SEC & materiality: Not as easy as it sounds!

by Kurt Schulzke

What misstatements or omissions are “material” and which are not?  With the recent roll-out of the SEC’s new whistleblower regulations, this is a popular question among companies and potential whistleblowers.  This brief summary offers insights into this important topic as it applies to changes in accounting principle.

First, despite recent IFRS rumblings, SEC regulations require “domestic issuers” of public securities (usually meaning stocks or bonds) to follow U.S. Generally Accepted Accounting Principles (a.k.a. “U.S. GAAP”).   The SEC is currently seeking input regarding a possible future move to International Financial Reporting Standards (“IFRS”) promulgated by the International Accounting Standards Board (“IASB”).  However, for now, U.S. GAAP is still published by the U.S.-based and controlled Financial Accounting Standards Board (“FASB”) through its Accounting Standards Codification (“Codification”).

Beyond U.S. GAAP as contained in the Codification, domestic issuers are also obligated to abide by the financial statement content standards prescribed by SEC Regulation S-X.  As a practical matter, issuers and their auditors tend to follow the technically non-binding opinions of SEC staff expressed through so-called Staff Accounting Bulletins (“SABs”).

So what about changes in accounting principle?  At what point is a change material? Under the Codification, a presumption exists that an accounting principle, once adopted, shall not be changed in accounting for events and transactions of a similar type.[1] A change in the method of applying an accounting principle is considered a change in accounting principle. [2] Entities must report changes in accounting principle through retrospective application of the new accounting principle to all prior periods (including interim ones), unless it is impracticable to do so.[3]

Take mortgage banking, for example, an industry on the bleeding edge of the financial markets meltdown of 2007.  Issuers involved in the mortgage industry are required to disclose the method (aggregate or individual loan basis) used in determining the lower of cost or fair value of the mortgage loans carried as assets on their balance sheets.[4] An issuer (a company registered with the SEC) that makes a material change in its method of accounting, including accounting for mortgage loans, must indicate the date of and the reason for the change.  It must also include as an exhibit, in the first Form 10-Q filed subsequent to the date of an accounting change, a letter from the issuer’s independent accountants indicating whether or not the change is to an alternative principle which in the judgment of the accountants is preferable under the circumstances.[5]

For SEC purposes, a fact is material if there is a substantial likelihood that the fact would have been viewed by a reasonable investor as having significantly altered the “total mix” of information available.[6] While some financial market players — including some auditors — might prefer to define “materiality” solely with reference to an item’s numeric magnitude (because percentages make much better bright lines), materiality must be assessed for SEC purposes with respect to quantitative and qualitative factors.   As a result, in numerous circumstances, misstatements below an arbitrary quantitative threshold — say 5%-of-basis — may be material.[7]

Potentially significant qualitative factors include whether (a) the misstatement masks a change in earnings or other trends; (b) whether the misstatement affects the registrant’s compliance with regulatory requirements; (c) whether the misstatement affects the registrant’s compliance with loan covenants or other contractual requirements; (d) whether the misstatement involves concealment of an unlawful transaction.[8]

As one hypothetical illustration, a $5,000 embezzlement by the president of a Fortune 100 corporation might seem numerically insignificant in relation to the company’s balance sheet or income statement.  However, the fact that the president was involved in the embezzlement suggests serious weaknesses in the company’s governance and internal control systems and, therefore, would arguably be “material”.

Bottom line:  In assessing the materiality of a change in accounting principle or any other aspect of an issuer’s SEC reports and disclosures, it is important to remember that easily quantified numbers and percentage thresholds are only the beginning of a thorough analysis.

[1] FASB Codification Topic 250-10-45-1.

[2] FASB Codification, Glossary.

[3] FASB Codification Topic 250-10-45-5 and 45-14.

[4] FASB Codification Topic 948-310-50-1, Financial Services, Mortgage Banking, Receivables, Disclosure.  This requirement has been in effect since the original issuance of FASB Statement No. 65 in 1982.

[5] Regulation S-X, Rule 10-01(b)(6).

[6] TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). See also Basic, Inc. v. Levinson, 485 U.S. 224 (1988).

[7] SEC Staff Accounting Bulletin No. 99.

[8] SEC Staff Accounting Bulletin No. 99.


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