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Earnings Management and the Abuse of Materiality

2000; American Institute of Certified Public Accountants; Volume: 190; Issue: 3 Linguagem: Inglês

0021-8448

C. Terry Grant, Chauncey M. DePree, Gerry H. Grant,

Auditing, Earnings Management, Governance

Help for auditors in evaluating financial statement misstatements. Take your pick of fraudulent financial reporting schemes. One of these gimmicks, manipulating reported income through techniques, draws its share of attention in the financial press. A company can effect earnings management practices in variety of ways. One of the most popular vehicles for earnings management, however, stems from misuse or misunderstanding of the proper application of materiality, concept central to the preparation and audit of all financial statements. SEC Staff Accounting Bulletin (SAB) no. 99, Materiality, provides guidance for preparers and independent auditors on evaluating the materiality of misstatements in the financial reporting and auditing processes by summarizing and putting in perspective certain GAAP and the federal securities laws as they relate to materiality. Armed with the guidelines of SAB no. 99 and skepticism about management's motivation for meeting revenue expectations through aggressive reporting, the auditor can be alert to possible signs of fraud. It's no secret that battling financial fraud is priority for the SEC. At the New York University Center of Law and Business on September 28, 1998, SEC Chairman Levitt put the accounting profession on notice that those who operate in the gray area between legitimacy and outright fraud are poisoning the reporting process. (See Arthur Levitt Addresses `Illusions,' JofA, Dec.98, page 12.) One of these illusions is earnings management, where, for example, financial reports reflect the desires of management--rather than the company's underlying financial performance--in order to meet Wall Street's earnings projections. SEC RESPONSE As response to some of the concerns raised by Chairman Levitt, the SEC issued SAB no. 99 in August 1999. Although it does not really say anything new, the SAB synthesizes long-standing audit practices and addresses the application of materiality thresholds to the preparation and audit of financial statements filed with the SEC. FASB defined materiality in Financial Accounting Concepts Statement no. 2, Qualitative Characteristics of Accounting Information: magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of reasonable person relying on the information would have been changed or influenced by the omission or misstatement. SAB no. 99 contends that FASB's definition is similar to the interpretation of materiality upheld by the courts under federal securities laws. The U.S. Supreme Court held that fact is material if there is a substantial likelihood that the ... fact would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available (Basic, Inc. v. Levinson, 485 U.S. 224, 1988). SAB no. 99 also offers examples of what is acceptable and what is not in regard to materiality. Acceptable Concept of materiality. Noting that the concept of materiality plays vital role in the financial reporting process, the SAB cites the FASB Discussion Memorandum, Criteria for Determining Materiality: If presentations of financial information are to be prepared economically on timely basis and presented in concise intelligible form, the concept of materiality is crucial. It further states, This SAB is not intended to require that misstatements arising from accounting close processes, such as clerical error or an adjustment for missed accounts payable invoice, always be corrected, even if the error is identified in the audit process and known to management. Assessing materiality as an initial step. Auditors' reliance on quantitative thresholds, such as materiality threshold of 5%, has become commonplace in the preparation and audit of financial statements. …