On August 13, 1999, the SEC issued Staff Accounting Bulletin (SAB) 99, which addresses the concept of "materiality" in the preparation and audit of financial statements. In summary, the SEC has emphasized that there is no numerical threshold under which known accounting errors may be ignored as "immaterial" to reported financial results. For example, accounting errors that amounted to less than five percent of net income traditionally have been considered immaterial and auditors often would agree to "pass" on proposed adjustments to the financial statements if they fell within the five percent range. While the SEC does not object to such a "rule of thumb" being used initially to assess materiality, SAB 99 provides that "the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations." The analysis of materiality must consider the facts in the context of the "surrounding circumstances" as described in the accounting literature, or the "total mix of information," as defined in the TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976).

A financial statement item may be material even though when netted against other positive or negative items, the financial statements as a whole are not materially erroneous. In addition, an intentional financial misstatement, even if immaterial, may still be illegal under the Federal Securities Laws, and the outside auditors must report such immaterial misstatements to the company's Audit Committee. Thus SAB 99 threatens to drastically alter the normal give-and-take between auditors and the management over even routine accounting issues.

Among the factors that the SEC believes could render material even a quantatively small financial statement item are:

  • whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate. In other words, a small deviation in the accounts payable or receivable items, which should be exact, is more likely to be material than an identical misstatement in estimating a contingent liability.
  • whether the misstatement masks a change in earnings or sales trends. Thus small misstatements which are intended to over-or under-state sales or earnings in order to reach certain trend lines, or attain earnings or margins that are certain percentages of gross revenues, would be material.
  • whether the misstatement hides a failure to meet analysts' consensus expectations for the company. Even a small misstatement likely will be material if the company and its auditors are aware from past market performance that the misstatement is likely to produce a significant positive or negative reaction. Thus, hypothetically, a misstatement which amounts only to a penny per share could be material if management had reason to believe that the stock price might drop sharply in response to even a slight failure to reach consensus analysts' estimates.
  • whether the misstatement changes a loss into income or vice versa.
  • whether the misstatement concerns a segment or other portion of the company's business that has been identified as playing a significant role in operations and profitability, even if the misstatement, when combined with other misstatements, does not have a material effect on the company's overall results. In addition, a misstatement of revenue or profit in a small segment that management has identified as important to future profitability may be material.
  • whether the misstatement affects the registrant's compliance with regulatory requirements, loan covenants, or other contractual requirements.
  • whether the misstatement has the effect of increasing management compensation, such as satisfying certain requirements for the award of bonuses or other incentive compensation.
  • whether the misstatement involves concealment of an unlawful transaction.

The SEC also emphasized that an intentional misstatement, even if immaterial, may still violate the books and records provisions of the Securities Exchange Act of 1934 (Sections 13(b)(2)-(7)). These provisions require companies to keep books and records accurately in "reasonable detail" and which provide "reasonable assurance" that transactions are recorded as necessary to prepare financial statements that conform to GAAP. The SEC identified four factors for determining whether a misstatement violates the books and records provisions even if it is immaterial: the significance of the misstatement; how the misstatement arose; the cost of correcting the misstatement; and the clarity of authoritative accounting guidance with respect to the misstatement.

Section 10A of the Exchange Act requires auditors to report to a company's Audit Committee the discovery of an illegal act, regardless of whether there is a material impact on the financial statements. Thus, according to the SEC, an intentional immaterial misstatement that violates the books and records provisions constitutes an illegal act and must be reported to the Audit Committee irrespective of any "netting" of the misstatement with other financial statement items.

Section 10A(b)(1)(B) does not require auditors to report illegal acts to the Audit Committee if the act "is clearly inconsequential." SAB 99, however, likely will compel auditors to report to the Audit Committee immaterial misstatements that previously would have been "passed." There always are legitimate disagreements between management and the auditors concerning financial statement items and accounting matters. In situations where auditors previously may have passed on proposed adjustments which were not material in themselves or when netted against other financial statement items, the auditors, wary of the SEC, may now believe that they must report — or at least threaten to report — such proposed adjustments to the Audit Committee on the ground that management's failure to record the adjustment constituted an "illegal act." In summary, it is essential that public companies understand how SAB 99 might substantially affect relationships with their outside auditors.

A copy of SAB 99 can be found at www.sec.gov/rules/acctreps/sab99.htm. The accompanying press release can be found at www.sec.gov/news/matlacct.htm.