financial statements as a whole to be materially misstated. Under SAB 99, the overall effect cannot be eliminated by other misstatements that diminish the impact of the original misstatement.
The SEC also warns companies of the material potential of misstatements from prior reporting periods, "where immaterial misstatements recur in several years and the cumulative effect becomes material in the current year."
Expect Stiffer Audits
The SEC hasn't assigned all responsibility for adhering to the new guidelines to corporate executives. Previously, some outside auditors felt comfortable in giving unqualified opinions with respect to financial statements concerning international misstatements, if the amounts weren't believed to be material. "It's not that they are missing this stuff, but they give the company a pass for these small, 'immaterial' items," notes Jay Strum, a securities attorney with Kaye, Scholer, Fierman, Hays & Handler, in New York.
Now independent auditors will be required to bring intentional misstatements, whether material or not, to a company's audit committee, unless the item is "clearly inconsequential." Discerning what's intentional or inconsequential may be difficult. But under SAB 99, signing off on an intentional, consequential misstatement of immaterial items may be illegal.
At this point, opinion is divided on the SAB's potential effects. Joseph Berardino, managing partner with Arthur Andersen's North American Assurance and Business Advisory, in New York, disputes the notion that auditing costs must rise, though he agrees that for companies that abuse accounting regulations or use "cute" accounting, there will be an increased emphasis on recording adjustments that in the past were ignored as immaterial. Yet critics wonder how fees won't rise, given the additional time required to settle adjustment items.
As for legal complications, securities attorney Goodman thinks the impetus that more exacting standards will provide to litigation will be at least partially offset by two pieces of recently enacted federal legislation. The Private Securities Litigation Reform Act is designed to thwart frivolous lawsuits, while the Securities Litigation Uniform Standards Act mandates that securities lawsuits be brought on the federal level. The laws, says Goodman, "will help to mitigate that in part."
And, contrary to Dixon's fears, Berardino predicts that SAB 99 will produce fewer restatements rather than more. The reason? He thinks it will lead to more adjustments being recorded during closing. When auditors discover errors and debate them with management, the SAB "is going to potentially change that dialogue, and that's probably good," Berardino says. "The issue-resolving phase, in some cases, will be more disciplined," as outside auditors more often insist on booking items into the financial statements.
In fact, the SAB's most far-reaching impact may be to stiffen auditors' spines. As Strum puts it, the materiality bulletin is, in reality, "talking to accountants." And that means CFOs will have a tougher time getting them to roll over and play dead.
----------------------------------------------- --------------------------------- Poof, It's Material
The SEC's new guidelines on materiality say "qualitative" factors can turn "quantitatively small" amounts into material misstatements. The SEC then lists what it describes as a less than exhaustive list of considerations that can perform that magnifying trick. Under the guidelines, a misstatement may be material if it does any of the following:
Source: "SEC Staff Accounting Bulletin No. 99: Materiality"