SOX and Materiality Threshold 1532

  • A recent bill has been proposed that challenges the materiality threshold for reporting of control weaknesses…
    ‘… In a move of possibly sweeping implications for financial reporting, the bill would also change the current Sarbox standard of MATERIALITY for reporting controls weaknesses to 5 percent of net profits. Under current 404 rules, controls weaknesses must be reported if there is ‘more than a remote likelihood’ that a misstatement is ‘more than inconsequential’ and will not be prevented or found.
    By stating a specifically numeric standard, the bill departs radically from the reigning materiality guidance under the Securities and Exchange Commission’s Staff Accounting Bulletin No. 99. SAB 99 specifically rules out the use of a percentage threshold to gauge whether amounts are material to the financial statements.’

  • Interesting. In practical terms the threshold sounds abour right for many circumstances, but what if the company is not particularly profitable e.g. profit of USD10m on turnover of USD10bn.
    I always felt one of the best things about SOX was that it was principles based - as opposed to the American Accounting and Auditing professions which wer traditionally very rules based. Unfortunately it seems like it may be too good to last :x

  • Agree. SOX was principles-based in some respect, but required adoption of formal rules through additional guidance such as AS2, SEC Q-and-A’s, etc., to enable organizations to interpret, adjust, execute, and comply with the SOX Act.
    Some of the earlier and ongoing complaints are that the SOX Act is too ambiguous and auditors’ interpretation of compliance led to excessive costs from resources to develop business process documentation, perform controls testing and validation efforts.
    In short, I would suggest that everyone involved has an opinion on it (the Act), how it should have been written, interepreted, and the essence of compliance.
    As for the recent changes, it seems that the government is making a statement to avoid future misinterpretation and to ‘fine tune’ the various risks (control risk, audit risk, etc.) by addressing the materiality threshold.

  • Wow. 5% of net income.%0AFor a company like PepsiCo with USD4Bn of net income (2004), this would equate to USD200MM (USD285MM pre-tax), or 12 cents per share. Of course, you also wouldn’t want to measure this as a penny or two of EPS as all it would take to double the USDUSD materiality threshhold would be to split the stock.%0AUnfortunately, in today’s environment, all it takes for the market to react unfavorably to an issue is a 1-2 cent per share miss versus expectations, no matter whether the company earns USD1 or USD5 per share annually. %0ASo, what is material to a normal investor? What is a normal investor? Certainly not a hedge fund, though they sometimes tend to drive the market for certain stocks.%0AIf the 5% threshold were enacted, that would significantly reduce the controls that a company like PepsiCo would need to include in scope for SOX purposes.%0AWe use a threshold that is closer to 1%-2% of EPS to define material. For public companies, I believe that a % of EPS would be a better measure than a % of net income.

  • _at_milan - I agree that what you’re saying is what has happened. It is such a shame that things are going this way though. Part of the problem with the accounting/auditing profession in the US is that it is so rules based - it doesn’t matter if what you do makes sense so long as you completed the checklist.%0AMateriality is a great example. All audit firms have a rule of thumb that says materiality calculations start with considering 0.5-1% of turnover. However, there are often circumstances that would require you to modify that position e.g. the company is loss-making or at break-even, or there is particular volatility in the results, or that turnover is not the appropriate measure due to the industry. However, if the SEC proscribes the relevant materiality then you will increasingly situations where a stupid result arises - but it’s OK because it was ‘compliant’%0AVery frustrating 😞

  • Hi Denis,
    I appreciate your thoughts about the tendency of some managements to comply with the letter of the SOX Act, not the ‘spirit’ of it. In my opinion, I believe that most people will do the right thing in their compliance efforts. There will always be bad apples, true…there will also be a few apples in the barrel that are borderline, but shouldn’t be taken out to feed to the pigs.
    The analogy is that, by establishing some more definite criteria for determining what is considered material (materiality threshold), it is more easy to separate the bad apples from the borderline ones, and those that are good through to the core–a way to refine the classification and make it easier for someone looking in the barrel to see what can be eaten.
    US GAAP contains some underlying principles. However, full attainment of these principles is opposed by certain restraints (see below). Thus, Management must achieve a balance in these two influences to ensure that financial information is reliable and more importantly, that investors can make an informed decision.

    • Historical cost principle
    • Revenue recognition principle
    • Matching principle
    • Full disclosure principle
    • Cost-benefit relationship
    • Materiality
    • Industry practices
    • Conservatism
      In short, I believe that ‘tweaking’ the weighting of an element (Materiality) having influence on financial reporting is an effective means to refine the process for better results. No human process is void of judgment and even under a rules based system, there is still plenty of room for management to exercise good judgement regardless of the constraints placed upon the organization.

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