2.15 Materiality of Errors | DART – Deloitte Accounting Research Tool

Examples of SEC Comments

We note your disclosure that the Company identified certain errors in its audited consolidated financial statements . . . and that after evaluating these errors it concluded that they were not material to prior periods, individually or in the aggregate. Provide us with a detailed materiality analysis to support how you determined that the impacted accounts were not quantitatively or qualitatively material to any of the periods presented.
We note your disclosure that you made certain adjustments to [earnings in the fiscal year] to correct errors attributable to prior years which you believe are both quantitatively and qualitatively immaterial to the current period and previously reported periods, including quarterly periods. . . . In order to assist us in understanding your disclosure, please provide us with the following additional information:
- Please provide us with your analysis regarding how you determined these errors were both quantitatively and qualitatively immaterial to the current period and all previously reported periods. Please refer to SAB Topics 1.M. and 1.N. when preparing your response.
- Please tell us the specific nature of these errors, how and why you believe they occurred, and when and how you discovered them. . . .
- Please tell us how you considered the potential impact of these errors on your conclusions regarding the effectiveness of your internal controls over financial reporting and disclosure controls and procedures.
We note your disclosure that you identified and corrected a presentation error related to funds held on behalf of clients in the Consolidated Statements of Cash Flows. Please address the items below.
- Provide us with a full and detailed description of the error, including, but not limited to, a discussion of who identified the error, when, and how, and whether it was the result of any control deficiency.
- In your response to the above bullet, ensure you include a thorough discussion and description of the control deficiency to the extent one was identified, the Company’s evaluation of whether it was a control deficiency, significant deficiency, or material weakness, and any remediation plans. To the extent the Company concluded there was not a control deficiency, tell us why.
- Provide us with your assessment of materiality supporting your conclusion that it was immaterial. Ensure that your response thoroughly addresses both qualitative and quantitative factors as well as an objective assessment of materiality from the perspective of a reasonable investor, including your consideration of guidance in ASC 250, SAB 99, and management’s assessment of the design and effectiveness of internal controls over financial reporting.
- Tell us how far you believe the errors go back and whether you quantified the impact on periods prior to [year X].
Refer to your conclusion [in] MD&A that the errors you identified and their related impacts were not material. We note that the adjustments to the audited statements of cash flows for the [fiscal year] appear to be significant to cash flows from operating activities and cash flows from investing activities. . . . Please provide us a detailed analysis that supports your conclusion that the identified errors are not material to all of the periods presented.

Registrants perform materiality analyses to determine the impact of identified errors on their (1) financial statements and (2) previous conclusions about ICFR and disclosure controls and procedures (DC&P).

ASC 250-10-45-27 provides guidance on materiality determinations related to the correction of errors, and SAB Topics 1.M (SAB 99) and 1.N (SAB 108) contain the SEC staff’s guidance on assessing the materiality of misstatements identified as part of the audit process or during the preparation of financial statements.

SAB Topic 1.M indicates that a “matter is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important.” The definition of materiality is based on FASB Concepts Statement 27 and on legal precedent in interpretations of the federal securities laws. The SEC staff has noted that in U.S. Supreme Court cases, the Court has followed precedent regarding materiality — namely, that the materiality requirement is met when there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

SAB Topic 1.M also indicates that registrants should consider (1) each misstatement individually and (2) the aggregate effect of all misstatements. SAB Topic 1.N provides guidance on how a registrant should consider the effects of prior-year misstatements when quantifying misstatements in current-year financial statements.

In his March 9, 2022, statement, Paul Munter, then acting chief accountant (and currently chief accountant) of the SEC, shared the SEC staff’s observations about the concept of materiality and correction of errors, including the following:

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, 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.

More recently, in his December 4, 2023 statement, Mr. Munter (in his capacity as chief accountant of the SEC) emphasized that the “statement of cash flows has consistently been a leading area of restatements,” noting that the SEC staff has “observed that a significant majority of these restatements represent prior period errors corrected in the current period comparative financial statements.” He also shared the following observations about the evaluation of classification misstatements in the statement of cash flows:

In certain instances, the staff in [the SEC’s Office of the Chief Accountant (OCA)] have been presented with analyses that conclude an error in the statement of cash flows is not material because it is an error in classification only. We have not found such analyses and their corresponding arguments persuasive since classification itself is the foundation of the statement of cash flows. Accurately classifying cash flows as operating, investing, or financing activities is paramount to investors understanding the nature of the issuer’s activities that generated and used cash during the reporting period.

To understand registrants’ materiality assessments and conclusions, the SEC staff frequently asks registrants about the nature of an error, the quantitative and qualitative factors that registrants considered, and an error’s impact on their conclusions about the effectiveness of their ICFR and DC&P. The staff often challenges registrants’ conclusions that errors are immaterial; for example, it has asked about (1) whether the method used to correct an error was appropriate, (2) whether restatement disclosures were appropriately presented, and (3) whether an Item 4.02 Form 8-K was required to indicate nonreliance on previously issued financial statements.

Accordingly, a registrant should first decide whether an individual error is material by considering (1) the effect of the misstatement on line items, subtotals, and totals in the financial statements and (2) the financial statements as a whole — keeping in mind what metrics are most important to the users of the financial statements. Then, if the registrant concludes that an individual error has not caused the financial statements as a whole to be materially misstated, it should consider other errors, including offsetting errors, in determining whether the errors taken as a whole are material to the users of the financial statements. In reaching this conclusion, the registrant should consider individual line items, subtotals and totals in the financial statements, and the financial statements as a whole. The SEC staff has cautioned registrants to avoid bright-line rules or litmus tests and “not to succumb” to rules of thumb or percentage thresholds when determining materiality because no one factor can be viewed as determinative.

SAB Topic 1.M specifies quantitative and qualitative factors a registrant should consider when assessing the materiality of known errors to its financial statements. However, in observing that registrants’ materiality assessments are often presented in a “checklist” fashion in which only the factors in SAB Topic 1.M are considered, the SEC staff has indicated that registrants should (1) describe all factors that are relevant to their materiality assessment (i.e., not just those factors noted in SAB Topic 1.M) and (2) explain how each of those factors was considered. That is, a registrant should provide a detailed, thoughtful analysis that takes into account the registrant’s specific circumstances and what is determined to be relevant to its financial statement users. In addition, as Mr. Munter noted in his March 2022 statement, registrants’ arguments that certain financial statements, specific line items, or certain elements prepared in accordance with U.S. GAAP or IFRS® Accounting Standards are irrelevant or do not provide useful information are not persuasive. Further, the SEC staff has stressed that quantitative considerations in registrants’ materiality assessments continue to be de-emphasized while qualitative factors are overemphasized. Specifically, Mr. Munter stated that “as the quantitative magnitude of the error increases, it becomes increasingly difficult for qualitative factors to overcome the quantitative significance of the error.”

The SEC staff has also indicated that registrants should consider company-specific trends, performance metrics that may influence investment decisions, and the effects of unrelated circumstances on factors that are important to reasonable investors (such as the magnification of an error in the income statement simply because it occurs in a period in which net income is “abnormally small” relative to historical and expected trends).

In considering company-specific trends and performance metrics, a registrant should address in its materiality assessments what metrics it deemed important enough to include in press releases and earnings calls, what metrics are used in debt covenants, and what analysts use to value the registrant in their reports. The SEC staff often considers analysts’ reports and investor calls as it assesses the registrant’s assertion of what is important to investors.

When considering whether net income is abnormally small, management should determine whether a decline in operating performance is an abnormal event or whether it represents a new normal. Management should also determine whether unusual or infrequent events or transactions, such as an asset sale or impairment that would affect trends, are reflected in the results. In those instances, it sometimes may be appropriate to evaluate the relative significance of the identified error by using normalized metrics, which may cause an otherwise quantitatively significant error to be less significant. Documentation of such considerations should be included in management’s analysis.

The SEC staff has also observed that certain registrants have argued that a quantitatively large error in the GAAP financial statements is immaterial when it has a quantitatively small impact on non-GAAP metrics. While the staff has indicated that it may be appropriate for a registrant to look at metrics other than those that are GAAP-based in determining whether the financial statements taken as a whole are materially misstated, the staff will most likely focus on the GAAP metrics unless a registrant can demonstrate why other metrics are more important to its investors. The GAAP metrics are considered to be the starting point for management’s analysis, and relevant non-GAAP measures should be analyzed in addition to GAAP metrics and not as a substitute for them. In addition, the staff has acknowledged that while it is possible for quantitatively small errors to be material and for quantitatively large errors to be immaterial, a quantitatively large GAAP error does not become immaterial simply because of the presentation of non-GAAP measures. Further, there may be circumstances in which an error that is otherwise immaterial to the GAAP financial statements — when taken as a whole and depending on the focus that management, investors, and financial statement users have historically placed on non-GAAP information — is material in the context of non-GAAP information.8

In addition to inquiring about a registrant’s materiality analysis under SAB Topics 1.M and 1.N, the SEC staff often asks questions about the errors themselves. Registrants should consider the impact that misstatements (and immaterial restatements) may have on their previous conclusions about ICFR and DC&P. As a result of such misstatements, the staff may question whether a material weakness existed at the time of the initial assessment. In his March 2022 statement, Mr. Munter observed that “[m]anagement’s ICFR effectiveness assessment must consider the magnitude of the potential misstatement that could result from a control deficiency,” further noting that “the actual error is only the starting point for determining the potential impact and severity of a deficiency.” For additional considerations, see Sections 3.5 and 3.6.

After reaching a materiality conclusion, registrants should also consider whether they are required to file Form 8-K. Under Item 4.02(a) of Form 8-K, a registrant must file a Form 8-K when it has concluded that previously issued financial statements, covering either an annual or an interim period, should no longer be relied on because of an error.

In addition, under the SEC’s October 26, 2022, final rule, an issuer listed on a national exchange whose filed financial results are subsequently restated because of material noncompliance with financial reporting requirements is required to “claw back” any excess compensation awarded on the basis of the previously filed results. See Deloitte’s November 14, 2022, Heads Up for more information.