Andrew Acito Quoted in Wall Street Journal
The Wall Street Journal recently published an article about the decline in the prominence with which companies report errors in their previously issued financial statements. For errors deemed material, companies are required to alert investors and reissue corrected financial statements. These corrections are known as “Big R” restatements. While there is no bright-line test for what is considered a material error, 5% of earnings is considered a common rule of thumb. Recent studies show, however, that the number of Big R restatements has dropped more than 80% since 2005. Instead some companies appear to be ignoring the 5% guideline and opting for “Little r” revisions or adjustments, which simply means the errors are corrected in subsequent financial statements, but investors are not alerted and financial statements are not reissued.
Andrew Acito and co-authors Jeffrey Burkes at the University of Notre Dame and W. Bruce Johnson at the University of Iowa recently published a study in Contemporary Accounting Research which finds that the SEC sometimes asks for managers’ detailed materiality analyses behind Little r revisions and adjustments, but rarely challenges managers’ judgments directly. Dr. Acito said the SEC may be concerned that frequently challenging companies over their treatment of errors "could lead managers to become too conservative in their judgments, leading to unnecessary restatements."
The purpose of the study was to gain insights into how managers make materiality judgments about accounting errors by examining the detailed analyses disclosed through the SEC’s comment letters on companies’ financial statements. Their study found that managers frequently deem errors immaterial in spite of exceeding the customary 5% of earnings threshold. Managers make no attempt to conceal the errors; instead they argue that other key metrics are not affected or that the 5% benchmark is too low because of unusually low earnings.
Dr. Acito's study also found substantial variation in the extent to which qualitative factors are mentioned in the analyses as materiality considerations. While the SEC is generally deferential toward managers’ arguments and judgments, it is more likely to challenge immateriality claims when managers admit there are qualitative factors that indicate errors are material.