Source: https://corporate.findlaw.com/finance/sec-release-on-materiality-in-financial-disclosure.html
Timestamp: 2019-04-20 04:38:35+00:00

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The general rule that has judicially evolved for determining the materiality of particular information is whether there is a substantial likelihood that a reasonable investor would have considered the information important in making his or her investment or voting decision.3 Put another way, there must be a substantial likelihood that the misstated or omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information available.
The total mix standard continues to be applied on a casebycase basis, with certain categories of statements or omissions deemed to be immaterial as a matter of law because they present or omit such insignificant data that would not matter to a reasonable investor. For example, courts have routinely held that statements of optimism, belief, or mere puffery may be so vague and such obvious hyperbole that no reasonable investor would rely upon them." 6 Additionally, under the "bespeaks caution" doctrine, forward-looking information will generally be immaterial if accompanied by sufficiently cautionary language. Similarly, the Private Securities Litigation Reform Act (PSLRA), enacted in 1995, created a statutory safe harbor from liability for forward-looking statements under certain circumstances.
SEC Rule 405,7 the safe harbor, under the Securities Act of 1933, essentially mirrors the common law definition of materiality. Specifically, Rule 405 provides that "when used to qualify a requirement for the furnishing of information as to any subject," materiality "limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered." SEC Rule 12b2,8 under the Securities Exchange Act of 1934, differs slightly from Rule 405, defining materiality as information "to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to buy or sell the securities registered."
Materiality determinations within the context of financial reporting has recently become the subject of intense scrutiny by the SEC. Specifically, certain types of materiality determinations, such as the perceived practice among issuers and their independent auditors, to deem certain financial information as immaterial if it falls below a certain percentage threshold, 10 have recently come under attack by the SEC.
To that end, last Fall, SEC Chairman Arthur Levitt, in a speech entitled "The Numbers Game," 11 criticized such disclosure practices, noting his views of their corrosive effect on the quality of financial reporting. Saying that the concept of materiality "serves an important purpose by recognizing that some items may be so insignificant that they are not worth measuring and reporting with exact precision," Chairman Levitt stated "[b]ut some companies misuse the concept of materiality. They intentionally record errors within a defined percentage ceiling. They then try to excuse that fib by arguing that the effect on the bottom line is too small to matter.... When either management or the outside auditors are questioned about these clear violations of GAAP, they answer sheepishly. 'It doesn't matter. It's immaterial.'"
Accordingly, Chairman Levitt called upon the SEC staff to focus on the issue of materiality and publish guidance that emphasizes the need to consider qualitative, not just quantitative factors. "Materiality is not a bright line cutoff of three or five percent," pronounced Chairman Levitt. "It requires considerations of all relevant factors that could impact an investor's decision."
In apparent response to Chairman Levitt's speech, on August 13, 1999, the SEC accounting staff issued Staff Accounting Bulletin No. 99 (SAB 99), which addresses materiality in the preparation of financial statements. Although the staff asserts that SAB 99 does not create new standards or definitions for materiality, but rather reaffirms the concepts of materiality as expressed in the accounting and auditing literature as well as in longstanding case law, the actual implications of SAB 99 on disclosure determinations remain to be seen.
Whether a particular accounting principle is "generally accepted" is often difficult to determine because no single reference source exists for all such principles. The hierarchy of sources of GAAP established by the American Institute of Certified Public Accountants' (AICPA),15 Statement on Auditing Standards (SAS) No. 69, lists: (1) Statements and Interpretations of the Financial Accounting Standards Board (FASB),16 APB Opinions, and AICPA Accounting Research Bulletins; (2) FASB Technical bulletins, AICPA Industry and Audit and Accounting Guides, and AICPA Statements of Position; (3) consensus positions of the FASB Emerging Issues Task Force and AICPA Practice Bulletins; (4) AICPA accounting interpretations, "Q's and A's published by the FASB Staff, as well as industry practices widely recognized and prevalent; and (5) other accounting literature, including FASB Concepts Statements, AICPA Issues Papers; International Accounting Standards Committee Statements; GASB Statements, Interpretations, and Technical Bulletins; pronouncements of other professional associations or regulatory agencies; AICPA Technical Practice Aids; and accounting textbooks, handbooks and articles.
To the extent existing auditing and accounting literature offers guidance for making materiality determinations, such guidance is in substance similar to the Supreme Court's initial formulation of materiality in TSC. Specifically, one of the most important initiatives of the accounting profession on the topic of materiality was the issuance of FASB's Statement of Financial Accounting Concepts No. 2 (Concepts Statement No. 2 17 According to FASB, "[t]he essence of the materiality concept is clear ... [t]he omission or misstatement of an item in a financial report is material if, in light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item." To that end, Concepts Statement No. 2 offers certain factors to be considered in determining whether an item of information is material, such as the degree of precision that is attainable in estimating the "judgment item"18 and the suggestion that the relative rather than the absolute size of a judgment item determines whether it should be considered material in a given situation.
One example of quantitative materiality guidance is SEC Regulation SX, Rule 504, which notes that with respect to receivables from officers and stockholders, registrants must disclose details of receivables from any officer or principal stockholder it if equals or exceeds $20,000 or 1 percent of total assets. Additionally, SEC Accounting Series Release No. 147 provides that with respect to information on present value of lease commitments under non-capitalized financing leases, disclosure is necessary if the present value is 5 percent or more of total of long-term debt, stockholders equity, and present value of commitments, or if the impact of capitalization on income is 3 percent or more of the average net income for the most recent three years. Concepts Statement No. 2 asserted that such guidelines generally specify "minima only," in that they do not prohibit the recognition of a smaller percentage as also being material. According to Concepts Statement No. 2 quantitative guidelines for materiality therefore, "leave room for individual judgment in at least one direction."
For example, in Parnes v. Gateway 2000,33 the U.S. Court of Appeals for the Eighth Circuit concluded that the defendant's alleged overstatement of assets by $6.8 million, amounting to only 2 percent of the company's total assets, was not material because "a reasonable investor, faced with a high risk/high-yield investment opportunity in a company with a history of very rapid growth, would not have been put off by an asset column that was 2 percent smaller."
SAB 99, issued in response to Chairman Levitt's remarks regarding the "Numbers Game," is the SEC's most recent word on materiality. SAB 99 essentially restates the existing standards of materiality as promulgated thus far by judicial precedent, the Commission itself and applicable accounting and auditing literature. The Accounting Staff notes that SAB 99 is not intended to create new standards or definitions for materiality.
Significantly, SAB 99 also states that registrants and their auditors must consider each misstatement separately as well as the aggregate effect of all misstatements. Thus, if a single misstatement has a material impact on the financial statements as a whole, it cannot be "cured" by another misstatement that "cancels out" the impact of the first item. Moreover, while a single misstatement itself may not be material, the staff asserts that the effect may be material when the misstatement is combined with others.
Based on all the foregoing, SAB 99 contends that a registrant and the auditors of its financial statements should not assume that even small intentional misstatements in financial statements are immaterial.37 The staff notes that while the intent of management does not render a misstatement material per se, it may provide significant evidence of materiality. Such evidence, according to SAB 99, may be particularly compelling where management has intentionally misstated items in the financial statements to "manage" earnings, since in that instance it presumably has done so believing that the resulting amounts and trends would be significant to users of the registrant's financial statements. In short, the staff believes that investors generally would regard as significant a management practice to over or understate earnings up to an amount just short of a percentage threshold in order to manage earnings as well as an accounting practice that rendered all earning figures subject to a management-directed margin of misstatement.
In part two of SAB 99, the staff reminds registrants that intentional misstatements, even if they are immaterial, may nevertheless violate the books and records provisions of Sections 13(b)(2)(7) of the Exchange Act. Under these provisions each registrant with securities registered pursuant to Section 12 of the Exchange Act or required to file reports pursuant to Section 15(d), must make and keep books, records and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the registrant and must maintain internal accounting controls that are sufficient to provide "reasonable assurances" that transactions are recorded as necessary to prepare financial statements that conform to GAAP.
SAB 99 acknowledges that there is limited authoritative guidance38 concerning the "reasonableness" standard. Unlike materiality, according to the staff, reasonableness is not necessarily a measure of the significance of a financial statement item to investors, but rather reflects a judgment as to whether an issuer's failure to correct a known misstatement implicates the purposes underlying the accounting provisions of Section 13(b)(2)(7) of the Exchange Act.
Accordingly, SAB 99 identifies four factors for determining whether a misstatement results in a violation of a registrant's obligation to keep books and records that are accurate "in reasonable detail": (1) the significance of the misstatement: (2) how the misstatement arose; (3) the cost of correcting the misstatement; and (4) the clarity of authoritative accounting guidance with respect to the misstatement.
SAB 99 also reminds registrants and auditors that Section 10A(b) of the Exchange Act requires auditors to report to a registrant's Audit Committee the discovery of an "illegal act"39 regardless of whether there is a material impact on the financial statements. Accordingly, SAB 99 notes that an intentional albeit immaterial misstatement in a registrant's financial statements that violates the books and records provisions of the Exchange Act40 constitutes an illegal act and must be reported to the Audit Committee irrespective of any "netting" of the misstatement with other financial statement items.
Although the staff contends that SAB 99 "is not intended to change current law or guidance in the accounting or auditing literature," the effect that the release will have on management and auditor materiality determinations remains to be seen. Because SAB 99 was issued in response to perceived abuses, presumably the staff intended to change the behavior of persons preparing or auditing financial statements.
Given SAB 99's message that any deviation from GAAP will be viewed by the staff with skepticism, management and auditors may react by adopting conservative accounting treatments to avoid after-the-fact enforcement proceedings when conservatism not only may be unwarranted, but also not reflective of the issuer's actual financial position. Indeed, the accounting literature cautions that conservatism may be as misleading in certain circumstances as more aggressive interpretations of GAAP.
Moreover, any suggestion in SAB 99 that deviations from GAAP may be per se material is contrary to caselaw and the accounting literature. Further, it is not clear whether compliance with Section 13(b) of the Exchange Act will supersede and moot determinations of immateriality for purposes of compliance with GAAP in the preparation of financial statements. In that regard, in criticizing a quantitative approach to assessing materiality, the staff appears to make certain assumptions as to the cost of evaluating the "materiality" or "reasonableness" of small deviations from GAAP which may not be appropriate.
SAB 99 also suggests the staff's particular objection to "intentional" violations of GAAP, yet it is not clear how "intent" will be assessed in practice. For example, if management or auditors affirmatively determine that a deviation from GAAP is immaterial, will that determination be viewed as "intentional" if the staff later disagrees? The staff's comment that "consequences may be severe" for registrants and auditors "when disagreements occur after a transaction or an event has been reported," suggests that the staff may give little consideration to good faith attempts at compliance or even good faith disagreements as to the application of GAAP.
The staff's suggestion that registrants and auditors consult the staff when evaluating these matters does not appear practical. It is also not clear whether the staff would require restatement where it disagrees with the materiality or reasonableness determinations of management or auditors in circumstances where the deviation from GAAP (at least as the staff interprets GAAP) constitutes a small percentage of the relevant financial statement benchmark.
George S. Branch & James A. Rubright, "Integrity of Management Disclosures Under the Federal Securities Laws," 37 Bus. Law. 1447, 1453 (1982) (citing H.R. Rep. No. 85-73, at 1-2 (1933)).
See 15 U.S.C. 77k to 771 (1994); 15 U.S.C. 78j (1994).
See TSC Industries v. Northway, 426 U.S. 438, 439 (involved a claim of fraud under §14(a) of the Securities Exchange Act of 1934 for misstatements and omissions in the solicitation of proxies); see also Basic Inc. v. Levinson, 485 U.S. 224 (1988).
See TSC, 426 U.S. at 449.
Private Securities Litigation Reform Act of 1995, Pub. L. 104-67, 109 Stat. 737 (1995).
See Dennis J. Block & Jonathan M. Hoff, "Application Of The Safe Harbor For Forward-Looking Statements," New York Law Journal at 1, Oct. 6, 1999 (for purposes of the statute, a forward-looking statement includes statements containing projections of financial matters, plans and objectives for future operations or future economic performance, as well as assumptions underlying or relating to such statements).
See, e.g., In re Burlington Coat Factory Secs. Litig., 25 F.3d 1410 (3rd Cir. 1998) (earning reports are among the pieces of data that investors find most relevant to their investment decision); see also In re Kidder Peabody Secs. Litig., 10 F. Supp. 398 (S.D.N.Y. 1998) (profit statements and financial reports are of particular interest to investors).
See Elizabeth MacDonald "SEC Readies New Rules for Companies About What is 'Material' for Disclosure," Wall St. J. at A2, Nov. 3, 1998 ("[m]ost auditors - and their corporate clients - define materiality as any event of news that might affect a company's earnings positively or negatively, by 3 percent to 10 percent ... [it] has become standard practice in corporate America. Thus, if a particular charge or event does not meet the 3% to 10% level, companies feel they don't have to disclose it.").
See Remarks by Chairman Arthur Levitt, Securities and Exchange Commission, "The Numbers Game," New York University Center for Law and Business, Sept. 28, 1998.
See Marianne M. Jennings et al., "The Auditor's Dilemma: The Incongruous Judicial Notions of the Auditing Profession and Actual Auditor Practice," 29 Am. Bus. L.J. 99 (1991) (The statutory filings in which auditors participate include SEC registration statements for securities offerings, proxy solicitation materials, annual and quarterly and information reports such as Forms 10-K, 8-K and 10-Q filed with the SEC.).
Rule 2-02(c) of Regulation S-X, 17 C.F.R. §210.2-02(c).
See Statement on Auditing Standards (SAS) No. 69, par. 2.
The AICPA is a premier national professional association for CPAs in the United States that provides technical support, standard setting (GAAP) and guidelines in conjunction and accounting guidelines in conjunction with the Financial Accounting Standards Board, subject to the overview of the SEC.
The Financial Accounting Standards Board (FASB) is the designated organization in the private sector for establishing standards of financial accounting and reporting with respect to the preparation of financial reports. FASB is officially recognized as authoritative by the Securities and Exchange Commission (Financial Reporting Release No. 1, Section 101) and the American Institute of Certified Public Accountants (Rule 203, Rules of Conduct, as amended May 1973 and May 1979).
See FASB, Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information ("Concepts Statement No. 2"), P132 (1980); see also Concepts Statement No. 2, Glossary of Terms - Materiality.
Concepts Statement No. 2, 128 ("A judgment item is whatever has to be determined to be material or immaterial. It may be an asset or liability item, a transaction, an error, or any number of things.").
See, e.g., SEC Accounting Series, Release No. 41, "Separate disclosure of balance sheet items"; SEC Accounting Series, Release No. 147, "Gross rental expense under leases"; SEC Accounting Series, Release No. 258, "Proved oil and gas reserves"; Statement of Financial Accounting Standards No. 14, "Segmental reporting: recognition of reportable segment."
Concepts Statement No. 2, 131.
Concepts Statement No. 2, 125.
Codification of Statements on Auditing Standards ("AU") §312, "Audit Risk and Materiality in Conducting an Audit."
See e.g., In re Carter-Wallace Inc. Sec Litig., 150 F.3d 153 (2d Cir. 1998); In re Software Toolworks Inc., 50 (F.3d 615 (9th Cir. 1994); Adams v. Standard Knitting Mills Inc., 623 F.2d 422 (6th Cir. 1980).
See Thor Power Tool Co. v. Commissioner of Internal Revenue, 439 U.S. 522, 544 (1979); accord Shalala v. Guernsey Mem. Hosp., 514 U.S. 87 (1995).
See Adams, 623 F.2d at 432-433.
See. e.g., Basic, 485 U.S. at 238 ("It is not enough that a statement is false or incomplete if the misrepresented fact is otherwise insignificant."); In re Computervision Corp. Secs. Litig., 914 FSupp. 717 (D. Mass. 1996) (omitted information was 3 percent to 9 percent of actual revenues and therefore immaterial). At least one court, however, declined to hold that an omission or misstatement is immaterial simply because it falls below a certain percentage threshold. See In re Kidder, 10 FSupp. 2d 398 (S.D.N.Y. 1998) (although none of the alleged misstatements, taken individually, affected the disclosing company's profits by more than 2.54 percent, with most of the alleged misstatements individually affecting the company's profits by less than 1 percent, the U.S. District Court for the Southern District of New York nevertheless concluded that it was "hard pressed to find misstatements of profits totaling over $338 million dollars are immaterial as a matter of law.") Id. at 410.
122 F.3d 539 (8th Cir. 1997).
The Staff stated in understands the Big Five Audit Materiality Task Force (Task Force) was convened in March of 1998 and has made some recommendations to the Auditing Standard Board including suggestions regarding communications with audit committees about unadjusted misstatements. See generally Big Five Audit Materiality Task Force, "Materiality in a Financial Statement Audit-Considering Qualitative Factors When Evaluating Audit Findings" (August 1998).
SAB 99 (citing to Concepts Statement No. 2, 169).
SAB 99 clarifies this statement by noting that intentional management of earnings and intentional misstatements do not include insignificant errors and omissions that may occur in systems and recurring processes in the normal course of business.
SAB 99 notes that the courts generally have found that no private right of action exists under the accounting and books and records provisions of the Exchange Act. See, e.g., Lamb v. Philip Morris Inc., 915 F.2d 1024 (6th Cir. 1990): see also JS Service Center Corporation v. General Electric Technical Services Co., 937 FSupp. 216 (S.D.N.Y. 1996).
Section 10A(f) defines, for purposes of Section 10A, an "illegal act" as "an act or omission that violates any law, or any rule or regulation having the force of the law."
Section 13(b)(2) of the Exchange Act.
See Statement on Auditing Standards ("SAS") No. 54, "Illegal Acts by Clients," and SAS No. 82, "Consideration of Fraud in a Financial Statement Audit."
See AU §§316.34 and 316.36. Auditors should document their determinations in accordance with AU §§316.37, 319.57, 339, and other appropriate sections.
Dennis J. Block and Jonathan M. Hoff are partners at Cadwalader, Wickersham & Taft. Associate Alla Lerner assisted in the preparation of this article.
This article is reprinted with permission from the December 30th issue of the New York Law Journal © 1999 NLP LP Company.

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