Materiality Debate Emerges from the Dark

SEC's Pozen committee aims to reduce financial restatements, and members think new guidance on that sensitive issue will help with the effort.
Marie LeoneJuly 14, 2008

The Securities and Exchange Commission has been very careful about defining what is — and what is not — “material” information for investors. Mainly, it has wanted to avoid setting bright-line rules that companies can finagle around. But while a strict financial-statement materiality definition may never be issued, on Friday an SEC advisory group drew close to recommending new guidance on how materiality affects financial restatements.

The Committee on Improvements to Financial Reporting, headed by Robert Pozen, chairman of MFS Investment Management, is due to release its final recommendations in August. The committee was formed last July by the SEC to help the regulator assess and eliminate “unnecessary complexity” within the U.S. financial reporting system.

CIFR members emphasized that they would not recommend changing the SEC’s existing materiality guidance, contained in SAB 99, but rather would enhance the guidelines by requiring that companies consider both qualitative and quantitative factors when determining whether errors are material to financial statements. Including qualitative information in the mix will nudge U.S. companies and regulators to a more principles-based environment, said members.

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Furthermore, the group was adamant that the factors should be vetted from the “perspective of a reasonable investor,” rather than a preparer or auditor. Preparers and users of financial statements “must step into the shoes” of an investor, commented Linda Griggs, a CIFR member and law partner with Morgan, Lewis & Bockius LLP.

Committee members agreed that the SEC would have the same prerogative that it has now, to challenge preparer and auditor judgments, but they hope that adjusted guidance will result in better judgments, more “right answers,” and therefore fewer restatements. The debate over professional judgment regarding financial statements is extremely contentious, as preparers and auditors complain that their accounting decisions are often second-guessed by the SEC and the Public Company Accounting Oversight Board. Without a bright-line standard for materiality, preparers and auditors wind up being especially conservative in their accounting treatment, rather than run the risk of a restatement.

Restatements have risen in recent years, and are problematic for investors, according to the committee. While material restatements that affect an investor’s decision to buy or sell shares are important, restatements that are immaterial in nature tend to be an “annoyance” to investors who rerun models to factor in information that has no bearing on investment decisions, say James Quigley, a CIFR member and CEO of Deloitte Touche Tohmatsu.

The CIFR draft report says that the number of financial restatements in the United States has increased significantly over recent years, reaching about 1,600 companies in 2006, according to the Government Accountability Office. Between 2002 and 2005 a total of 1,084 restatements were filed.

CIFR members cite several reasons for the rise in restatements, including increased regulatory and investor scrutiny and “rigorous interpretations of accounting and reporting standards;” improvements in internal controls as mandated by Section 404 of the Sarbanes-Oxley Act; control weaknesses that companies failed to identify and fix; and an “overly broad application of the concept of materiality,” coupled with misinterpretations of SAB 99.

One way to combat misinterpretations of materiality guidance is to foster the idea that materiality judgments are a “two-way street,” said J. Michael Cook, a CIFR member and former CEO and chairman of Deloitte & Touche LLP. For instance, the draft report explains that while qualitative factors may lead to a conclusion that a small error is material, qualitative factors can easily lead to conclusions that a large error is immaterial. “We have an excellent one-way street, but I would like to see a two-way street. We need a mix of information that goes two ways,” reasoned Cook. He pointed out that issuers are currently making “almost mechanic restatements” that are “really not material or important to investors.” For instance, such errors include those associated with discontinued operations or that occurred when companies sold-off assets.

Committee members also addressed the issue of a restatement’s “dark period,” during which no information flows to a company’s investors. The blackout comes between the time an error is discovered and disclosed, and when the restatement is completed and new results filed. “The dark period is bad for users,” claimed Greg Jonas, a CIFR member and managing director at Moody’s Investors Service.

The dark period’s silence creates significant uncertainty regarding the size and nature of the error’s effect on the company. In turn, the uncertainty often results in decreases in the company’s stock price. To shed some light on the restatement period, the draft proposal asks the SEC to require companies to provide investors with details about the nature of the error, the impact of the error, and management’s response to the problem, throughout the restatement process.

Another controversial, yet likely recommendation, stems from the committee’s suggestion about how companies correct errors. The CIFR committee would like to see all errors, regardless of whether they lead to a restatement, corrected and disclosed in the current period, which is a departure from current practice. “No one gets a chance to hide an error  we need to make this loud and clear,” asserted Cook, who added, “no more stealth restatements.” The thought here is that by correcting small errors immediately, rather than in future financial statements, it lessens the chance that the problem will build over time into a material amount that triggers a restatement.

But, the committee also is set to recommend that companies abandon the practice of restating prior period results if the errors are immaterial to those older periods. If the error turns out to be material to current results, then the company should disclose the correction immediately, however.

Companies may not have to go through the “pain of restatement” to inform investors about errors, but they should feel the “pain of disclosure,” says Moody’s Jonas. Disclosure would put the “bright light of public scrutiny” on judgments of materiality.