[Federal Register Volume 64, Number 160 (Thursday, August 19, 1999)]
[Rules and Regulations]
[Pages 45150-45155]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-21484]


=======================================================================
-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 211

[Release No. SAB 99]


Staff Accounting Bulletin No. 99

AGENCY: Securities and Exchange Commission.

ACTION: Publication of Staff Accounting Bulletin.

-----------------------------------------------------------------------

SUMMARY: This staff accounting bulletin expresses the views of the 
staff that exclusive reliance on certain quantitative benchmarks to 
assess materiality in preparing financial statements and performing 
audits of those financial statements is inappropriate; misstatements 
are not immaterial simply because they fall beneath a numerical 
threshold.

DATES: Effective August 12, 1999.

FOR FURTHER INFORMATION CONTACT: W. Scott Bayless, Associate Chief 
Accountant, or Robert E. Burns, Chief Counsel, Office of the Chief 
Accountant (202-942-4400), or David R. Fredrickson, Office of General 
Counsel (202-942-0900), Securities and Exchange Commission, 450 Fifth 
Street, NW, Washington, DC 20549-1103; electronic addresses: 
[email protected]; [email protected]; [email protected].

SUPPLEMENTARY INFORMATION: The statements in the staff accounting 
bulletins are not rules or interpretations of the Commission, nor are 
they published as bearing the Commission's official approval. They 
represent interpretations and practices followed by the Division of 
Corporation Finance and the Office of the Chief Accountant in 
administering the disclosure requirements of the Federal securities 
laws.

    Dated: August 12, 1999.
Margaret H. McFarland,
Deputy Secretary.

PART 211--[AMENDED]

    Accordingly, Part 211 of Title 17 of the Code of Federal 
Regulations is amended by adding Staff Accounting Bulletin No. 99 to 
the table found in Subpart B.
Staff Accounting Bulletin No. 99
    The staff hereby adds Section M to Topic 1 of the Staff Accounting 
Bulletin Series. Section M, entitled ``Materiality,'' provides guidance 
in applying materiality thresholds to the preparation of financial 
statements filed with the Commission and the performance of audits of 
those financial statements.

Staff Accounting Bulletins

Topic 1: Financial Statements

* * * * *

[[Page 45151]]

M. Materiality

1. Assessing Materiality
    Facts: During the course of preparing or auditing year-end 
financial statements, financial management or the registrant's 
independent auditor becomes aware of misstatements in a registrant's 
financial statements. When combined, the misstatements result in a 4% 
overstatement of net income and a $.02 (4%) overstatement of earnings 
per share. Because no item in the registrant's consolidated financial 
statements is misstated by more than 5%, management and the independent 
auditor conclude that the deviation from generally accepted accounting 
principles (``GAAP'') is immaterial and that the accounting is 
permissible.\1\
---------------------------------------------------------------------------

    \1\ American Institute of Certified Public Accountants 
(``AICPA''), Codification of Statements on Auditing Standards 
(``AU'') Sec. 312, ``Audit Risk and Materiality in Conducting an 
Audit,'' states that the auditor should consider audit risk and 
materiality both in (a) planning and setting the scope for the audit 
and (b) evaluating whether the financial statements taken as a whole 
are fairly presented in all material respects in conformity with 
generally accepted accounting principles. The purpose of this Staff 
Accounting Bulletin (``SAB'') is to provide guidance to financial 
management and independent auditors with respect to the evaluation 
of the materiality of misstatements that are identified in the audit 
process or preparation of the financial statements (i.e., (b) 
above). This SAB is not intended to provide definitive guidance for 
assessing ``materiality'' in other contexts, such as evaluations of 
auditor independence, as other factors may apply. There may be other 
rules that address financial presentation. See, e.g., Rule 2a-4, 17 
CFR 270.2a-4, under the Investment Company Act of 1940.
---------------------------------------------------------------------------

    Question: Each Statement of Financial Accounting Standards adopted 
by the Financial Accounting Standards Board (``FASB'') states, ``The 
provisions of this Statement need not be applied to immaterial items.'' 
In the staff's view, may a registrant or the auditor of its financial 
statements assume the immateriality of items that fall below a 
percentage threshold set by management or the auditor to determine 
whether amounts and items are material to the financial statements?
    Interpretive Response: No. The staff is aware that certain 
registrants, over time, have developed quantitative thresholds as 
``rules of thumb'' to assist in the preparation of their financial 
statements, and that auditors also have used these thresholds in their 
evaluation of whether items might be considered material to users of a 
registrant's financial statements. One rule of thumb in particular 
suggests that the misstatement or omission \2\ of an item that falls 
under a 5% threshold is not material in the absence of particularly 
egregious circumstances, such as self-dealing or misappropriation by 
senior management. The staff reminds registrants and the auditors of 
their financial statements that exclusive reliance on this or any 
percentage or numerical threshold has no basis in the accounting 
literature or the law.
---------------------------------------------------------------------------

    \2\ As used in this SAB, ``misstatement'' or ``omission'' refers 
to a financial statement assertion that would not be in conformity 
with GAAP.
---------------------------------------------------------------------------

    The use of a percentage as a numerical threshold, such as 5%, may 
provide the basis for a preliminary assumption that--without 
considering all relevant circumstances--a deviation of less than the 
specified percentage with respect to a particular item on the 
registrant's financial statements is unlikely to be material. The staff 
has no objection to such a ``rule of thumb'' as an initial step in 
assessing materiality. But quantifying, in percentage terms, the 
magnitude of a misstatement is only the beginning of an analysis of 
materiality; it cannot appropriately be used as a substitute for a full 
analysis of all relevant considerations.
    Materiality concerns the significance of an item to users of a 
registrant's financial statements. A matter is ``material'' if there is 
a substantial likelihood that a reasonable person would consider it 
important. In its Statement of Financial Accounting Concepts No. 2, the 
FASB stated the essence of the concept of materiality as follows:

    The omission or misstatement of an item in a financial report is 
material if, in the light of surrounding circumstances, the 
magnitude of the item is such that it is probable that the judgment 
of a reasonable person relying upon the report would have been 
changed or influenced by the inclusion or correction of the item.\3\
---------------------------------------------------------------------------

    \3\ FASB, Statement of Financial Accounting Concepts No. 2, 
Qualitative Characteristics of Accounting Information (``Concepts 
Statement No. 2''), para. 132 (1980). See also Concepts Statement 
No. 2, Glossary of Terms--Materiality.

     This formulation in the accounting literature is in substance 
identical to the formulation used by the courts in interpreting the 
federal securities laws. The Supreme Court has held that a 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.\4\
---------------------------------------------------------------------------

    \4\ TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). 
See also Basic, Inc. v. Levinson, 485 U.S. 224 (1988). As the 
Supreme Court has noted, determinations of materiality require 
``delicate assessments of the inferences a `reasonable shareholder' 
would draw from a given set of facts and the significance of those 
inferences to him. . . . .'' TSC Industries, 426 U.S. at 450.

    Under the governing principles, an assessment of materiality 
requires that one views the facts in the context of the ``surrounding 
circumstances,'' as the accounting literature puts it, or the ``total 
mix'' of information, in the words of the Supreme Court. In the context 
of a misstatement of a financial statement item, while the ``total 
mix'' includes the size in numerical or percentage terms of the 
misstatement, it also includes the factual context in which the user of 
financial statements would view the financial statement item. The 
shorthand in the accounting and auditing literature for this analysis 
is that financial management and the auditor must consider both 
``quantitative'' and ``qualitative'' factors in assessing an item's 
materiality.\5\ Court decisions, Commission rules and enforcement 
actions, and accounting and auditing literature \6\ have all considered 
``qualitative'' factors in various contexts.
---------------------------------------------------------------------------

    \5\ See, e.g., Concepts Statement No. 2, Paras. 123-124; AU 
Sec. 312.10 (`` . . . materiality judgments are made in light of 
surrounding circumstances and necessarily involve both quantitative 
and qualitative considerations.''); AU Sec. 312.34 (``Qualitative 
considerations also influence the auditor in reaching a conclusion 
as to whether misstatements are material.''). As used in the 
accounting literature and in this SAB, ``qualitative'' materiality 
refers to the surrounding circumstances that inform an investor's 
evaluation of financial statement entries. Whether events may be 
material to investors for non-financial reasons is a matter not 
addressed by this SAB.
    \6\ See, e.g., Rule 1-02(o) of Regulation S-X, 17 CFR 210.1-
02(o), Rule 405 of Regulation C, 17 CFR 230.405, and Rule 12b-2, 17 
CFR 240.12b-2; AU Sec. Sec. 312.10--.11, 317.13, 411.04 n. 1, and 
508.36; In re Kidder Peabody Securities Litigation, 10 F. Supp. 2d 
398 (S.D.N.Y. 1998); Parnes v. Gateway 2000, Inc., 122 F.3d 539 (8th 
Cir. 1997); In re Westinghouse Securities Litigation, 90 F.3d 696 
(3d Cir. 1996); In the Matter of W.R. Grace & Co., Accounting and 
Auditing Enforcement Release No. (``AAER'') 1140 (June 30, 1999); In 
the Matter of Eugene Gaughan, AAER 1141 (June 30, 1999); In the 
Matter of Thomas Scanlon, AAER 1142 (June 30, 1999); and In re 
Sensormatic Electronics Corporation, Sec. Act Rel. No. 7518 (March 
25, 1998).
---------------------------------------------------------------------------

    The FASB has long emphasized that materiality cannot be reduced to 
a numerical formula. In its Concepts Statement No. 2, the FASB noted 
that some had urged it to promulgate quantitative materiality guides 
for use in a variety of situations. The FASB rejected such an approach 
as representing only a ``minority view,'' stating--

    The predominant view is that materiality judgments can properly 
be made only by those who have all the facts. The Board's present 
position is that no general standards of materiality could be 
formulated to take into account all the considerations that enter 
into an experienced human judgment.\7\
---------------------------------------------------------------------------

    \7\ Concepts Statement No. 2, para. 131 (1980).
---------------------------------------------------------------------------

    The FASB noted that, in certain limited circumstances, the 
Commission and other authoritative bodies had issued quantitative 
materiality guidance, citing as examples guidelines ranging from one to 
ten percent with

[[Page 45152]]

respect to a variety of disclosures.\8\ And it took account of 
contradictory studies, one showing a lack of uniformity among auditors 
on materiality judgments, and another suggesting widespread use of a 
``rule of thumb'' of five to ten percent of net income.\9\ The FASB 
also considered whether an evaluation of materiality could be based 
solely on anticipating the market's reaction to accounting 
information.\10\
---------------------------------------------------------------------------

    \8\ Concepts Statement No. 2, Paras. 131 and 166.
    \9\ Concepts Statement No. 2, para. 167.
    \10\ Concepts Statement No. 2, Paras. 168-69.
---------------------------------------------------------------------------

    The FASB rejected a formulaic approach to discharging ``the onerous 
duty of making materiality decisions'' \11\ in favor of an approach 
that takes into account all the relevant considerations. In so doing, 
it made clear that--
---------------------------------------------------------------------------

    \11\ Concepts Statement No. 2, para. 170.

    [M]agnitude by itself, without regard to the nature of the item 
and the circumstances in which the judgment has to be made, will not 
generally be a sufficient basis for a materiality judgment.\12\
---------------------------------------------------------------------------

    \12\ Concepts Statement No. 2, Paras. 125.

    Evaluation of materiality requires a registrant and its auditor to 
consider all the relevant circumstances, and the staff believes that 
there are numerous circumstances in which misstatements below 5% could 
well be material. Qualitative factors may cause misstatements of 
quantitatively small amounts to be material; as stated in the auditing 
---------------------------------------------------------------------------
literature:

    As a result of the interaction of quantitative and qualitative 
considerations in materiality judgments, misstatements of relatively 
small amounts that come to the auditor's attention could have a 
material effect on the financial statements.\13\
---------------------------------------------------------------------------

    \13\AU Sec. 312.11.

    Among the considerations that may well render material a 
---------------------------------------------------------------------------
quantitatively small misstatement of a financial statement item are--

     Whether the misstatement arises from an item capable of 
precise measurement or whether it arises from an estimate and, if 
so, the degree of imprecision inherent in the estimate \14\
---------------------------------------------------------------------------

    \14\ As stated in Concepts Statement No. 2, Paras. 130:
    Another factor in materiality judgments is the degree of 
precision that is attainable in estimating the judgment item. The 
amount of deviation that is considered immaterial may increase as 
the attainable degree of precision decreases. For example, accounts 
payable usually can be estimated more accurately than can contingent 
liabilities arising from litigation or threats of it, and a 
deviation considered to be material in the first case may be quite 
trivial in the second.
    This SAB is not intended to change current law or guidance in 
the accounting literature regarding accounting estimates. See, e.g., 
Accounting Principles Board Opinion No. 20, Accounting Changes 
Paras. 10, 11, 31-33 (July 1971).
---------------------------------------------------------------------------

     Whether the misstatement masks a change in earnings or 
other trends.
     Whether the misstatement hides a failure to meet 
analysts' consensus expectations for the enterprise.
     Whether the misstatement changes a loss into income or 
vice versa.
     Whether the misstatement concerns a segment or other 
portion of the registrant's business that has been identified as 
playing a significant role in the registrant's operations or 
profitability.
     Whether the misstatement affects the registrant's 
compliance with regulatory requirements.
     Whether the misstatement affects the registrant's 
compliance with loan covenants or other contractual requirements.
     Whether the misstatement has the effect of increasing 
management's compensation--for example, by satisfying requirements 
for the award of bonuses or other forms of incentive compensation.
     Whether the misstatement involves concealment of an 
unlawful transaction.

    This is not an exhaustive list of the circumstances that may affect 
the materiality of a quantitatively small misstatement.\15\ Among other 
factors, the demonstrated volatility of the price of a registrant's 
securities in response to certain types of disclosures may provide 
guidance as to whether investors regard quantitatively small 
misstatements as material. Consideration of potential market reaction 
to disclosure of a misstatement is by itself ``too blunt an instrument 
to be depended on'' in considering whether a fact is material.\16\ 
When, however, management or the independent auditor expects (based, 
for example, on a pattern of market performance) that a known 
misstatement may result in a significant positive or negative market 
reaction, that expected reaction should be taken into account when 
considering whether a misstatement is material.\17\
---------------------------------------------------------------------------

    \15\ The staff understands that the Big Five Audit Materiality 
Task Force (``Task Force'') was convened in March of 1998 and has 
made recommendations to the Auditing Standards Board including 
suggestions regarding communications with audit committees about 
unadjusted misstatements. See generally Big Five Audit Materiality 
Task Force, ``Materiality in a Financial Statement Audit--
Considering Qualitative Factors When Evaluating Audit Findings'' 
(August 1998). The Task Force memorandum is available at 
www.aicpa.org.
    \16\ See Concepts Statement No. 2, para. 169.
    \17\ If management does not expect a significant market 
reaction, a misstatement still may be material and should be 
evaluated under the criteria discussed in this SAB.
---------------------------------------------------------------------------

    For the reasons noted above, the staff believes that a registrant 
and the auditors of its financial statements should not assume that 
even small intentional misstatements in financial statements, for 
example those pursuant to actions to ``manage'' earnings, are 
immaterial.\18\ While the intent of management does not render a 
misstatement material, it may provide significant evidence of 
materiality. The evidence may be particularly compelling where 
management has intentionally misstated items in the financial 
statements to ``manage'' reported earnings. In that instance, it 
presumably has done so believing that the resulting amounts and trends 
would be significant to users of the registrant's financial 
statements.\19\ The staff believes that investors generally would 
regard as significant a management practice to over- or under-state 
earnings up to an amount just short of a percentage threshold in order 
to ``manage'' earnings. Investors presumably also would regard as 
significant an accounting practice that, in essence, rendered all 
earnings figures subject to a management-directed margin of 
misstatement.
---------------------------------------------------------------------------

    \18\ Intentional management of earnings and intentional 
misstatements, as used in this SAB, do not include insignificant 
errors and omissions that may occur in systems and recurring 
processes in the normal course of business. See notes 38 and 50 
infra.
    \19\ Assessments of materiality should occur not only at year-
end, but also during the preparation of each quarterly or interim 
financial statement. See, e.g., In the Matter of Venator Group, 
Inc., AAER 1049 (June 29, 1998).
---------------------------------------------------------------------------

    The materiality of a misstatement may turn on where it appears in 
the financial statements. For example, a misstatement may involve a 
segment of the registrant's operations. In that instance, in assessing 
materiality of a misstatement to the financial statements taken as a 
whole, registrants and their auditors should consider not only the size 
of the misstatement but also the significance of the segment 
information to the financial statements taken as a whole.\20\ ``A 
misstatement of the revenue and operating profit of a relatively small 
segment that is represented by management to be important to the future 
profitability of the entity'' \21\ is more likely to be material to 
investors than a misstatement in a segment that management has not 
identified as especially important. In assessing the materiality of 
misstatements in segment information--as with materiality generally--

    \20\ See, e.g., In the Matter of W.R. Grace & Co., AAER 1140 
(June 30, 1999).
    \21\ AUI Sec. 326.33.
---------------------------------------------------------------------------

    situations may arise in practice where the auditor will conclude 
that a matter relating to segment information is qualitatively 
material even though, in his or her judgment, it is quantitatively 
immaterial to the financial statements taken as a whole.\22\
---------------------------------------------------------------------------

    \22\ Id.

---------------------------------------------------------------------------

[[Page 45153]]

Aggregating and Netting Misstatements

    In determining whether multiple misstatements cause the financial 
statements to be materially misstated, registrants and the auditors of 
their financial statements should consider each misstatement separately 
and the aggregate effect of all misstatements.\23\ A registrant and its 
auditor should evaluate misstatements in light of quantitative and 
qualitative factors and ``consider whether, in relation to individual 
line item amounts, subtotals, or totals in the financial statements, 
they materially misstate the financial statements taken as a whole.'' 
\24\ This requires consideration of--

    \23\ The auditing literature notes that the ``concept of 
materiality recognizes that some matters, either individually or in 
the aggregate, are important for fair presentation of financial 
statements in conformity with generally accepted accounting 
principles.'' AU Sec. 312.03. See also AU Sec. 312.04.
    \24\ AU Sec. 312.34. Quantitative materiality assessments often 
are made by comparing adjustments to revenues, gross profit, pretax 
and net income, total assets, stockholders' equity, or individual 
line items in the financial statements. The particular items in the 
financial statements to be considered as a basis for the materiality 
determination depend on the proposed adjustment to be made and other 
factors, such as those identified in this SAB. For example, an 
adjustment to inventory that is immaterial to pretax income or net 
income may be material to the financial statements because it may 
affect a working capital ratio or cause the registrant to be in 
default of loan covenants.

    the significance of an item to a particular entity (for example, 
inventories to a manufacturing company), the pervasiveness of the 
misstatement (such as whether it affects the presentation of 
numerous financial statement items), and the effect of the 
---------------------------------------------------------------------------
misstatement on the financial statements taken as a whole. . . .\25\

    \25\ AU Sec. 508.36.

    Registrants and their auditors first should consider whether each 
misstatement is material, irrespective of its effect when combined with 
other misstatements. The literature notes that the analysis should 
consider whether the misstatement of ``individual amounts'' causes a 
material misstatement of the financial statements taken as a whole. As 
with materiality generally, this analysis requires consideration of 
both quantitative and qualitative factors.
    If the misstatement of an individual amount causes the financial 
statements as a whole to be materially misstated, that effect cannot be 
eliminated by other misstatements whose effect may be to diminish the 
impact of the misstatement on other financial statement items. To take 
an obvious example, if a registrant's revenues are a material financial 
statement item and if they are materially overstated, the financial 
statements taken as a whole will be materially misleading even if the 
effect on earnings is completely offset by an equivalent overstatement 
of expenses.
    Even though a misstatement of an individual amount may not cause 
the financial statements taken as a whole to be materially misstated, 
it may nonetheless, when aggregated with other misstatements, render 
the financial statements taken as a whole to be materially misleading. 
Registrants and the auditors of their financial statements accordingly 
should consider the effect of the misstatement on subtotals or totals. 
The auditor should aggregate all misstatements that affect each 
subtotal or total and consider whether the misstatements in the 
aggregate affect the subtotal or total in a way that causes the 
registrant's financial statements taken as a whole to be materially 
misleading.\26\
---------------------------------------------------------------------------

    \26\ AU Sec. 312.34.
---------------------------------------------------------------------------

    The staff believes that, in considering the aggregate effect of 
multiple misstatements on a subtotal or total, registrants and the 
auditors of their financial statements should exercise particular care 
when considering whether to offset (or the appropriateness of 
offsetting) a misstatement of an estimated amount with a misstatement 
of an item capable of precise measurement. As noted above, assessments 
of materiality should never be purely mechanical; given the imprecision 
inherent in estimates, there is by definition a corresponding 
imprecision in the aggregation of misstatements involving estimates 
with those that do not involve an estimate.
    Registrants and auditors also should consider the effect of 
misstatements from prior periods on the current financial statements. 
For example, the auditing literature states,

    Matters underlying adjustments proposed by the auditor but not 
recorded by the entity could potentially cause future financial 
statements to be materially misstated, even though the auditor has 
concluded that the adjustments are not material to the current 
financial statements.\27\

    \27\ AU Sec. 380.09.

    This may be particularly the case where immaterial misstatements 
recur in several years and the cumulative effect becomes material in 
the current year.
2. Immaterial Misstatements That are Intentional
    Facts: A registrant's management intentionally has made adjustments 
to various financial statement items in a manner inconsistent with 
GAAP. In each accounting period in which such actions were taken, none 
of the individual adjustments is by itself material, nor is the 
aggregate effect on the financial statements taken as a whole material 
for the period. The registrant's earnings ``management'' has been 
effected at the direction or acquiescence of management in the belief 
that any deviations from GAAP have been immaterial and that accordingly 
the accounting is permissible.
    Question: In the staff's view, may a registrant make intentional 
immaterial misstatements in its financial statements?
    Interpretive Response: No. In certain circumstances, intentional 
immaterial misstatements are unlawful.

Considerations of the Books and Records Provisions Under the Exchange 
Act

    Even if misstatements are immaterial,28 registrants must 
comply with Sections 13(b)(2)-(7) of the Securities Exchange Act of 
1934 (the ``Exchange Act'').29 Under these provisions, each 
registrant with securities registered pursuant to Section 12 of the 
Exchange Act,30 or required to file reports pursuant to 
Section 15(d),31 must make and keep books, records, and 
accounts, which, in reasonable detail, accurately and fairly reflect 
the transactions and dispositions of assets of the registrant and must 
maintain internal accounting controls that are sufficient to provide 
reasonable assurances that, among other things, transactions are 
recorded as necessary to permit the preparation of financial statements 
in conformity with GAAP.32 In this context, determinations 
of what constitutes ``reasonable assurance'' and ``reasonable detail'' 
are based not on a ``materiality'' analysis but on the level

[[Page 45154]]

of detail and degree of assurance that would satisfy prudent officials 
in the conduct of their own affairs.33 Accordingly, failure 
to record accurately immaterial items, in some instances, may result in 
violations of the securities laws.
---------------------------------------------------------------------------

    \28\ FASB Statements of Financial Accounting Standards 
(``Standards'' or ``Statements'') generally provide that ``[t]he 
provisions of this Statement need not be applied to immaterial 
items.'' This SAB is consistent with that provision of the 
Statements. In theory, this language is subject to the 
interpretation that the registrant is free intentionally to set 
forth immaterial items in financial statements in a manner that 
plainly would be contrary to GAAP if the misstatement were material. 
The staff believes that the FASB did not intend this result.
    \29\ 15 U.S.C. Sec. Sec. 78m(b)(2)-(7).
    \30\ 15 U.S.C. Sec. 78l.
    \31\ 15 U.S.C. Sec. 78o(d).
    \32\ Criminal liability may be imposed if a person knowingly 
circumvents or knowingly fails to implement a system of internal 
accounting controls or knowingly falsifies books, records or 
accounts. 15 U.S.C. 78m(4) and (5). See also Rule 13b2-1 under the 
Exchange Act, 17 CFR 240.13b2-1, which states, ``No person shall, 
directly or indirectly, falsify or cause to be falsified, any book, 
record or account subject to Section 13(b)(2)(A) of the Securities 
Exchange Act.''
    \33\ 15 U.S.C. Sec. 78m(b)(7). The books and records provisions 
of section 13(b) of the Exchange Act originally were passed as part 
of the Foreign Corrupt Practices Act (``FCPA''). In the conference 
committee report regarding the 1988 amendments to the FCPA, the 
committee stated, ``The conference committee adopted the prudent man 
qualification in order to clarify that the current standard does not 
connote an unrealistic degree of exactitude or precision. The 
concept of reasonableness of necessity contemplates the weighing of 
a number of relevant factors, including the costs of compliance.'' 
Cong. Rec. H2116 (daily ed. April 20, 1988).
---------------------------------------------------------------------------

    The staff recognizes that there is limited authoritative guidance 
34 regarding the ``reasonableness'' standard in Section 
13(b)(2) of the Exchange Act. A principal statement of the Commission's 
policy in this area is set forth in an address given in 1981 by then 
Chairman Harold M. Williams.35 In his address, Chairman 
Williams noted that, like materiality, ``reasonableness'' is not an 
``absolute standard of exactitude for corporate records.'' 
36 Unlike materiality, however, ``reasonableness'' is not 
solely a measure of the significance of a financial statement item to 
investors. ``Reasonableness,'' in this context, reflects a judgment as 
to whether an issuer's failure to correct a known misstatement 
implicates the purposes underlying the accounting provisions of 
Sections 13(b)(2)-(7) of the Exchange Act.37
---------------------------------------------------------------------------

    \34\ So far as the staff is aware, there is only one judicial 
decision that discusses Section 13(b)(2) of the Exchange Act in any 
detail, SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724 
(N.D. Ga. 1983), and the courts generally have found that no private 
right of action exists under the accounting and books and records 
provisions of the Exchange Act. See e.g., Lamb v. Phillip Morris 
Inc., 915 F.2d 1024 (6th Cir. 1990) and JS Service Center 
Corporation v. General Electric Technical Services Company, 937 F. 
Supp. 216 (S.D.N.Y. 1996).
    \35\ The Commission adopted the address as a formal statement of 
policy in Securities Exchange Act Release No. 17500 (January 29, 
1981), 46 FR 11544 (February 9, 1981), 21 SEC Docket 1466 (February 
10, 1981).
    \36\ Id. at 46 FR 11546.
    \37\ Id.
---------------------------------------------------------------------------

    In assessing whether a misstatement results in a violation of a 
registrant's obligation to keep books and records that are accurate 
``in reasonable detail,'' registrants and their auditors should 
consider, in addition to the factors discussed above concerning an 
evaluation of a misstatement's potential materiality, the factors set 
forth below.
     The significance of the misstatement. Though the staff 
does not believe that registrants need to make finely calibrated 
determinations of significance with respect to immaterial items, 
plainly it is ``reasonable'' to treat misstatements whose effects are 
clearly inconsequential differently than more significant ones.
     How the misstatement arose. It is unlikely that it is ever 
``reasonable'' for registrants to record misstatements or not to 
correct known misstatements--even immaterial ones--as part of an 
ongoing effort directed by or known to senior management for the 
purposes of ``managing'' earnings. On the other hand, insignificant 
misstatements that arise from the operation of systems or recurring 
processes in the normal course of business generally will not cause a 
registrant's books to be inaccurate ``in reasonable detail.'' 
38
---------------------------------------------------------------------------

    \38\ For example, the conference report regarding the 1988 
amendments to the FCPA stated, ``The Conferees intend to codify 
current Securities and Exchange Commission (SEC) enforcement policy 
that penalties not be imposed for insignificant or technical 
infractions or inadvertent conduct. The amendment adopted by the 
Conferees [Section 13(b)(4)] accomplishes this by providing that 
criminal penalties shall not be imposed for failing to comply with 
the FCPA's books and records or accounting provisions. This 
provision [Section 13(b)(5)] is meant to ensure that criminal 
penalties would be imposed where acts of commission or omission in 
keeping books or records or administering accounting controls have 
the purpose of falsifying books, records or accounts, or of 
circumventing the accounting controls set forth in the Act. This 
would include the deliberate falsification of books and records and 
other conduct calculated to evade the internal accounting controls 
requirement.'' Cong. Rec. H2115 (daily ed. April 20, 1988).
---------------------------------------------------------------------------

     The cost of correcting the misstatement. The books and 
records provisions of the Exchange Act do not require registrants to 
make major expenditures to correct small misstatements.39 
Conversely, where there is little cost or delay involved in correcting 
a misstatement, failing to do so is unlikely to be ``reasonable.''
---------------------------------------------------------------------------

    \39\ As Chairman Williams noted with respect to the internal 
control provisions of the FCPA, ``[t]housands of dollars ordinarily 
should not be spent conserving hundreds.'' 46 FR 11546.
---------------------------------------------------------------------------

     The clarity of authoritative accounting guidance with 
respect to the misstatement. Where reasonable minds may differ about 
the appropriate accounting treatment of a financial statement item, a 
failure to correct it may not render the registrant's financial 
statements inaccurate ``in reasonable detail.'' Where, however, there 
is little ground for reasonable disagreement, the case for leaving a 
misstatement uncorrected is correspondingly weaker.
    There may be other indicators of ``reasonableness'' that 
registrants and their auditors may ordinarily consider. Because the 
judgment is not mechanical, the staff will be inclined to continue to 
defer to judgments that ``allow a business, acting in good faith, to 
comply with the Act's accounting provisions in an innovative and cost-
effective way.'' 40
---------------------------------------------------------------------------

    \40\ Id., at 11547.
---------------------------------------------------------------------------

The Auditor's Response to Intentional Misstatements

    Section 10A(b) of the Exchange Act requires auditors to take 
certain actions upon discovery of an ``illegal act.'' 41 The 
statute specifies that these obligations are triggered ``whether or not 
[the illegal acts are] perceived to have a material effect on the 
financial statements of the issuer. . . .'' Among other things, Section 
10A(b)(1) requires the auditor to inform the appropriate level of 
management of an illegal act (unless clearly inconsequential) and 
assure that the registrant's audit committee is ``adequately informed'' 
with respect to the illegal act.
---------------------------------------------------------------------------

    \41\ Section 10A(f) defines, for purposes of Section 10A, an 
illegal act as ``an act or omission that violates any law, or any 
rule or regulation having the force of law.'' This is broader than 
the definition of an ``illegal act'' in AU Sec. 317.02, which 
states, ``Illegal acts'' by clients do not include personal 
misconduct by the entity's personnel unrelated to their business 
activities.''
---------------------------------------------------------------------------

    As noted, an intentional misstatement of immaterial items in a 
registrant's financial statements may violate Section 13(b)(2) of the 
Exchange Act and thus be an illegal act. When such a violation occurs, 
an auditor must take steps to see that the registrant's audit committee 
is ``adequately informed'' about the illegal act. Because Section 
10A(b)(1) is triggered regardless of whether an illegal act has a 
material effect on the registrant's financial statements, where the 
illegal act consists of a misstatement in the registrant's financial 
statements, the auditor will be required to report that illegal act to 
the audit committee irrespective of any ``netting'' of the 
misstatements with other financial statement items.
    The requirements of Section 10A echo the auditing literature. See, 
for example, Statement on Auditing Standards No. (``SAS'') 54, 
``Illegal Acts by Clients,'' and SAS 82, ``Consideration of Fraud in a 
Financial Statement Audit.'' Pursuant to paragraph 38 of SAS 82, if the 
auditor determines there is evidence that fraud may exist, the auditor 
must discuss the matter with the appropriate level of management. The 
auditor must report directly to the audit committee fraud involving 
senior management and fraud that causes a material misstatement of the 
financial statements. Paragraph 4 of SAS 82 states that ``misstatements 
arising from fraudulent financial reporting are intentional 
misstatements or omissions of amounts or disclosures

[[Page 45155]]

in financial statements to deceive financial statement users.'' \42\ 
SAS 82 further states that fraudulent financial reporting may involve 
falsification or alteration of accounting records; misrepresenting or 
omitting events, transactions or other information in the financial 
statements; and the intentional misapplication of accounting principles 
relating to amounts, classifications, the manner of presentation, or 
disclosures in the financial statements.\43\ The clear implication of 
SAS 82 is that immaterial misstatements may be fraudulent financial 
reporting.\44\
---------------------------------------------------------------------------

    \42\ AU Sec. 316.04. See also AU Sec. 316.03. An unintentional 
illegal act triggers the same procedures and considerations by the 
auditor as a fraudulent misstatement if the illegal act has a direct 
and material effect on the financial statements. See AU 
Sec. Sec. 110 n. 1, 316 n. 1, 317.05 and 317.07. Although 
distinguishing between intentional and unintentional misstatements 
is often difficult, the auditor must plan and perform the audit to 
obtain reasonable assurance that the financial statements are free 
of material misstatements in either case. See AU Sec. 316 note 3.
    \43\ AU Sec. 316.04. Although the auditor is not required to 
plan or perform the audit to detect misstatements that are 
immaterial to the financial statements, SAS 82 requires the auditor 
to evaluate several fraud ``risk factors'' that may bring such 
misstatements to his or her attention. For example, an analysis of 
fraud risk factors under SAS 82 must include, among other things, 
consideration of management's interest in maintaining or increasing 
the registrant's stock price or earnings trend through the use of 
unusually aggressive accounting practices, whether management has a 
practice of committing to analysts or others that it will achieve 
unduly aggressive or clearly unrealistic forecasts, and the 
existence of assets, liabilities, revenues, or expenses based on 
significant estimates that involve unusually subjective judgments or 
uncertainties. See AU Sec. Sec. 316.17a and .17c.
    \44\ AU Secs. 316.34 and 316.35, in requiring the auditor to 
consider whether fraudulent misstatements are material, and in 
requiring differing responses depending on whether the misstatement 
is material, make clear that fraud can involve immaterial 
misstatements. Indeed, a misstatement can be ``inconsequential'' and 
still involve fraud.
    Under SAS 82, assessing whether misstatements due to fraud are 
material to the financial statements is a ``cumulative process'' 
that should occur both during and at the completion of the audit. 
SAS 82 further states that this accumulation is primarily a 
``qualitative matter'' based on the auditor's judgment. AU 
Sec. 316.33. The staff believes that in making these assessments, 
management and auditors should refer to the discussion in Part 1 of 
this SAB.
---------------------------------------------------------------------------

    Auditors that learn of intentional misstatements may also be 
required to (1) re-evaluate the degree of audit risk involved in the 
audit engagement, (2) determine whether to revise the nature, timing, 
and extent of audit procedures accordingly, and (3) consider whether to 
resign.\45\
---------------------------------------------------------------------------

    \45\ AU Secs. 316.34 and 316.36. Auditors should document their 
determinations in accordance with AU Sec. Sec. 316.37, 319.57, 339, 
and other appropriate sections.
---------------------------------------------------------------------------

    Intentional misstatements also may signal the existence of 
reportable conditions or material weaknesses in the registrant's system 
of internal accounting control designed to detect and deter improper 
accounting and financial reporting.\46\ As stated by the National 
Commission on Fraudulent Financial Reporting, also known as the 
Treadway Commission, in its 1987 report,
---------------------------------------------------------------------------

    \46\ See, e.g., AU Sec. 316.39.

    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 by management is lax, 
fraudulent financial reporting is more likely to occur.\47\
---------------------------------------------------------------------------

    \47\ Report of the National Commission on Fraudulent Financial 
Reporting at 32 (October 1987). See also Report and Recommendations 
of the Blue Ribbon Committee on Improving the Effectiveness of 
Corporate Audit Committees (February 8, 1999).

    An auditor is required to report to a registrant's audit committee 
any reportable conditions or material weaknesses in a registrant's 
system of internal accounting control that the auditor discovers in the 
course of the examination of the registrant's financial statements.\48\
---------------------------------------------------------------------------

    \48\ AU Sec. 325.02. See also AU Sec. 380.09, which, in 
discussing matters to be communicated by the auditor to the audit 
committee, states, ``The auditor should inform the audit committee 
about adjustments arising from the audit that could, in his 
judgment, either individually or in the aggregate, have a 
significant effect on the entity's financial reporting process. For 
purposes of this section, an audit adjustment, whether or not 
recorded by the entity, is a proposed correction of the financial 
statements. . . .''
---------------------------------------------------------------------------

GAAP Precedence Over Industry Practice

    Some have argued to the staff that registrants should be permitted 
to follow an industry accounting practice even though that practice is 
inconsistent with authoritative accounting literature. This situation 
might occur if a practice is developed when there are few transactions 
and the accounting results are clearly inconsequential, and that 
practice never changes despite a subsequent growth in the number or 
materiality of such transactions. The staff disagrees with this 
argument. Authoritative literature takes precedence over industry 
practice that is contrary to GAAP.\49\
---------------------------------------------------------------------------

    \49\ See AU Sec. 411.05.
---------------------------------------------------------------------------

General Comments

    This SAB is not intended to change current law or guidance in the 
accounting or auditing literature.\50\ This SAB and the authoritative 
accounting literature cannot specifically address all of the novel and 
complex business transactions and events that may occur. Accordingly, 
registrants may account for, and make disclosures about, these 
transactions and events based on analogies to similar situations or 
other factors. The staff may not, however, always be persuaded that a 
registrant's determination is the most appropriate under the 
circumstances. When disagreements occur after a transaction or an event 
has been reported, the consequences may be severe for registrants, 
auditors, and, most importantly, the users of financial statements who 
have a right to expect consistent accounting and reporting for, and 
disclosure of, similar transactions and events. The staff, therefore, 
encourages registrants and auditors to discuss on a timely basis with 
the staff proposed accounting treatments for, or disclosures about, 
transactions or events that are not specifically covered by the 
existing accounting literature.
---------------------------------------------------------------------------

    \50\ The FASB Discussion Memorandum, Criteria for Determining 
Materiality, states that the financial accounting and reporting 
process considers that ``a great deal of the time might be spent 
during the accounting process considering insignificant matters . . 
. . If presentations of financial information are to be prepared 
economically on a timely basis and presented in a concise 
intelligible form, the concept of materiality is crucial.''
    This SAB is not intended to require that misstatements arising 
from insignificant errors and omissions (individually and in the 
aggregate) arising from the normal recurring accounting close 
processes, such as a clerical error or an adjustment for a missed 
accounts payable invoice, always be corrected, even if the error is 
identified in the audit process and known to management. Management 
and the auditor would need to consider the various factors described 
elsewhere in this SAB in assessing whether such misstatements are 
material, need to be corrected to comply with the FCPA, or trigger 
procedures under Section 10A of the Exchange Act. Because this SAB 
does not change current law or guidance in the accounting or 
auditing literature, adherence to the principles described in this 
SAB should not raise the costs associated with recordkeeping or with 
audits of financial statements.

[FR Doc. 99-21484 Filed 8-18-99; 8:45 am]
BILLING CODE 8010-01-P