Assessing the Materiality of Financial Misstatements

Abstract:     
While investors rely on accurate financial reports to value stocks, it can be difficult for companies to interpret vague accounting rules. Federal securities law thus makes liability for financial misstatements contingent on a showing of materiality.

There are two competing approaches to assessing the materiality of a financial misstatement. First, there is a quantitative approach, where a misstatement can only be material if it is above a bright-line threshold - typically 5 percent of net income. Second, there is a qualitative approach, where a misstatement under the 5 percent threshold can still be material if it allows a company to meet its earnings forecasts or results in management bonuses.

In 1999, the SEC adopted the second approach. The qualitative standard has been criticized as unworkable and the SEC has been urged to adopt a 5 percent quantitative standard. This Article argues that neither approach is adequate and offers two proposals.

First, rather than focusing on the size or motivation of a misstatement, courts should mainly consider the persistence of a financial misstatement in assessing its materiality. Persistent misstatements, which inflate earnings or hide significant declines in earnings over multiple reporting periods, are far more likely to affect the market's ability to estimate the future cash flows of the company than isolated misstatements, which smooth or manipulate earnings in one reporting period. Persistent misstatements should be presumed to be material while isolated misstatements should be presumed to be immaterial.

Second, the quantitative and qualitative standards should be seen as addressing two different problems. The quantitative standard is directed at large scale accounting frauds that cause substantial economic disruption. The qualitative standard addresses the problem of individuals who manipulate a company's stock price for personal gain. Both standards could be simultaneously deployed in determining whether a company is vicariously liable for a financial misstatement. Vicarious liability would only attach for quantitatively large misstatements. However, individuals who are unjustly enriched through manipulation could still be liable for qualitative misstatements.

Keywords: accounting fraud, securities fraud, qualitative materiality, quantitative materiality, materiality, financial misstatements, 10b-5, SAB-99, vicarious liability, valuation, fundamental analysis

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