ETHICAL ISSUES FACING THE ACCOUNTING PROFESSION

A NEW LOOK AT MATERIALITY

What are the latest views on materiality in financial accounting? How have standards for measuring materiality changed since passage of the Sarbanes-Oxley Act? And what new approaches are being taken to better assess the materiality of financial information? In the aftermath of the Enron scandal, corporate financial statements are under greater scrutiny than ever, forcing auditors to pay closer attention to many transactions previously considered immaterial. This paper reviews the basis of materiality in financial reporting and the methods commonly used to assess what is – and what is not – material.

The concept of materiality has been receiving increased scrutiny by the Securities and Exchange Commission since at least 1998, when then-chairman Arthur Levitt made his much-quoted “Numbers Game” speech. Levitt complained of the misuse of materiality by companies that deliberately record misleading financial information to increase their earnings statements, and then later claim that any errors introduced were immaterial. Levitt clearly abhorred the practice and went on to say that “in markets where missing an earnings projection can result in a loss of millions of dollars in market capitalization, I have a hard time accepting that some of these so-called non-events simply don’t matter” (Messier, et al, 2005, p. 154).  In the year following Levitt’s speech, the SEC issued Staff Accounting Bulletin No. 99, which made it clear that quantitative measures alone are insufficient to determine materiality; qualitative measures must be considered, too. For example, if the inclusion of any item or transaction, however small, will cause a firm to miss forecasted earnings estimates, then that item must be properly recorded and reported.

The abuse of materiality standards can be traced back to the mid-1980s, when Wall Street intensified its focus on quarterly earnings and practically demanded continual increases in corporate profitability. Meanwhile, most accountants expected the widespread adherence to generally accepted accounting principles to maintain a certain level of honesty in financial reporting, but unfortunately “GAAP only specifies methodologies for accounting – it doesn’t demand ethics and integrity” (Sherpenseel, 2004, p. 49).  The resulting pressures and monetary incentives were too much for some executives to withstand, and their downfall eventually led to passage of the Sarbanes-Oxley Act in 2002. SOX-mandated scrutiny of financial statements will likely improve corporate governance and restore the public’s confidence in financial reporting, but it comes at the cost of significantly higher expenses.

The misuse and abuse of materiality standards is also due in part to the extremely subtle nature of the subject. Gist, Shastri, and Colson (2003) found that “although the concept of materiality…forms the backbone of the audit process, applying it properly has often been elusive, and professional standards do not provide specific guidelines…” (p. 60) To further complicate matters, materiality constraints extend not only to misstatements and misrepresentations but also to omissions of fact – anything at all that may influence the judgment or decision of a reasonable person. And although some simple quantitative rules of thumb exist for assessing materiality, determining the extent of relevant information needed by investors is generally left to auditors’ professional judgment, which can open the door to multiple interpretations and/or abuse. Thus, “it should surprise no one that differences of opinion are common – what’s material is, in many ways, in the eye of the beholder” (Holder et al,  2003, p. 61).  In the end, auditors are obliged to consider any relevant qualitative factors when using quantitative measures to gauge an item’s materiality.

Despite the SEC’s insistence on incorporating qualitative factors and well-founded professional judgment into materiality decisions, auditors still make extensive use of quantitative measures to determine materiality. For instance, many estimates of materiality are made using the so-called five-percent rule, which is based on the assumption that a reasonable investor will not be swayed by a change in net income of 5% or less. The five-percent rule is applicable to individual line items in the income statement as well, provided that the cumulative effect on net income is still 5% or less. The SEC frowns upon over-reliance on such quantitative rules of thumb in issues of materiality, preferring that a more holistic view be taken of what will or will not influence the decision of an informed investor. However, Vorhies (2005) contends that “because such a qualitative analysis is very complex, almost everyone – including CPAs – uses quantitative estimates to identify potential materiality issues” (p. 53).  But in doing so, they may run afoul of the SEC, which declared unequivocally in SAB 99 that such conduct is inappropriate and that “misstatements are not immaterial simply because they fall beneath a numerical threshold” (Vorhies, 2005, p. 53).

Material misstatements can take many forms. Some may seem to be trivial and obscure, but are nonetheless meaningful, such as the deliberately biased, or favorable, rounding of financial figures. For instance, a firm that routinely rounds their earnings up from $1.9 million to $2.0 million but does not round down from $2.1 million to $2.0 million is engaging in upwardly biased rounding. According to Cox, Guan, and Wendell (2005), a 2003 study of over 30,000 financial statements using a statistical method called digit pattern analysis suggested that 14% of the firms studied were inappropriately rounding their earnings figures up  (p. 31).  Not too surprisingly, none of the financial statements in the study showed any signs of excessive downward rounding. Unfortunately, a statistical analysis of this type is not capable of identifying exactly which firms were guilty of improper rounding.

The inherent difficulty of assessing materiality qualitatively has led to increased reliance on simpler, more quantitative approaches, such as the five-percent rule. But rules of thumb have their limitations, and the search continues for a simple, effective method of measuring materiality while still complying with SEC rules. One solution, proposed by Rosner, Comunale, and Sexton (2006), involves the use of “fuzzy logic” expert systems (p. 27).  Such a system would add shades of gray to the typically black or white (yes or no) decisions auditors must make about materiality. A fuzzy logic system would allow an auditor to initially assess an item as somewhat (say 60%) material, rather than wholly material or wholly immaterial. The initial assessment could then be weighted upwards or downwards by other, more qualitative factors (e.g., compliance with regulatory requirements), with the result falling on a scale somewhere between very low materiality (0%) and very high materiality (100%). To be effective, such an expert system requires periodic user feedback to maintain and improve performance.

Assessing materiality thresholds will always be a challenge for managers and auditors. Accurately determining the needs of investors and creditors for meaningful financial information is both art and science, requiring sound professional judgment and skillful use of all available tools. The simplicity of quantitative measures has made them attractive to auditors, but in order to satisfy regulators, qualitative measures must also be considered when assessing materiality.