Adjusting to the Evaluation of Materiality in Financial Reports for the Securities and Exchange Commission
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 crucial for understanding how errors in financial reports can impact investors.
Audit committees play a significant role in this regard. They should comprehend how management applies materiality in deciding whether to restate previously-issued financial statements. If uncorrected misstatements are immaterial, auditors are required to discuss with the audit committee the basis for this conclusion.
Auditors use materiality to determine which classes of accounts and disclosures should be subject to audit procedures. Similarly, they decide whether a control deficiency is a material weakness for the audit of management's assessment on the effectiveness of the company's internal control over financial reporting.
The SEC registrants are expected to evaluate all relevant facts and circumstances around an identified error to determine its materiality. This evaluation should follow the principle-based standard of materiality, where a fact is material if there is a substantial likelihood that it would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available.
The Office of the Chief Accountant (OCA) has encountered unpersuasive arguments about materiality, such as investors not caring about identified errors, other SEC filers making the same innocent mistake, and all identified errors zeroing each other out. However, the appropriate materiality analysis takes into account all relevant facts and circumstances, including both quantitative and qualitative factors.
When a material accounting error has been identified, it must be corrected by restating prior-period financial statements (Big R restatement). On the other hand, if the identified error is not material to previously-issued financial statements, it may be corrected in the current period by correcting the prior period information (little r restatement).
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. This trend has raised concerns, with Paul Munter, the acting Chief Accountant of the SEC, expressing his concern about the increasing trend of "little r" restatements.
Audit committees and auditors should discuss materiality thresholds and appreciate how the auditors assess materiality. Companies should refer to SAB 99 when considering materiality in the context of an identified error.
In 2021, the U.S. Securities and Exchange Commission (SEC) issued a detailed explanation about materiality in the context of federal securities laws. This explanation aims to provide clarity and ensure that financial statements are prepared accurately and in accordance with GAAP or IFRS, the role of comparative financial statements in trend analysis, and the need to consider each individual error separately in materiality determinations.
In conclusion, understanding materiality is essential for maintaining the integrity of financial statements and protecting investors. Audit committees and auditors have a crucial role to play in this process, ensuring that errors are identified, assessed, and corrected appropriately.
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