Exam 7: Earnings Management

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The principle of materiality underscores the concept that some financial transactions are so insignificant that they are not worth measuring and reporting with exact precision.For example,some companies may define an item as material only if it affects earnings by more than 5 percent to 10 percent.This principle allows for some judgment and flexibility in financial reporting.One approach would be to consider items below 5 percent as immaterial; over 10 percent as material; and between 5 and 10 percent dependent on motivation where professional judgment is needed to make that determination.One problem with quantitative measures is a company could manipulate revenues or expenses deliberately,and yet do so within an established maximum percentage of acceptability and claim that the misstatement is not material.
The concept of "materiality" is important in securities law.Whether in a registration statement,or in a filing under the 1934 Act,or in providing information to the trading markets,a company will be liable for any material misstatement,or any material omission of facts necessary to make other statements "not misleading."
Tests of the materiality standard occur periodically in court proceedings.One such case,Matrixx Initiatives,Inc.,v.Siracusano,occurred in 2011.The petitioners had suggested that there should be a bright-line test for materiality in a securities fraud suit.The Supreme Court adopted the position of the SEC-the "total mix" of information as viewed by a reasonable investor standard of materiality articulated earlier in TSC Industries,Inc.v.Northway,Inc.
SOX increased demands on management to prevent and detect material internal control weaknesses.To develop the controls,SOX requires that auditors need to be able to identify key control exceptions and apply a materiality concept to determine the financial impact of such exceptions.In this regard,Vorhies identifies four perspectives to help auditors meet their responsibilities under SOX,including: (1) the actual financial statement misstatement or error,(2) an internal control deficiency caused by the failure in design or operation of a control,(3) a large variance in an accounting estimate compared with the actual determined amount,and (4) financial fraud by management or other employees to enhance a company's reported financial position and operating results.
In Staff Accounting Bulletin (SAB) No.99,the SEC noted that qualitative factors may cause misstatements of quantitatively small amounts to be material.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.
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
•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.
When 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.
The SEC 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.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.The SEC 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.