Could $51 Million Be Immaterial When Enron Reports Income of $105 Million?

The collapse of Enron raises a number of questions about the adequacy of financial statement audits. A primary factor generating these questions was Enron's need to correct its books going back to 1997, thereby reducing its audited profits by $591 million. The correction included a $51 million adjustment that would have cut Enron's 1997 income by almost 50 percent, from $105 million to $54 million, if it was booked in 1997 (Hilzenrath 2001). The note to the financial statements states simply: Audit Adjustments. The restatements include prior-period proposed audit adjustments and reclassifications, which were determined to be immaterial in the periods originally proposed. (Enron 2001) Some have questioned how such adjustments, representing almost half of 1997's reported income, could be deemed to be immaterial (Hilzenrath 2001). This commentary considers whether there is a reasonable basis for considering this amount as quantitatively immaterial using guidance available at the time of the audit. In the following section of this commentary we review professional standards related to materiality, emphasizing that which was available at the time of the Enron audit early in 1998. We then review available literature and the issue of assessing materiality for Enron. Finally we present our approach, results, and conclusions. PROFESSIONAL STANDARDS AVAILABLE AT THE TIME OF THE 1997 ENRON AUDIT The Auditing Standards Board addressed materiality in 1983 when it issued Statement on Auditing Standards (SAS) No. 47 (AU 312), Audit Risk and Materiality in Conducting the Audit. To serve as a frame of reference for the materiality judgment, SAS No. 47 cites FASB Statement of Financial Accounting Concepts No. 2, para. 132, which defines materiality as follows: The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying on the report would have been changed or influenced by the inclusion or correction of the items. SAS No. 47's provisions relating to materiality require auditors to make a "preliminary judgment about materiality levels" in planning the audit. Subsequently, when misstatements are identified, an auditor must consider both quantitative and qualitative considerations in determining whether the financial statements are materially misstated. That is, the amount used to evaluate a misstatement may or may not differ from that used in planning the audit. When does one expect the auditor's materiality level for evaluation purposes to equal that used in planning? SAS No. 47 addresses this in para. 22 when it states that "assuming, theoretically, that the auditor's judgment about materiality at the planning stage was based on the same information available at the evaluation stage, materiality for planning and evaluation purposes would be the same." However, SAS No. 47 goes on to suggest that the planning and evaluation amounts of materiality may differ due to the findings of the audit. The example it includes at the time of the audit simply illustrates how a qualitative factor such as an illegal payment of an otherwise immaterial amount could be material if it led to a material contingent liability or a material loss of revenue. It was not until December 2000 that an interpretation to SAS No. 47 included additional examples of qualitative factors (AICPA 2002). (1) SAS No. 39 (AU 350), Audit Sampling, also provides some general guidance on qualitative factors. In para. 27 it suggests that in addition to considering the frequency and amounts of misstatements, the auditor should consider qualitative aspects of misstatements that include: (a) the nature and cause of misstatements, such as whether there are differences in principle or in application, are errors or are caused by fraud, or are due to misunderstanding of instructions or to carelessness, and (b) the possible relationship of the misstatements to other phases of the audit. …