Assessing the materiality of financial misstatements.

Author:Park, James J.
  1. INTRODUCTION II. GAAP AND MATERIALITY A. Financial Statements and GAAP B. Materiality. The Shift from a Quantitative to Qualitative Standard C. Mapping the Liability Framework 1. Liability Under a Quantitative Standard 2. Liability Under a Qualitative Standard 3. Effect on Pre-Trial Motions 4. Summary III. VALUING FINANCIAL MISSTATEMENTS A. Valuation Methods 1. Market Price 2. Fundamental Analysis B. The Case for Assessing Financial Misstatements Using Fundamental Analysis IV. PERSISTENCE A. Illustration Using Fundamental Analysis 1. Persistent Misstatements a. Earnings Inflation b. Hiding Earnings Decline c. One-Time Charge to Earnings 2. Isolated Misstatements a. Earnings Smoothing b. One-Time Misstatement B. Objections 1. Market Psychology and Isolated Misstatements 2. Managerial Abuse C. Persistence as a Presumption in Assessing the Materiality of Financial Misstatements V. TARGETED VICARIOUS LIABILITY FOR FINANCIAL MISSTATEMENTS A. Distinguishing Types of Accounting Fraud 1. Large Scale Accounting Fraud 2. Small Scale Accounting Fraud B. The Vicarious Liability Debate 1. Criticisms of Vicarious Liability 2. Defending Vicarious Liability for Financial Misstatements C. A Refined Vicarious Liability Standard 1. Companies a. Quantitatively Large Misstatements b. Quantitatively Small Misstatements 2. Individual Managers 3. Benefits VI. IMPLEMENTATION VII. CONCLUSION I. INTRODUCTION

    The regulation of financial reporting by public companies is principally shaped by two considerations: accuracy and cost. If financial reports are inaccurate, stock prices may not reflect the underlying economic value of companies. But because of the complexity of public companies, as well as the ambiguity of the generally accepted accounting principles (GAAP) with which financial statements must conform, it is expensive to ensure that the accounting for every transaction is appropriate.

    The law attempts to balance such concerns by making securities fraud liability contingent on a showing of materiality. (1) A financial misstatement can only trigger liability if it is material, or important to a reasonable investor. (2) The materiality standard should thus play a crucial role in screening out trivial from substantial financial misstatements, making the potential liability companies face for inaccuracies in their financial statements manageable. (3) But there is little consensus as to what a reasonable investor would consider important with respect to financial misstatements. The current approach, which has been described as qualitative, considers a wide range of factors and has been criticized as nebulous. (4) On February 8, 2008, a Securities and Exchange Commission (SEC) Commissioner pointed out the need to "clear up [the issue of materiality] with the full input of the investor, legal, accounting, academic, and business communities." (5) While numerous proposals for reforming securities class actions have recently been made, none has focused on clarifying the materiality standard. (6) This Article attempts to provide a clearer and more rational basis for assessing materiality with respect to financial misstatements. (7)

    At the outset, it is important to distinguish between financial misstatements, which are the focus of this Article, and nonfinancial misstatements. This Article's analysis is limited to financial misstatements, or misstatements in a company's financial reports. Though financial and nonfinancial misstatements are generally governed by the same reasonable investor standard, financial misstatements are more susceptible to scrutiny through quantitative benchmarks than nonfinancial misstatements.

    For a time, materiality with respect to financial misstatements was arguably defined by a rule-like quantitative standard. (8) If a financial misstatement had an impact on net income below a certain threshold--often five percent--it was presumed to be immaterial. (9) The obvious problem with a quantitative standard is that it allowed for a significant amount of earnings manipulation. Aggressive companies could tweak their earnings at will to meet market expectations. As long as a financial misstatement was below the five percent quantitative threshold, the company would not be in violation of the securities laws.

    In 1999, the SEC responded to such earnings manipulation by releasing Staff Accounting Bulletin No. 99 (SAB No. 99), which asserted that a principle-like qualitative standard governed financial statements. (10) While SAB No. 99 used a term--qualitative materiality--that had earlier been used to describe controversial efforts to require disclosures relating to managerial ethics, it redefined that term to focus on financial misstatements. Under a qualitative standard, a financial misstatement under five percent can still be material if it meets certain qualitative criteria, such as allowing the company to meet earnings targets or affecting management compensation. The qualitative standard requires an assessment of a wide range of factors, including the subjective motivation for the misstatement, and is directed at the problem of manipulation that results from a rule-like quantitative standard.

    This shift to a qualitative standard has been criticized. One SEC Commissioner asserted: "Anyone who has tried to apply SAB 99 is left with little certainty." (11) A 2006 report by the Committee on Capital Markets Regulation criticized SAB No. 99 as nebulous. (12) Legal commentators have almost uniformly argued that the standard is vague and impossible to implement. (13) Some practitioners have asserted that the standard has increased compliance costs, leading to a significant rise in unnecessary restatements by public companies. (14)

    These critics assume that the solution is to simply reinstate a quantitative standard. (15) For example, the Committee on Capital Markets Regulation recommended that "the SEC revise its guidance on materiality for financial reporting so that scoping materiality is generally defined, as it was traditionally, in terms of a five percent pre-tax income threshold." (16) But the critics of the qualitative standard do little to acknowledge that a quantitative standard can be a blank check for earnings manipulation.

    The current debate myopically focuses on the practicalities of the standard--whether it is easy to apply (favoring the quantitative standard) or allows prevention of earnings manipulation (favoring the qualitative standard). But there has been little discussion about what types of misstatements are most likely to adversely affect the market's ability to value a company. A deeper analysis of what misstatements are most likely to impact the market's assessment of a company's value and the circumstances in which companies should be liable for such financial misstatements is necessary. This Article makes two proposals that will provide a clearer basis for distinguishing between financial misstatements.

    First, the law should mainly consider the persistence of a financial misstatement in determining its materiality. (17) The Article comes to this conclusion by contrasting two valuation methods that can be used to assess whether a financial misstatement is material. The first--market price--simply looks at the market's reaction to the financial misstatement. The second-fundamental analysis--analyzes the way in which the financial misstatement should affect the market's assessment of the discounted cash flows of the company. (18)

    The current qualitative test, as set forth by SAB No. 99, rests on the assumption that even small misstatements can matter because they can prevent large fluctuations in market price. But market fluctuations can be an arbitrary way of assessing whether a misstatement has affected the market's perception of the true value of a stock because such movements may also reflect irrational or noneconomic behavior. While the term reasonable investor can encompass both irrational and rational investors, the case for focusing on the perspective of the rational investor is strongest with respect to financial misstatements. Rational investors, who typically utilize fundamental analysis in assessing value, rely more on the integrity of financial statements than irrational investors.

    An investor valuing a stock through fundamental analysis will be more concerned with persistent misstatements, which consistently inflate earnings or hide significant and lasting declines in a company's earnings power over multiple periods, than isolated misstatements, which hide or smooth temporary earnings shortfalls. A persistent misstatement is more likely to cause the market to significantly overestimate the future cash flows of the company than an isolated misstatement.

    Thus, in assessing the materiality of a misstatement, the law should consider not only the magnitude and motivation of the misstatement, but also its persistence. In securities fraud cases, evidence of a persistent misstatement might create a rebuttable presumption of materiality while evidence that the misstatement is isolated might create a rebuttable presumption of immateriality. While considering persistence may not simplify the materiality analysis in all cases, it will likely give judges a more meaningful basis for determining the materiality of a financial misstatement.

    Second, the quantitative and qualitative standards should be seen as targeting two different problems. The quantitative test prohibits large misstatements that may distort the fundamental value of a company. The qualitative test prohibits unjust enrichment by individuals who might benefit from market fluctuations caused by manipulations. Both standards might be deployed as a way of determining when a company should be vicariously liable for a financial misstatement. In fraud on the market cases, companies would only be vicariously liable for quantitatively large misstatements. Individuals, though, could still be liable for quantitatively small...

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