Don't Be All Thumbs on Financial Statements

by George Yungmann and David Taube

In the fall of 1998, SEC Chairman Arthur Levitt committed that the Commission's staff would clarify its views on the criteria for evaluating materiality. On August 12, 1999, the SEC issued Staff Accounting Bulletin No. 99 ("the Bulletin") which becomes effective immediately. The Bulletin emphasized that qualitative as well as quantitative factors must be used in making determinations as to whether a misstatement in the financial statements is material. The Bulletin states: "materiality concerns the significance of an item to users of financial statements" and "a matter is material if there is a substantial likelihood that a reasonable person would consider it important."

The management of many companies, if not most, currently evaluate whether or not a misstatement in its financial statements is material based on a quantitative rule of thumb or guideline. In many situations, misstatements of less than 5 percent of net earnings or, in the real estate industry, 5 percent of FFO, may be determined by management to be immaterial and no adjustment is made. But are these misstatements really immaterial if they:

• Hide a failure to meet analysts' consensus expectations;
• Change a net loss into a net income
• Mask a change in earnings or other important trends;
• Are capable of precise measurement
• Materially misstate the operating results of an important business segment but are quantitatively immaterial to the consolidated operating results;
• Represent illegal acts under statutes such as Section 13(b) of the Securities Exchange Act of 1934 which requires that companies, "make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets of the registrant and to permit the preparation of financial statements in conformity with GAAP";
• Affect the company's compliance with regulating requirements, loan covenants or other contractual arrangements; or
• Enhances management compensation?

The Bulletin is clear that these and similar circumstances, "may well render material quantitatively small misstatements of a financial statement item." The Bulletin also indicates that a quantitative rule of thumb approach might be used "as an initial step," but that all "facts and circumstances" such as those identified above, must be evaluated to determine materiality.

Offsetting Misstatements
The Bulletin confirms that, contrary to some practice, separate material misstatements cannot be cured by offsetting misstatements. For example, a material overstatement of rental revenue should not be disregarded because of an overstatement of interest expense. Likewise, a material understatement of operating expenses cannot be cured by an overstatement of gains on sales of assets. And clearly, multiple separate immaterial misstatements cannot be ignored if, in aggregate, they cause the financial statements as a whole to be materially misstated.

GAAP Precedence over Industry Practice
The SEC staff clarifies in the Bulletin that authoritative literature takes precedence over industry practice that is contrary to GAAP. In some cases, industry practices that are contrary to GAAP, may have developed around transactions, which were clearly immaterial in the past. When the results of these transactions have become material, companies have agreed that the practices should continue to be acceptable because of their historical use. The SEC staff disagrees with this argument and requires that the results be adjusted to reflect GAAP.

SEC Staff Encourages Timely Discussions
Regarding the Reporting of Unique Transactions
The SEC staff states that the bulletin does not change current law or guidance in the accounting and auditing literature. At the same time, the staff notes that the literature cannot specifically address all of the novel and complex business transactions and events that may occur. The staff recognizes that management and auditors attempt to make informed judgments regarding these unusual transactions based on analogies to similar situations and facts. At the same time, the staff encourages companies and auditors to discuss with the staff, on a timely basis, proposed accounting treatments for transactions or events that are not specifically covered by existing accounting literature.

The Tone at the "Top"Is Critical
In its 1987 report, the National Commission on Fraudulent Financial Reporting, also known as the Treadway Commission, recognized that the attitude among the most senior management of a company regarding misstatements on financial statements represents the greatest single influence on financial reporting integrity. The Commission's report stated, "The tone set by top management-the corporate environment or culture within which financial reporting occurs-is the most important factor contributing to the integrity of the financial reporting process. Notwithstanding an impressive set of written rules and procedures, if the tone set my management is lax, fraudulent financial reporting is more likely to occur."

Many managers will need to consider additional factors, primarily qualitative, in their determinations of whether financial statement misstatements are immaterial.

George L. Yungmann is senior advisor, financial standards, and David M. Taube is financial standards analyst for NAREIT.

NAREIT is the exclusive mark of the National Association of Real Estate Investment Trusts®, Inc. Copyright © 2008 National Association of Real Estate Investment Trusts®. All rights reserved. NAREIT documents available from this web site are protected by the copyright laws of the United States and international treaties. All use subject to conditions of use. Web site disclaimer