From the preface of Political Standards: Corporate Interest, Ideology, and Leadership in the Shaping of Accounting Rules for the Market Economy:
“In subtle but significant ways, our corporate accounting system has been captured…. [T]he evidence of capture in accounting rule-making can be symptomatic of a broader problem with how the ‘rules of the game’ in our market economy are determined—particularly esoteric and highly technical rules that are outside the understanding and oversight of the general public. …
In several instances, I find evidence of rules that benefit one or more special-interest groups (e.g., industrial corporations, financial firms, and audit firms) at the potential expense of the general interest.” [emphasis added]
I agree with those sentiments, and I am very much looking forward to reading (and reviewing) this new book by Karthik Ramanna, a Harvard accounting professor. Yet, despite my intense personal despair at the condition of financial reporting policymaking, one of the most interesting things I do is attend the semiannual meetings of the PCAOB’s Standing Advisory Group.* I am energized by the exchange of ideas—even between the agents of special interests, and advocates for the general interest like myself. Who knows if I am actually moving the needle! But, it feels good to try, and it’s great fun.
That said, I didn’t get enough airtime at the most recent SAG meeting to fully explain my views on materiality (a topic I have already written about here and here). I’ll admit that I loathe the FASB’s recent proposals and I came loaded for bear. But I also knew that this SAG meeting would not be an appropriate forum in which to echo the concerns that the SEC heard at its recent Investors Advisory Committee. I tried to focus on what the PCAOB should be doing.
What I Said (More or Less)** — Plus What I Didn’t Have a Chance to Say*
The development of the concept of materiality in GAAP is prototypical of the frustrations by many that lawyers seem to be the power behind disclosure decisions; but also how the courts may be affirming rights that perhaps Congress did not contemplate when it wrote the securities laws in the 1930s. With respect to the rights of investors to rely on the auditors and their reporting, I have in mind the landmark Continental Vending case of the early 1970s.
I proposed to the SAG that, as the courts did in Continental Vending, we should first consider the auditor’s standard opinion language that the financial statements and related disclosures “present fairly, in all material respects, … in conformity with U.S. GAAP.” Although a fair reading of the audit opinion language is that “fair presentation” is a higher benchmark than “materiality,” the fact of the matter is that the FASB proposals on materiality is just the latest initiative to diminish the emphasis on fair presentation by the profession, which started in reaction to the Continental Vending case. The court clearly stated that “fairly presented” and “in accordance with GAAP” were two separate claims about financial statements; or in other words, mere compliance with GAAP was not sufficient to assert compliance with the securities laws.
And up until the guilty verdict against auditors in Continental Vending (they were pardoned by Richard Nixon), the accounting profession seemed to have shared the view of “fair presentation” enunciated by the courts. Even though prohibitions against material misstatements existed in securities laws enacted three decades earlier, phrases like “fairly presented” and “substance over form” were the terms the profession used to inform investors about what they could expect from financial statements and disclosures. But subsequent to Continental Vending, the accounting profession has worked to make “fairly presented” and “in accordance with GAAP” one statement instead of two.
The FASB was established shortly after the Continental Vending Case. In Concepts Statement No. 2, it attempted to provide a definition for materiality, and essentially ignored the concept of fair presentation. Each authoritative standard that the FASB published had a prominent “black box” legend stating that the provisions of that standard need not be applied to immaterial items. The black box escape clause was used in enough questionable circumstances to compel the SEC staff to rein in the abuses with Part 2 of SAB 99 (1999). But, in my view, more appropriate black box language would have been—consistent with the Continental Vending decision—that a standard need not be applied to a transaction within its scope if in doing so, fair presentation would not be sacrificed. (Sorry for the double negative!) Indeed, if it were interested in the general interest as opposed to lessening the workload and legal exposure of well-paid audit committee members, the FASB could make that simple change—instead of the one it has proposed, to continue with the charade that materiality is a legitimate accounting concept.
As for the PCAOB, it inherited “fairly presented” from the AICPA, which had done its level best to dilute its meaning after Continental Vending shocked the profession. But if “fairly presented” is to continue to be in the auditor’s report, the PCAOB’s standards must clarify that it means something apart from the absence of material errors when applying GAAP. If it would makes this clarification, the logical extension is that compliance with the FASB proposal is too low of a bar for determining which escape routes for omitting required disclosures are open.
Stated bluntly, if financial reports are purported to be fairly presented, the PCAOB owes it to investors to “walk the talk.”
(This was about the point where I was cut off due to time constraints on the first day of the SAG meeting. I didn’t receive a standing ovation, but I did receive some pats on the back from others in attendance during private moments. What follows, is what I wanted to add the following morning, but didn’t have the opportunity.
I want to make two points: (1) that “materiality” can be a useful legal concept; and (2) the legal definition of materiality is not compatible with the objective of fair presentation.
Point #1: The Legal Concept of Materiality
It is broadly acknowledged that in enacting the securities laws in 1933 and 1934, Congress intended to establish a market-based system of enforcement. They succeeded. Although I don’t have exact numbers, I have been told that around 90% of securities law cases are private actions.
It seems to me that, by extension, “materiality” is a market-based concept. A private plaintiff must make the decision to invest time and money for an uncertain outcome. Effectively, this means that a “material” misstatement is one where the recoverable damages is equal to the plaintiff’s investment plus a reasonable expected return on that investment. Think about what this implies about the FASB’s proposal to make “materiality” strictly a legal concern: a material misstatement is one where the issuer or the auditor could lose in court to some plaintiff with financial wherewithal, and who believes that suing would be profitable.
I readily concede that in the 100 days or so that it took Congress to pass the securities laws, not a single member may have been thinking in those terms. But, whatever the original intent, the manner in which materiality is applied by plaintiffs makes for a pretty specious accounting concept.
Point #2: However Defined, “Materiality” Is Not an Operational Accounting Concept
My first point was that a purely legal concept of materiality is not appropriate as an accounting standard. My second point is that the FASB has convincingly demonstrated that “materiality” is not operational as an accounting concept. This is how the FASB has tried and failed to supplant “fair presentation” with some notion of materiality:
- The current definition of “material” is in Concepts Statement No. 8. Ask an economist what the definition in CON 8 means, and she will say that it is nothing more than a necessary condition for information to have a value greater than zero. In fact, the current CON 8 definition is just the concept of “relevance” re-phrased.
- The CON 8 formulation superseded the formulation in CON 2. It is much wordier, and I confess that I find it completely unhelpful. Ask an economist what the earlier CON 2 definition meant, and she won’t even be able to respond in conventional terms. She won’t be able to associate that definition with any economic attribute of information, let alone the attribute of relevance that is common to accounting and information economics.
* * * * * *
I realize that the reason the SAG was asked to provide its reactions to the FASB’s materiality proposals was only because of the effect they could have on PCAOB requirements regarding what omissions from disclosures that an auditor must bring to the attention of the audit committee. But, I want the PCAOB to use this moment to consider a broader question: what does “fair presentation” in the auditor’s report mean to shareholders?
If the PCAOB wants the report to mean what it says, I see only two choices: (1) to clarify that “fairly presented” in the auditor’s report means something; or (2) to remove “fairly presented” from the standard language.
The truth-in-advertising voice in my head tells me to cares less about which of these choices the PCAOB makes — only to care very much that the board makes a choice rather than do nothing. But the red-blooded American voice recognizes that there is not only a market in the U.S. for enforcing material misstatements, but a global market for accounting standards. Although the current SEC acts like communists when it comes to accounting standards, the fact is that we are engaged in a global competition to produce public capital markets that are differentiated from all others by transparency and safety.
If that is our goal, then “fair presentation” — and not merely “materiality” — should be the gold standard.
*These are my opinions, and not necessarily those of the PCAOB or its staff.
**A transcript of the SAG meeting that includes my actual remarks is not currently available.