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Materiality, Restatements, and the Reasonable Investor Standard

May 12, 2022, 8:45 AM

The materiality of an accounting misstatement or error has long been the deciding factor in whether a Securities and Exchange Commission (SEC) action will be pursued against a company and its officers. Recently, statements from the SEC signal that accounting issues—specifically the assessment of materiality—will be a primary focus.

Whenever a material error is identified in a previously issued financial statement, investors must be notified, and the error must be corrected. The determination of whether an error is material can be a complicated objective assessment, turning on whether there is a substantial likelihood it is important to the reasonable investor. Since the finding of an error being material could trigger a restatement, shareholder litigation, and an SEC investigation, the question of who is the reasonable investor becomes critical.

Paul Munter, the acting chief accountant at the SEC, offered some insight in a statement regarding assessing materiality, specifically focusing on the reasonable investor when evaluating errors, and discussing the different types of errors that may trigger a restatement of financials. Materiality is the trigger for determining whether a public company will have to restate prior financials. Whether to restate prior period financials can be a momentous decision in the life of a public company.

As Munter explained, when previously issued financial statements contain a material error, the error must be corrected by restating those prior period financial statements—sometimes referred to as a “Big R” restatement. If the error is not material to the previously issued financial statements, but either correcting the error or leaving the error uncorrected would be material to the current period financial statements, the error must still be corrected. But the registrant is not precluded from doing so in the current period comparative financial statements by restating the prior period information—sometimes referred to as a “little r” restatement. Staff Accounting Bulletin 99, or SAB 99, has long provided guidance to registrants for assessing both the quantitative and qualitative aspects of materiality.

Need for Objective Analysis

Those who assess materiality of errors must do so through the lens of the reasonable investor, according to Munter. The assessment must be objective, and those conducting the assessment need to thoroughly and objectively evaluate the total mix of information. (See Basic Inc. v. Levinson.) This includes taking into consideration all relevant facts and circumstances surrounding the error, including both quantitative and qualitative factors, to determine whether the error is material to investors. This objective analysis requires putting to the side any potential bias on the part of the registrant, auditor, or audit committee that would be inconsistent with the perspective of a reasonable investor. This means, as Munter described, that it would not be objective to determine that an error is not material to previously issued financial statements in order to avoid the reputational harm, decreased share price, and other consequences often associated with a “Big R” restatement.

One area where the staff in the Office of the Chief Accountant (OCA) at the SEC have observed an increased need for objectivity, according to Munter, is in the assessment of qualitative factors. Munter finds that these factors have been used to argue that a quantitatively significant error is nevertheless immaterial because of qualitative considerations. He and the staff believe, however, that as the quantitative magnitude of the error increases, it becomes increasingly difficult for qualitative factors to overcome the quantitative significance of the error.

Munter explained that OCA has observed that some materiality analyses appear to be biased toward supporting an outcome that an error is not material to previously issued financial statements, resulting in “little r” restatements. “Little r” restatements are not usually followed by the parade of horribles that a “Big R” restatement can lead to. As an example, Munter explained that the staff in OCA have, not infrequently, been presented with arguments that financial statements or specific line items in financial statements are irrelevant to investors’ current investment decisions. However, these types of arguments have not been found to be persuasive because such views could be used to justify a position that many errors in previously issued financial statements could never be material regardless of their quantitative significance or other qualitative factors.

OCA staff have also observed materiality analyses that argued that an error was not material to previously issued financial statements because the error was also made by other registrants and therefore reflected a widely held view rather than an intention to misstate. Munter noted that SAB 99 states that although the intent of management does not render a misstatement material, it may provide significant evidence of materiality. OCA staff, however, have not been persuaded by arguments that attempt to apply that SAB 99 premise in reverse—that the lack of intentional misstatement is viewed as providing evidence that the error is not material.

Identifying Errors

Munter further noted that registrants often argue that an error is not material because its effect is offset by other errors. But as mentioned in SAB 99, registrants and their auditors first should consider whether each misstatement is material irrespective of its effect when combined with other misstatements. The aggregated effects should then also be considered to determine whether an otherwise immaterial error, when aggregated with other misstatements, renders the financial statements taken as a whole to be materially misleading.

In his conclusion, Munter stated that when an error is identified, it is important for registrants, auditors, and audit committees to carefully assess whether the error is material by applying a well-reasoned, holistic, objective approach from a reasonable investor’s perspective based on the total mix of information. To be objective, Munter cautioned, those involved in the process must eliminate from the analysis their own biases, including those related to potential negative impacts of a restatement, that would be inconsistent with a reasonable investor’s view. Additionally, the objective analysis should consider all relevant facts and circumstances, including both quantitative and qualitative factors.

While the acting chief accountant’s statement is not law and may not seem to break new ground in the discussion of materiality, it is important because it is in part motivated by the apparent increase in the prevalence of “little r” restatements and the professional skepticism with which the SEC may view creative arguments against a finding of materiality. Close call decisions by senior management and the audit committee not finding materiality are fraught with danger and susceptible to legal challenge. Having outside counsel and advisers skilled in materiality determinations conduct and document a company’s SAB 99 determinations, particularly when a decision is made that misstatements are not material, is critical to defending the company and the acts of senior management.

Though the definition of materiality has existed for decades, Munter’s statement confirms that materiality determinations and the fair application of the reasonable investor standard are being watched by the SEC. For this reason, the first line of defense is in the boardroom, and it consists of documenting the legal and accounting basis for any materiality determination.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

John Carney, is a partner with BakerHostetler and serves as the firm’s White Collar, Investigations and Securities Enforcement and Litigation team co-leader. He is a former securities fraud chief, assistant US attorney, US Securities and Exchange Commission senior counsel, and CPA with extensive experience in accounting and disclosure cases.

Jimmy Fokas, also a partner with BakerHostetler, is an experienced white-collar and securities enforcement defense attorney with a broad practice representing public and private companies, regulated entities, audit committees and their officers, directors, and employees before various state and federal agencies. Prior to entering private practice, he served as senior counsel in the Division of Enforcement in the New York regional office of the SEC.

Bari Nadworny is an associate with BakerHostetler. She focuses her practice on white-collar defense and corporate investigations, regulatory enforcement, securities and governance litigation, and other complex commercial litigation.

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