Understanding Materiality Determinations for Financial Reports under SEC Guidelines

The Securities and Exchange Commission (SEC) has been emphasizing the concept of materiality in federal securities laws, particularly in the context of financial statements. This focus is reflected in the SEC's guidance, such as SAB 99, which provides insight into how companies should consider materiality when identifying errors.

Paul Munter, the acting Chief Accountant of the SEC, recently spoke about materiality from the perspective of the "reasonable investor." According to Munter, a material fact is one that has a substantial likelihood of being viewed by the reasonable investor as having significantly altered the total mix of information made available. This means that auditors and companies should be more accountable for the accuracy of financial statements, with a stronger focus on precision.

Companies should refer to SAB 99 when considering materiality in the context of an identified error, and expect that their materiality judgments will be stress-tested by the SEC staff. Audit committees should have a good understanding of how management applies materiality and uses it to decide whether to restate previously-issued financial statements.

In the context of a restatement, the materiality discussions between the audit committee and auditor are likely to be more involved, especially if the errors are potentially significant. Audit committees should discuss materiality thresholds with the outside auditors and appreciate how the auditors assess materiality in the context of financial reporting and disclosure issues.

If an identified error is not material to previously-issued financial statements, it may be corrected in the current period by correcting the prior period information, a "little r" restatement. On the other hand, when a material accounting error has been identified, it must be corrected by restating prior-period financial statements, a "Big R" restatement.

The Office of the Chief Accountant (OCA) has encountered arguments on materiality that it has found unpersuasive, such as investors not caring about identified errors, other SEC filers making the same innocent mistake, and all identified errors zeroing each other out. The OCA has also suggested that "little r" restatements may be the result of a bias toward concluding that an error is not material.

The total number of restatements by registrants declined each year from 2013 to 2020, but "little r" restatements as a percentage of total restatements rose to nearly 76% in 2020, up from approximately 35% in 2005. This shift towards less extensive restatements might indicate a trend towards more subjective assessments of materiality.

Auditors use materiality to decide whether a control deficiency is a material weakness for purposes of the audit of management's assessment on the effectiveness of the company's internal control over financial reporting. The analysis takes into account all relevant facts and circumstances regarding the error, including both quantitative and qualitative factors.

SEC Chair Gensler is ensuring that the SEC's climate proposal relies on a "legally defensible definition of materiality." This emphasis on materiality is part of a broader effort to increase transparency and accountability in financial reporting. Paul Munter has proposed new measures to strengthen oversight and provide clearer definitions of auditor responsibilities to improve transparency and responsibility in audit processes.

In conclusion, the SEC's focus on materiality is aimed at enhancing the accuracy and reliability of financial statements. Companies, audit committees, and auditors are encouraged to carefully consider materiality in their analyses and discussions, ensuring that their judgments are supported by documented evidence and that they are prepared to justify their decisions to the SEC staff.

Understanding Materiality Determinations for Financial Reports under SEC Guidelines