In this statement from the SEC's Office of the Chief Accountant, Acting Chief Accountant Paul Munter discusses materiality assessments in the context of errors in financial statements. As he summarizes the issue, the "determination of whether an error is material is an objective assessment focused on whether there is a substantial likelihood it is important to the reasonable investor." And when an error in historical financial statements is determined to be material, a "Big R" restatement of the prior period financial statements is required. On the other hand, if the error is not material, "but either correcting the error or leaving the error uncorrected would be material to the current period financial statements, a registrant must still correct the error, but is not precluded from doing so in the current period comparative financial statements by restating the prior period information and disclosing the error," known as a revision or "little r" restatement. In either case, Munter observes, "both of these methods—reissuance and revision, or 'Big R' and 'little r'—constitute restatements to correct errors in previously-issued financial statements as those terms are defined in U.S. GAAP." According to a review by Audit Analytics, "while the total number of restatements by registrants declined each year from 2013 to 2020, 'little r' restatements as a percentage of total restatements rose to nearly 76% in 2020, up from approximately 35% in 2005." Should we attribute this change to improvements in audit quality or internal control over financial reporting, or could it be that some companies are not being entirely objective in making their materiality determinations? In the event of error in the financial statements, Munter emphasizes, companies, auditors and audit committees must "carefully assess whether the error is material by applying a well-reasoned, holistic, objective approach from a reasonable investor's perspective based on the total mix of information."
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"Big R" v. "little r" statements have been a theme recently among accountants at the SEC, and many of the pronouncements by Munter here are echoes of prior statements by him and others. In this December 2021 Statement, Munter said that "if an error is identified in the financial statements, management must determine whether the error is material, which is based on what is important to the user. If that analysis indicates that previously issued financial statements are materially misstated, those financial statements would need to be restated and reissued." Munter cautioned that, under existing accounting guidance, the materiality of errors must be based on an evaluation of "the total mix of information, taking into consideration both quantitative and qualitative factors to determine whether an error is material to investors and other users." Similarly, at the Northwestern Pritzker School of Law's Annual Securities Regulation Institute in January, Lindsay McCord, Corp Fin Chief Accountant, raised the same question: were companies being properly "objective" in assessing whether a restatement should be a "Big R" or "little r" restatement? At SRI, the accounting panel emphasized that the test of materiality set forth in Basic v. Levinson still applies in this context and that the analysis under SAB 99 must include both quantitative and qualitative factors. But McCord stressed that, while it's not inevitable, it's very difficult to conclude that an error is immaterial when it is quantitatively large. In that context, the SEC often ended up disagreeing with management and requiring a "Big R" restatement. On the other hand, the errors could be quantitatively small but material from a qualitative perspective. (See this PubCo post.)
Munter reminded readers that the standard of materiality adopted by SCOTUS is that information is material if there is: "a substantial likelihood that the...fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." In light of that definition, Munter urges that assessments of the materiality of errors be made "through the lens of the reasonable investor. To be consistent with the concept of materiality, this assessment must be objective. A materiality analysis is not a mechanical exercise, nor should it be based solely on a quantitative analysis. Rather, registrants, auditors, and audit committees need to thoroughly and objectively evaluate the total mix of information. Such an evaluation should take into consideration all relevant facts and circumstances surrounding the error, including both quantitative and qualitative factors, to determine whether an error is material to investors." An objective analysis would "put aside any potential bias," such as a potential "clawback of executive compensation, reputational harm, a decrease in the registrant's share price, increased scrutiny by investors or regulators, litigation, or other impacts."
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In October 2021, the SEC re-opened the comment period for the rules proposed in 2015 to implement Section 954 of Dodd-Frank, the clawback provision. Section 954 required the SEC to direct the national securities exchanges to adopt listing standards obliging each listed company to adopt, disclose and enforce a policy for recouping executive compensation that was paid on the basis of erroneous financial information, the theory being that it was compensation to which the executives were never really entitled in the first place. Under the 2015 proposal, new Rule 10D-1 would require exchange-listed companies to adopt and implement clawback policies under which they must recover from current and former executive officers the amount of erroneously awarded "incentive-based compensation" received during the three years preceding the date of an accounting restatement that resulted from the company's material noncompliance with any financial reporting requirement under the securities laws. The "amount erroneously awarded" means the compensation that exceeds the amount the executive would have received had the compensation instead been determined based on the restated financial information. In re-opening the comment period, the SEC asked what should be considered as an accounting restatement for purposes of the rule? Essentially, the proposal considered restatements to be only "reissuance" restatements, but what about "revision" restatements? Since 2015, the SEC noted, concerns have been raised about whether companies are making appropriate materiality determinations for errors identified—perhaps because they are attempting to avoid application of clawbacks. In addition, commenters suggested that the clawback provisions also be made applicable in the event of revision restatements. The SEC believed that expanding the proposal to cover both types of restatements would be appropriate to trigger recoveries and asks for comment about that possibility. (See this PubCo post.)
Munter highlights in particular an increased need for objectivity regarding qualitative factors. Under SAB No. 99, qualitative factors could make a quantitatively small error material, but most often, companies argue the reverse, an argument that seems to be quite an uphill climb: to OCA, "as the quantitative magnitude of the error increases, it becomes increasingly difficult for qualitative factors to overcome the quantitative significance of the error." In addition, different qualitative factors may be relevant for a quantitatively significant error as compared with a quantitatively small error.
Through the staff's monitoring and interactions with companies, notwithstanding all of the previous staff statements, the staff has "observed that some materiality analyses appear to be biased toward supporting an outcome that an error is not material to previously-issued financial statements, resulting in 'little r' revision restatements." With regard to accounting errors, companies have tried to sell the staff on a number of theories: that the financial statements or line items in the financials are irrelevant or not useful to investors' decision-making or too old to be material to current decisions. But those arguments did not find any buyers at OCA: Munter maintains that those arguments "could be used to justify a position that many errors in previously-issued financial statements could never be material regardless of their quantitative significance or other qualitative factors." Rather, OCA considers "financial statements prepared in accordance with U.S. GAAP or IFRS, as required by Commission rules, to be the starting point for any objective materiality analysis." But errors in non-GAAP financial measures should not be ignored; "analysis of key non-GAAP measures, where applicable, should be performed in addition to, but not as a substitute for, the analysis of materiality to the financial statements."
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At SRI, McCord raised the example of SPAC restatements, where the SEC staff had provided guidance on warrants and equity classification that required many companies to restate. In that context, some companies attempted to use a "passage of time" argument; that is, they contended that errors in financial statements were not really material because those old financial statements were not really important to investors, who were instead focused only on the latest financial statements. But, she said, investors aren't focused only on the current financial results; many also consider historical information as well. For example, a pattern of error could lead to questions about reliability. Former Corp Fin Chief Accountant Mark Kronforst, how back at EY, observed that you're probably not in a good place if your argument to the SEC is that the financial statements are not important.
Other unpersuasive arguments submitted by companies have been that the mistakes are just common errors that others have also made, reflecting a "widely-held view rather than an intention to misstate." But the absence of intent, Munter advises, does not make an error immaterial. Nor do offsetting errors eliminate materiality. Instead, the materiality of each misstatement should be considered separately, and also on an aggregated basis "to determine whether an otherwise immaterial error, when aggregated with other misstatements, renders the financial statements taken as a whole to be materially misleading. However, we do not believe this analysis of the aggregate effects should serve as the basis for a conclusion that individual errors are immaterial."
Munter also observes that accounting errors raise questions about the effectiveness of ICFR, and the same principles obtain in that context. Notably, management's ICFR analysis
"must consider the magnitude of the potential misstatement that could result from a control deficiency, and we note that the actual error is only the starting point for determining the potential impact and severity of a deficiency. Therefore, while the existence of a material accounting error is an indicator of the existence of a material weakness, a material weakness may also exist without the existence of a material error. Management's assessment of the effectiveness of ICFR should therefore be focused on a holistic, objective analysis of what could happen in the context of current and evolving financial reporting risks."
Munter emphasizes the need for audit committee attention to the adequacy of and basis for a company's ICFR effectiveness assessment—"particularly where there are close calls in the assessment of whether a deficiency is a significant deficiency (and only required to be reported to the audit committee) or a material weakness (required to be disclosed to investors)."
Munter also stresses the importance of audit firms' having "policies and processes in place to ensure that the appropriate individuals are involved in the supervision and review in evaluating the significant judgments made about materiality and the effects of identified accounting errors."
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