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Sep 30, 1999

Material things

What really matters- or at least what is really material

When Horton the elephant hears a Who, he has a hard time persuading his elephant friends of its existence. The question posed in Dr Seuss' children's books is: If you can't see a Who, and it doesn't have any noticeable effect, is it material?

Accountants and auditors, like those elephants, have always enjoyed the convenience of ignoring certain things if they're small enough. Problem is, Horton cares about Whos, and many investors may care about those small financial items.

SEC chairman Levitt to the rescue: on August 13 the SEC released its much-anticipated Staff Accounting Bulletin No 99 (Sab 99), which contains guidance on 'materiality' in financial statements. Hailed as 'sweeping change' and 'bureaucratic muscle', Sab 99 does not create new rules, but clarifies old rules as they've been tested under case law.

Simply, Sab 99 says it's not good enough to use the old rule of thumb – that something has to cause a 5 percent shift in the results in order for it to be judged material. The SEC says companies have to judge whether 'a reasonable investor would consider the item to be important.'

The accounting bulletin is another volley fired in SEC chairman Arthur Levitt's cannonade against the 'numbers game' which began in the fall of 1998. Sab 99 states, for one thing, that 'management should not make intentional immaterial errors in a registrant's financial statements to manage earnings.' According to Harvey Goldschmid, the SEC's general counsel, 'there's nothing new, radical or dramatic in the release. But it analyzes, refines and elaborates in a way that even in my case – a guy who's taught securities law since 1970 – helped me to understand things a little better.'

Making distinctions

The bulletin addresses the accounting issue of managing earnings, not the investor relations issue of managing expectations – a differentiation that Niri has been working hard to make. However, Goldschmid says the SEC hopes Sab 99 'will provide better and more transparent information to investors.'

Boris Feldman, a partner at Wilson Sonsini Goodrich & Rosati in Palo Alto, California, says Sab 99 will have a 'massive impact' on the CFO and controller. 'In the past, if a company wanted to take an accounting action that the auditors were uncomfortable with, the auditors would bite down hard and say it's not material, explains Feldman. Basically Sab 99 says, Don't do that. It's a message to the outside audit committee that if you disagree, then put your foot down and don't sweep it under the rug of materiality.'

Corporate executives may be troubled by the fact that Sab 99 removes a quantitative measure of materiality and makes it more of a judgement call. In fact, companies have been clamoring for years for the SEC to set a clear guideline.

Feldman says investor relations officers at well-run companies are in the loop when it comes to deciding materiality because they can judge how the Street would react – a key factor in the decision. With materiality more of a qualitative call than ever, it's more important than ever that the investor relations officer be included.

'Everyone would love it if we could have a bright line,' says Goldschmid. 'But there's no way of avoiding what is simply true: there are qualitative and judgmental aspects to materiality.'

Making up numbers

How widespread is the managed earnings problem? What will Sab 99 change? Feldman points out that the numbers game plays out across a spectrum. Do companies massage particular estimates in order to fine-tune their results? Absolutely, he says. Indeed Microsoft is the master and many smaller companies do it too. 'But we're not talking about cooking the books, and there's nothing the SEC can do about it. It's a question of degree. If you're fine tuning it a little here and a little there, it's no big deal. On the other hand there have been plenty of cases recently where it has degenerated from that into making up numbers, such as Cendant and McKesson HBOC.'

In one important way, life may be a lot more difficult for IROs if companies really take heed and stop massaging earnings. Feldman points out that one of the criteria for materiality now is whether a line item would make the difference between meeting consensus earnings estimates or missing them by a penny. If it does make the difference, then it's material – even if it's below the 5 percent threshold. 'So things companies did in the past to squeak by and avoid a miss are tougher to do,' he concludes.

'A lot more companies will be missing earnings,' predicts Morgan Molthrop, a consultant with GA Kraut Co in New York who teaches Niri-New York's class on disclosure at NYU. 'Investor relations officers can no longer be sure that the magic number is going to come back from the accountants.'

The SEC's Goldschmid doubts that the crackdown on managing earnings will result in significantly more volatility, but he does agree that the IR role of managing expectations within the bounds of accepted disclosure will become more important. 'With the inhibitions on juggling numbers, it becomes more important to get out the company story in a way that lets analysts understand what's really going on.'

Not the end of the world

Goldschmid continues, 'The overall drive to stop managed earnings to meet expectations – which goes way beyond materiality and Sab 99 – is aimed at giving the market real, transparent, accurate numbers. On one level investors will be able to rely more on the information. On another, it may create a little more variance in hitting earnings estimates. But that isn't likely to end the world.'

'The bulletin is part of Levitt's long string of attacks against companies that are cooking the books,' adds Molthrop. He lists the SEC's major peeves: these include improper revenue recognition, unjustified restructuring charges and cookie jar reserves. 'The SEC is saying that these improper methods obscure the facts, and those are facts that investors need in order to find the true value of the company.'

He points out that the 'numbers game' is probably the oldest game in the book. Indeed, just about every company that did a restructuring charge in the last year got a letter from the SEC saying 'prove it'. And when General Electric was queried about its accounting practices in 1994, other companies were calling up to say, 'We do it too. So what do we do now?' What the SEC is really after is knowing and wilful conduct that violates the law – companies that knowingly misapply accounting standards to their advantage.

Maryann Waryjas, partner in the corporate securities practice at Jenner & Block in Chicago, doubts that the SEC can entirely stamp out the practice of managing earnings. 'Can anything the SEC does stop the numbers game? No. People are going to do what they do,' she remarks. 'My father used to say you can put up all the locks you want but a determined thief will somehow get in.'

Still, she has seen the SEC focusing more on restructurings or transactions and their treatment of R&D expenses in the past year. Letters asking questions have been coming back not just to high-tech companies, but to Fortune 100 and 500 blue-chips.

Ivory tower

Feldman is not very optimistic. 'The effort to eliminate earnings management is an ivory tower initiative. It's going to be a failure. The crackdown on gross financial fraud will have an impact, and over time government prosecutions will help to reduce it. Sab 99 will have an impact in that the auditors will crack down. But it is unrealistic to think a company that is coming in close to the results is not going to be able to nudge them one way or another.'

Indeed CFOs seem not to be overly concerned, at least over Sab 99. During a Financial Executives Institute teleconference about the bulletin, participants were surveyed about its impact. Over 80 percent said Sab 99 wouldn't change the way they close their books. On the other hand, some 84 percent said it provides useful guidance.

Waryjas points out that the fundamental rule of disclosure has been there all along, with or without Sab 99: 'Don't lie!' she proclaims. 'And half truths are just as actionable as full lies.' What has changed, however, is the nebulous concept of a 'reasonable investor' – that mythical archetype that US companies have to focus so hard on. 'The reasonable investor used to be somebody who had money in for the long term,' Waryjas comments. 'People have different trading goals these days. They have immediate access to information on a global level and their expectations have been raised along with the level of technology. Whereas in the past information would take a little bit of time to be digested by the market, today investors are reacting by the nanosecond. So the reasonable investor is out there – the question is how that individual evolved over time.'

In the children's books, Dr Seuss' Horton finally proves the existence of the tiny Whos by setting up a large loudspeaker to amplify their tiny voices. In its own way, the SEC is working to amplify a world of financial items that have, in the past, gone unnoticed and unseen.