SAB 99 Codification for Assessing Financial Materiality

The Securities and Exchange Commission’s Staff Accounting Bulletin No. 99 (SAB 99) provides guidance on applying materiality standards in the preparation and auditing of financial statements. Issued in August 1999, its purpose was to clarify that assessing the significance of a financial misstatement is not a simple mechanical exercise. The bulletin emphasizes that both quantitative and qualitative factors must be considered.

The Concept of Materiality

SAB 99 refutes the idea that a quantitative threshold, such as the 5% rule of thumb, can be the sole determinant of materiality. The bulletin was issued to correct the misconception that any misstatement falling below a certain percentage of a financial metric is automatically immaterial. The core principle is that materiality must be judged through the lens of a “reasonable investor.”

The ultimate test of materiality is whether a misstatement or omission would have altered the judgment of a reasonable person. A misstatement is considered material if there is a substantial likelihood that it would be viewed by the reasonable investor as having significantly altered the “total mix” of information made available. This assessment is based on the likely perspective of an outside investor, not on what management or auditors believe is important.

Materiality judgments must involve both quantitative and qualitative considerations. A quantitatively small error could be material if it has a significant qualitative impact. Conversely, as the quantitative size of an error grows, it becomes increasingly difficult to argue it is immaterial based on qualitative factors alone. The focus is on objectivity and avoiding bias from the company’s or auditor’s perspective.

Key Qualitative Factors in Assessing Materiality

SAB 99 provides a list of qualitative factors that can make a quantitatively small misstatement material. These factors highlight circumstances where a minor error could influence an investor’s perception of the company. The context surrounding a misstatement is a primary driver of its significance.

• Whether the misstatement masks a change in earnings or other important trends. For instance, an adjustment that allows a company to report a steady increase in quarterly earnings, rather than a slight decline, could be material even if the dollar amount is small, as it conceals a negative shift in performance.
• Whether the misstatement allows a company to meet analysts’ consensus expectations. If a company would have missed its earnings target but a small accounting adjustment allows it to meet or beat that target, that adjustment is likely material because meeting expectations can have a disproportionate impact on stock price.
• Whether the misstatement changes a net loss into income or vice versa. The psychological and analytical difference between a profit and a loss is substantial, regardless of the amount. An adjustment that pushes a company from a loss to a profit crosses a significant threshold in the eyes of investors.
• The effect of a misstatement on a company’s compliance with regulatory requirements or loan covenants. A small adjustment to revenue or assets might enable a company to avoid violating the terms of a debt agreement, which could otherwise trigger default. The misstatement’s role in avoiding such a negative outcome gives it significance beyond its numerical value.
• If a misstatement has the effect of increasing management’s compensation. For example, if a bonus is tied to achieving a specific earnings target, a small, intentional misstatement that allows management to hit that target would be material because it involves self-interest.
• If a misstatement conceals an unlawful transaction. This is particularly sensitive, as it can signal serious underlying problems with governance and control.

Aggregating and Netting Misstatements

SAB 99 prohibits companies and auditors from evaluating financial statement errors in isolation. They are required to aggregate all identified misstatements, including those that might be individually insignificant, to determine if their combined effect is material. This prevents numerous small errors from collectively creating a misleading picture of the company’s financial health.

The aggregation principle requires looking at all uncorrected known and likely misstatements. For example, a small overstatement in one account, an understatement of a liability, and an error in revenue recognition might have a total impact on net income that is significant enough to influence an investor.

SAB 99 also forbids netting misstatements to make the aggregate error appear smaller. A company cannot offset an intentional overstatement of revenue with an unrelated understatement of an expense to argue the net effect on income is immaterial. Each misstatement must be evaluated on its own merits, as offsetting is viewed as potentially concealing the true nature of the individual errors.

Codification and Location in the ASC

The principles from Staff Accounting Bulletin No. 99 have been integrated into the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC), the primary source of authoritative accounting standards for U.S. companies.

The guidance from SAB 99 is codified within ASC Topic 250, Accounting Changes and Error Corrections. This placement is logical, as the bulletin provides the framework for evaluating the materiality of financial misstatements. The specific SEC staff guidance is found in sections marked with an “S” prefix, primarily in ASC 250-10-S99.