Could $51 million be immaterial when Enron reports income of $105 million?
Audit Adjustments. The restatements include prior-period proposed audit adjustments and reclassifications, which were determined to be immaterial in the periods originally proposed. (Enron 2001)
Some have questioned how such adjustments, representing almost half of 1997's reported income, could be deemed to be immaterial (Hilzenrath 2001). This commentary considers whether there is a reasonable basis for considering this amount as quantitatively immaterial using guidance available at the time of the audit.
In the following section of this commentary we review professional standards related to materiality, emphasizing that which was available at the time of the Enron audit early in 1998. We then review available literature and the issue of assessing materiality for Enron. Finally we present our approach, results, and conclusions.
PROFESSIONAL STANDARDS AVAILABLE AT THE TIME OF THE 1997 ENRON AUDIT
The Auditing Standards Board addressed materiality in 1983 when it issued Statement on Auditing Standards (SAS) No. 47 (AU 312), Audit Risk and Materiality in Conducting the Audit. To serve as a frame of reference for the materiality judgment, SAS No. 47 cites FASB Statement of Financial Accounting Concepts No. 2, para. 132, which defines materiality as follows:
The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying on the report would have been changed or influenced by the inclusion or correction of the items.
SAS No. 47's provisions relating to materiality require auditors to make a "preliminary judgment about materiality levels" in planning the audit. Subsequently, when misstatements are identified, an auditor must consider both quantitative and qualitative considerations in determining whether the financial statements are materially misstated. That is, the amount used to evaluate a misstatement may or may not differ from that used in planning the audit.
When does one expect the auditor's materiality level for evaluation purposes to equal that used in planning? SAS No. 47 addresses this in para. 22 when it states that "assuming, theoretically, that the auditor's judgment about materiality at the planning stage was based on the same information available at the evaluation stage, materiality for planning and evaluation purposes would be the same." However, SAS No. 47 goes on to suggest that the planning and evaluation amounts of materiality may differ due to the findings of the audit. The example it includes at the time of the audit simply illustrates how a qualitative factor such as an illegal payment of an otherwise immaterial amount could be material if it led to a material contingent liability or a material loss of revenue. It was not until December 2000 that an interpretation to SAS No. 47 included additional examples of qualitative factors (AICPA 2002). (1)
SAS No. 39 (AU 350), Audit Sampling, also provides some general guidance on qualitative factors. In para. 27 it suggests that in addition to considering the frequency and amounts of misstatements, the auditor should consider qualitative aspects of misstatements that include:
(a) the nature and cause of misstatements, such as whether there are differences in principle or in application, are errors or are caused by fraud, or are due to misunderstanding of instructions or to carelessness, and (b) the possible relationship of the misstatements to other phases of the audit. The discovery of fraud ordinarily requires a broader consideration of possible implications than does the discovery of an error.
Other authoritative literature from the SEC (2002) provides additional guidance on materiality. Rule 3-02 of SEC Regulation S-X states that if an "amount which would otherwise be required to be shown with respect to any item is not material, it need not be separately set forth." The SEC also says that a material matter is one "about which an average prudent investor ought reasonably to be informed" (Rule 1-02) and that material information is "such ... information as is necessary to make the required statements, in the light of the circumstances under which they are made, not misleading" (Rule 3-06).
In August 1999, after the 1997 Enron audit, the SEC issued Staff Accounting Bulletin (SAB) No. 99 in an attempt to clarify the principles of materiality for those who prepare or audit financial statements filed with the SEC. Because its stated purpose was not to provide new standards, but to provide additional interpretive guidance to the preexisting auditing and accounting literature, it may be argued that SAB No. 99 is also relevant. The Bulletin addresses several situations in which qualitative considerations may cause a quantitatively small misstatement to be material. For example, the misstatement may mask a change in earnings or other trends, it may have the effect of increasing management's compensation, or it may affect compliance with loan covenants or regulatory requirements. In these situations, and others described in the Bulletin, the auditor may view an item as qualitatively material even though it is quantitatively immaterial to the financial statements as a whole. (2) These examples went beyond the illustrations in the AICPA Professional Standards (AICPA 1998) available at the time of the audit.
The issue in Enron that we are addressing is whether identified misstatements totaling $51 million could reasonably be considered quantitatively immaterial using available professional guidance. If quantitatively immaterial, absent other qualitative considerations, Arthur Andersen's response to the uncorrected misstatement was proper--no audit report modification was required. If material, and if the client refused to record the adjustment, the professional standards state that the appropriate response by the auditors is to issue an audit report with either a qualified or an adverse opinion. However, since the Securities and Exchange Commission considers such a report to be unacceptable, auditor resignation or dismissal is the most likely result.
RESEARCH ON MATERIALITY THRESHOLDS
Researchers initially attempted to determine appropriate materiality thresholds with auditors and other user groups such as judges, attorneys, loan officers and financial analysts (Holstrum and Messier 1982; Jennings et al. 1987). Several quantitative thresholds or "rules of thumb" were investigated with the percentage effect of an item on net income being the most pervasive factor (Icerman and Hillison 1991; Iskandar and Iselin 1999; Tuttle et al. 2002). In addition, other research examines how nonfinancial and contextual information such as industry trends, internal control, debt covenants, and management's cooperativeness could potentially affect materiality judgments (Iskandar and Iselin 1999; Krogstad et al. 1984).
The concept of materiality recognizes that, although some adjustments are necessary for fair presentation of the financial statements, immaterial adjustments are not necessary and may be waived (Wright and Wright 1997). Research examines the disposition of audit adjustments to model auditor materiality thresholds as well as the identification of factors that cause auditors to waive certain adjustments. As expected, research indicates that waived adjustments are significantly smaller than those reported (Houghton and Fogarty 1991; Icerman and Hillison 1991). Houghton and Fogarty (1991) found that auditors waived 75 percent of all detected errors.
In related research, Wright and Wright (1997) utilize archival data from actual audit engagements to identify factors that auditors use to waive adjustments. Their findings reveal that quantitative size is the most important factor in determining whether to waive an audit adjustment. Qualitative factors that contribute to this process are directional impact on income, the extent to which the adjustment is objective or subjective, and the size of the client. That is, adjustments that were income increasing, more subjective, and from large clients had a higher propensity to be waived. Braun (2001) extended the work of Wright and Wright (1997) in an experimental setting. Her results indicate that audit adjustments are more likely to be waived when auditors perceive potential litigation risk to be low. She also found that auditors are more apt to waive those audit adjustments that result from immaterial adjustments that aggregate to a material level than those that represent a single material adjustment.
ASSESSING MATERIALITY FOR ENRON
The generality of the definition of what constitutes a material amount makes implementation of a materiality judgment difficult. The AICPA Audit and Accounting Manual (1996) provided operational guidance at the time of the 1997 Enron audit. (3) Para. 3140.20 of this nonanthoritative practice aid states that:
A common rule of thumb for materiality is 5 to 10 percent of pretax income. Some auditors apply this rule of thumb so that items less than 5 percent of normal pretax income are considered immaterial, whereas items that are more than 10 percent are material. For items between 5 and 10 percent, judgment is applied. For example, when unusual factors exist (perhaps the company is about to be sold for a multiple of audited earnings) auditors would tend to classify items between 5 and 10 percent as material. Others use 1 or 1.5 percent of the larger of total assets or revenues. (emphasis added)
A significant issue here is whether to base these percentages on any one year's financial data, or upon some sort of average or "normal" number. This "normal" income concept suggests the use of multiple periods. Consistently, para. 14 of SAS No. 47 explicitly refers to the use of one or more prior annual periods:
The auditor's preliminary judgment about materiality might be based on the entity's annualized interim financial statements or financial statements of one or more prior annual periods ... (emphasis added)
Joseph F. Berardino, managing partner and chief executive officer of Arthur Andersen, attempted to justify the firm's actions. He stated in his remarks before the Committee on Financial Services of the United States House of Representatives that:
In 1997, Enron had taken large nonrecurring charges. When the company decided to pass these proposed adjustments, our audit team had to determine whether the company's decision had a material impact on the financial statements. The question was whether the team should only use reported income of $105 million, or should it also consider adjusted earnings before items that affect comparability--what accountants call "normalized" income? We looked at "the total mix" and, in our judgment, on a quantitative basis, the passed adjustments were deemed not to be material, amounting to less than 8 percent of normalized earnings. Normalized income was deemed appropriate in light of the fact that the company had reported net income of $584 million one year earlier, in 1996, $520 million in 1995, and $453 million in 1994. (Berardino 2001) (4)
Concerning Mr. Berardino's comment on Enron taking "large recurring charges" in 1997, we found that Enron's 1997 SEC Form 10-K (Enron 1998) describes a nonrecurring contract restructuring charge of $675 million ($463 million after taxes).
Several accounting and auditing specialists challenged both Arthur Andersen's conclusion that the $51 million was not material and the concept of "normalized income." For example, Professor Baruch Lev commented that "if auditors judge materiality by such a fuzzy, loose concept as normalized income, almost anything can become immaterial." Further, Professor Bala Dharan has stated that "the whole logic seems fairly shaky to me, by any stretch of logic, $51 million is a significant, material amount" (Hilzenrath 2001). Andersen spokesman David Tabolt stated that normalized income is not a term used in the accounting literature but was used by Berardino to explain the process in a language that layman and members of Congress could understand (Hilzenrath 2001). In our view, Berardino's "normalized income" sounds like the AICPA's concept of "normal" income over several years.
APPLYING COMMON QUANTITATIVE THRESHOLDS TO ENRON'S DATA
We calculated the amounts involved using those "rules of thumb" suggested by the AICPA Audit and Accounting Manual (1996):
* 5 percent to 10 percent of either net income, or income pretax income
* 1 percent to 1 1/2 percent of total assets
* 1 percent to 1 1/2 percent of sales revenues
Panels A and B of Table 1 present Enron's financial data and the materiality rules of thumb. (5) The different rules of thumb provide widely varying measures of materiality. In general, the quantitative measures suggest that in audit planning, $51 million is below the materiality threshold for most, but not all of the measures. When using the total assets and total revenues bases or, as suggested by the AICPA, the larger of the two, the $51 million does not approach becoming a material amount. (6)
We also calculated "blended" amounts that combine rules of thumb presented in this article to calculate an average, such as combining three separate measures and dividing by 3. Again, as indicated in Panel B, any reasonable "blended" model suggests that the $51 million is quantitatively immaterial.
We base these assessments on ratios calculated with and without 1997, the year under audit. Table 1 indicates that including 1997 does not in general significantly affect the results.
The net income-based measures suggest that the $51 million is material for all of the 5 percent rule measures, but is mixed for the 10 percent rule measures. For instance, when using the average of the two preceding years' income, the $51 million is immaterial using a 10 percent rule, but material using a 5 percent rule. The actual computation indicates that the $51 million represents approximately 9 percent of the average of the preceding two years' income. We also recalculated the 5 percent and 10 percent net income based numbers using the $54 million (reported net income of $105 million--the $51 million adjustment). This change did not significantly alter the overall results presented in Table 1.
Finally, we calculated 5 percent and 10 percent of net income plus the nonrecurring contract restructuring charge (Panel C). Adding back the nonrecurring charge results in all 10 percent income-based measures exceeding the $51 million in adjustments not recorded in 1997; that is, $51 million is quantitatively immaterial using the 10 percent income-based measures. One could argue that using net income plus a nonrecurring charge is consistent with the currently ill-defined notions of "normalized" or "normal" income. (7)
LIMITATIONS AND CONCLUSIONS
Some limitations of our study should be noted. First, it is important to realize that while this commentary emphasizes quantitative materiality standards, full and complete reliance on quantitative standards was not acceptable at the time of the Enron audit. But at that time, very limited information on qualitative measures was available in professional pronouncements. Although SAB No. 99 (issued subsequent to that audit) states that its purpose is to interpret preexisting guidance, its illustrations go well beyond what was provided in the Professional Standards in effect during the 1997 Enron audit. Also, even if one assumes that auditors used such qualitative measures prior to issuance of SAB No. 99, data limitations make it impossible to consider many of them. Examples include the effect of the adjustment on management compensation, the adjustment's effect on compliance with regulatory or legal requirements, and the precision of the adjustment's measurement.
Second, we do not consider disaggregating our materiality measures into smaller, tolerable misstatement amounts that might be considered appropriate at the account level. Since the note describing the previously considered adjustments as immaterial refers to adjustments in the plural, and does not indicate which accounts are affected, such a disaggregation is not possible. But, since the materiality measures obtained using the revenue and asset totals are so large compared to the $51 million, even a disaggregation is likely to result in a situation in which the tolerable misstatement exceeds that amount. (8)
In conclusion, using the quantitative guidance available in the AICPA Audit and Accounting Manual (AICPA 1996), a $51 million restatement of Enron's $105 million 1997 net income is in a "gray area" when using various net-income-related materiality measures. When using the smaller income-based numbers (5 percent of income) it is generally material, but when using the larger income-based measures (10 percent of income) it is not material under some assumptions. It is immaterial when using any of the asset and revenue measures.
Given these results, and given that the same materiality measures continue to be included in the most recent version of the AICPA's (2001) Audit and Accounting Manual, the profession should investigate further whether rules of thumb such as those used in this paper are consistent with the verbal descriptions of materiality included in the professional literature. This inquiry could lead the AICPA to update their Audit and Accounting Manual as the current guidance reflecting SAB No. 99 and other authoritative sources is limited. However, to the extent that auditors use these measures when determining the scope of audit tests, revising them has significant ramifications for audit planning and the cost of an audit. Changes that lower planning materiality could substantially increase the scope of audit procedures, and, by extension, the cost of an audit.
TABLE 1 Enron Financial Data and Materiality Rules of Thumb Panel A: Enron Financial Data (in millions) 1997 + Nonrecurring Loss 1997 1996 Net Income 568 105 584 Total Assets 23,422 23,422 16,137 Sales Revenues 20,273 20,273 13,289 1995 1994 Net Income 520 453 Total Assets 13,239 11,966 Sales Revenues 9,189 8984 Panel B: Common Materiality Rules of Thumb Applied to Enron's Data (in millions) Average Average 1997 1995-97 1994-97 5% of Net Income 5.25 20.15 20.78 10% of Net Income 10.50 40.30 41.55 1% of Total Assets 234.22# 175.99# 161.91# 1 1/2% of Total Assets 351.33# 263.99# 242.87# 1% of Sales Revenues 202.73# 142.50# 129.34# 1 1/2% of Sales Revenues 304.10# 213.76# 194.01# Conservative Blend (a) 147.40# 112.88# 104.01# Non-Conservative Blend (b) 221.98# 172.68# 159.48# Average Average 1995-96 1994-96 5% of Net Income 27.60 25.95 10% of Net Income 55.20# 51.90# 1% of Total Assets 146.88# 137.81# 1 1/2% of Total Assets 220.32# 206.71# 1% of Sales Revenues 112.39# 104.87# 1 1/2% of Sales Revenues 168.59# 157.31# Conservative Blend (a) 95.62# 89.54# Non-Conservative Blend (b) 148.04# 138.64# Panel C: Income Materiality Rules of Thumb: Deleting Effect of 1997 Nonrecurring Loss (in millions) Average Average 1997 1995-97 1994-97 5% of Net Income + 1997 Nonrecurring Loss 28.4 27.86 26.56 10% of Net Income + 1997 Nonrecurring Loss 56.8# 55.73# 53.13# Average Average 1995-96 1994-96 5% of Net Income + 1997 Nonrecurring Loss 27.60 25.95 10% of Net Income + 1997 Nonrecurring Loss 55.20# 51.90# Bold numbers represent materiality thresholds that are higher than the proposed $51 million 1997 adjustment. That is, relying only upon the rule of thumb, the amount is considered immaterial. (a) (5 percent of Net Income + 1 percent of Total Assets + l percent of Sales Revenues)/3. (b) (10 percent of Net Income + 1.5 percent of Total Assets + 1.5 percent of Sales Revenues)/3. Note: Numbers represent materiality thresholds that are higher than the proposed $51 million 1997 adjustment. That is, relying only upon the rule of thumb, the amount is considered immaterial is indicated with #.
The authors acknowledge the helpful comments of three anonymous reviewer's.
(1) SAS Nos. 61, 89, and 90 (AU 380), Communication with Audit Committees, require certain communications to audit committees relating to adjustments that we do not address in this article. Also, both SAS Nos. 89 and 90 were issued subsequent to the 1997 audit of Enron.
(2) An interesting question arises as to whether qualitative considerations could make a quantitatively material adjustment become immaterial. While the professional literature does not seem to rule this out, it is not explicitly addressed. If one accepts this possibility, the nature of the transactions involved might lead to an increase in the materiality thresholds.
(3) The measures seem generally consistent with those proposed by academic and other professional literature. See, for example, Holstrum and Messier (1982), Iskander and Iselin (1999), and Pany and Wheeler (1989a, 1989b). Also, the various CPA firms probably have their own materiality guidance.
(4) Interestingly, this exact quote is also included in comments made six days later before the United States Senate Committee on Commerce, by Mr. C. E. Andrews, Global Managing Partner--Assurance and Business Advisory, Andersen (Andrews 2001).
(5) Since Enron reported the correction on an after-tax basis, we have been consistent by also calculating the income-based rules of thumb on the same basis.
(6) The press states that Enron reported various energy transactions at "gross" rather than "net" (Loomis 2002). As a simple illustration of the difference, assume a $1 million transaction, with an expected cost of $950,000. While both methods result in income of $50,000, the gross method reports revenues of $1,000,000 and expenses of $950,000, whereas the net method reports only a $50,000 gain. In 1997, either method was considered acceptable. Currently, the Emerging Issues Task Force (EITF) Issue No. 02-3 requires use of the net method (FASB 2002). For purposes of calculating materiality thresholds, the gross method leads to larger amounts in measures that use revenues. Because Enron's financial statements do not disclose the amount of revenues from energy trading contracts it is not possible to quantify the effect.
(7) A December 2000 interpretation of SAS No. 47 indicates that a misstatement affecting recurring earnings may be more relevant than one involving a nonrecurring charge. However, the nonrecurring charge is not the item that was waived. Related is the fact that 1997's income was low compared to that of prior years. This might have led to a belief that, with the change in direction of income obvious already, no entry was required for the $51 million.
(8) See Whittington and Pany (2001) for a discussion of allocation of materiality to individual accounts.
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Richard G. Brody is an Associate Professor at the University of New Haven, D. Jordan Lowe is an Associate Professor at Arizona State University West, and Kurt Pany is a Professor at Arizona State University.
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|Author:||Brody, Richard G.; Lowe, D. Jordan; Pany, Kurt|
|Date:||Jun 1, 2003|
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