Earlier this month, the Securities and Exchange Commission’s (“SEC”) Office of the Chief Accountant (“OCA”) published a statement focusing on the importance of objectivity in assessments of the materiality of errors in financial statements. Under the U.S. federal disclosure-based regulatory regime, public companies are required to provide investors with financial statements prepared in compliance with generally accepted accounting principles (“GAAP”) and to notify investors promptly whenever a material error is identified in previously-issued financial statements. Elucidating the Supreme Court’s holding that a fact 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,”1 OCA described the materiality determination as “an objective assessment focused on whether there is a substantial likelihood it is important to the reasonable investor” (emphasis in original).
Overall, OCA is paying attention to the type of restatement a registrant chooses to issue. Companies, auditors, and audit committees should put processes in place to carefully assess whether an error is material “by applying a well-reasoned, holistic, objective approach from a reasonable investor’s perspective based on the total mix of information.”
Guidance on Objectivity
Generally, a registrant must comply with a two-pronged approach to correction of errors in previously-issued financial statements. First, when a registrant determines an error to be material, the error must be corrected by restating the prior-period financial statements, in what is known as a reissuance restatement or a “Big R” restatement. Second, when an error is not material but either correcting the error or leaving the error uncorrected would be material to the current period financial statements, the registrant must correct the error and can do so in the current period comparative financial statements, in what is known as a revision restatement or a “little r” restatement.
In monitoring restatement trends, OCA has observed a rise in the proportion of restatements that are “little r” revision restatements, as opposed to “Big R” reissuance restatements. Though some, according to OCA, attribute this trend primarily to improvements in the effectiveness of internal control over financial reporting (“ICFR”) and audit quality, OCA 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 a higher ratio of “little r” revision restatements as of 2020 compared to 2005. Some of the biases OCA has observed include arguments that:
- certain elements of financial statements prepared in accordance with U.S. GAAP or International Financial Reporting Standards (“IFRS”) do not provide useful information to investors, so an error in those elements cannot be material;
- historical financial statements are irrelevant to investors’ current investment decisions;
- an error is not material to previously-issued financial statements because the error was also made by other registrants, and therefore reflects a widely-held view rather than an intention to misstate; and
- an error is not material because its effect is offset by other errors.
In response, OCA notes that financial statements prepared in accordance with U.S. GAAP or IFRS are the starting point for any objective materiality analysis, keeping in mind that analysis of key non-GAAP measures should also be performed where applicable. OCA further notes that registrants and their auditors should first consider whether an error is material, irrespective of its effect when combined with other misstatements, and then consider whether the aggregated effects render the statements as a whole to be materially misleading. OCA cautions, however, that an aggregate effects analysis should not be the basis for a conclusion that individual errors are immaterial.
- Reasonable Investor Standard of Objectivity in Materiality Assessments. Registrants, auditors, and audit committees must carefully assess whether an error in a financial statement is material by applying a well-reasoned, holistic, objective approach from a reasonable investor’s perspective based on the total mix of information.
- Quantitative and Qualitative Factors as Part of Objective Analysis. An objective analysis of materiality should consider all relevant facts and circumstances, including both quantitative and qualitative factors. A quantitatively small error could nevertheless be material because of qualitative factors. But the reverse also applies: as the quantitative magnitude of an error increases, it becomes increasingly difficult for qualitative factors to overcome the quantitative significance of the error.
- Material Weakness as Part of ICFR Effectiveness Assessment. Management’s assessment of the effectiveness of ICFR should be focused on a holistic, objective analysis of what could happen in the context of current and evolving financial reporting risks—which includes not only actual error but also material weakness even without material error.
- Suitable Design of Audit Firms’ Systems of Quality Control. Audit firms should have 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.
1TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976); see also Basic, Inc. v. Levinson, 485 U.S. 224 (1988).
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