SEC, PCAOB Pushed to Define Materiality

The new AS5 carefully avoids a bright-line definition of materiality, but both the PCAOB and the SEC are clearly feeling increasing pressure to put...
Sarah JohnsonJune 20, 2007

To some observers, the greatest flaw of the soon-to-be defunct Auditing Standard No. 2 was that it didn’t distinguish between large and small risks. That, critics charged, led auditors to spend countless, expensive hours on picayune controls that, even if not up to par, were unlikely to have a serious impact on a company’s financial statements.

That was certainly the view of commissioner Paul Atkins of the Securities and Exchange Commission. As staff from the SEC and the Public Company Accounting Oversight Board labored to rework the much loathed AS2, the auditing standard for internal control over financial reporting, Atkins regularly beat the drum about how the original rule encouraged auditors to focus on immaterial issues.

At conferences and open SEC meetings, Atkins criticized AS2 for lacking a “materiality filter,” and being “materially insensitive,” and he noted that without materiality, audits had been conducted in an inefficient, bottom-up approach.

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Atkins was not alone. There has been a mounting push for a detailed definition of materiality from business groups that believe Sarbox regulations went too far. For instance, the influential Committee on Capital Markets Regulation (CCMR), a group that enjoys the support of Treasury secretary Henry Paulson, last fall asked the PCAOB and the SEC to implement quantitative measures for materiality in the new auditing standard. Otherwise, the committee argued, managers and auditors can’t be sure how to circumscribe their reviews, leading to unnecessary work and the scrutiny of internal controls that pose no risk of a material misstatement. In addition, congressmen on both sides of the house have proposed bills asking the SEC to define materiality.

The CCMR and others are also calling on the SEC to make the definitions of materiality for financial reporting and internal controls consistent. For their part, the SEC staffs in the Office of the Chief Accountant and the Division of Corporation Finance have been considering questions around materiality for financial reporting, according to Zoe-Vonna Palmrose, SEC deputy chief accountant for auditing and professional practice issues.

The commission also addressed the issue in its first question to the public in its solicitation for feedback on the new internal-control auditing standard, An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements, which the PCAOB recently adopted and named as Auditing Standard No. 5. The SEC, which as the PCAOB’s oversight body approves all of the board’s standards, will decide whether to vote in favor of the new rule after the public comment period ends July 12.

After releasing AS5 for public comment on June 7, the SEC issued seven discussion points one week later. The first question asks, “Is the standard of materiality appropriately defined throughout AS5 to provide sufficient guidance to auditors?”

For the CCMR, the answer is no. In comments to the PCAOB during the first go-round of public comments on AS5, Hal Scott, the committee’s director and a Harvard Law School professor, again asked for a better definition of materiality. “There is no reason to examine internal controls that, even if deficient, could have no material impact on the financial statements of the company,” he wrote.

Scott wasn’t alone in his comments. For example, the National Capital Venture Association also took issue with the definitions of materiality by standard-setters. “These definitions are so all-inclusive that there are still only vague limits as to what an auditor can determine to be material,” the trade association wrote. “Since these determinations drive the scope of testing and the demands for documentation, AS5 would likely again drive audit work that is far in excess of any reasonable cost-benefit balance.”

These groups would rather go back in time to when common auditing practice was to base the scope of work on a numerical threshold. But that’s a habit that investor advocates say led to financial engineering workarounds and which the SEC has said muddies the data about material problems at companies. For example, companies would consider a “rule of thumb,” such as 5 percent of net income, to determine the size of a misstatement before it had to be reported.

Indeed, the SEC has long resisted any numerical definition of materiality. In 1999, SEC staff released guidance, which still applies today, that said relying solely on quantitative benchmarks to assess materiality for preparing and auditing financial statements is not acceptable. The document, SAB 99, gives examples for how companies and auditors should incorporate both quantitative and qualitative tests, saying a numerical threshold could be a starting point for figuring out an error’s materiality, but they have to “consider all the relevant circumstances.” Critics of SAB 99, such as CCMR, say the bulletin has led to an increase of immaterial restatements from wary companies.

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.