SEC on 5% Materiality Rule.
Out of concern that too many companies are omitting important items from financial statements on the grounds that the items are "immaterial," the Securities & Exchange Commission has issued an accounting bulletin telling corporate America to "think again." The bulletin expressly rules out use of a "5%" analysis to determine materiality. Auditing practice has held that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances, such as self-dealing or misappropriation by senior management. Issued on August 19, the bulletin states: "The staff reminds registrants and the auditors of their financial statements that exclusive reliance on this or any percentage or numerical threshold has no basis in the accounting literature or the law."
One SEC official says that the bulletin was issued based on "frustration that has built up over the years." There have been a couple of relatively high profile cases over the past year or two, such as the one involving W.R. Grace that convinced officials in the chief accountant's office to push for clarification inasmuch as Arthur Levitt has been talking far and wide on "earnings management." The SEC official adds that the new statement on materiality will give auditors added leverage when dealing with corporate financial executives.
The SEC says that any decision to omit some allegedly "immaterial" fact must be made based on whether "a reasonable person" wondering about buying that company's stock would change their decision if the item was omitted. The SEC takes the position that a company must weigh each item in a financial statement in relation to the totality of quantitative and qualitative factors before coming to a decision on omitting an item based on its supposed "immateriality." For example, the misstatement of revenue and operating profit related to a particular business segment within a company may be immaterial if that segment is unimportant to the future profitability of the entire company.
Your Chance to Influence SEC Policy
The SEC is soliciting papers from academic accountants on these topics: audit effectiveness, auditor independence, accounting and financial disclosure, and international accounting and auditing. Papers that cross the threshold before March 1, 2000, will go to the top of the list for presentation at a conference the Office of the Chief Accountant will probably host. Send the papers to: Academic Fellow, Office of the Chief Accountant, Securities & Exchange Commission, 450 5th St. NW, Washington, D.C., 20549-1103.