In all material respects, auditors' assurance falls short

Auto mechanic: “Your car's ready. I've repaired it in all material respects.

Job applicant: “Offer me the position. I can do the work in all material respects.”

Pulmonary oncologist: “Congratulations. Your lung X-rays appear normal in all material respects.”

In a world of daily decisions, from the trivial to the truly significant, the advice above would seldom be considered satisfactory. Yet every day, investors make decisions based on an auditor's opinion that “the financial statements present fairly, in all material respects, the financial position of the Company.”

Why does this elliptical and ambiguous assurance, coming from an auditor, carry greater weight than it would coming from another professional?

Why will people put up their life savings with less probing inquiry than given to their dental hygienist or travel agent, and then play the insulted victim when a stock price that had rocketed up has the audacity to go down?

The question has taken on new significance after the year of problems that began last autumn with the third-quarter results reported by Enron Corp.

Time and again, investors profess outrage, crying, “Why weren't we told?” The company and its auditors, in lame self-defensiveness, assert with as much conviction as they can muster, “But it wasn't material.”

It all brings to mind the 1943 classic film “Casablanca,” and the famous exchange between Humphrey Bogart, playing Rick, the outwardly cynical club owner, and Claude Rains, playing Captain Louis Renault, the local frontman for the occupying Nazi forces:

Rick: “How can you close me up? On what grounds?”

Louis: “I'm shocked – shocked – to find gambling is going on in here!”

Croupier: “Your winnings, sir.”

Louis: “Oh, thank you very much.”

The investors' bargain on materiality with companies and auditors is the same as that between Rick and Louis about the roulette wheel in the back room: We won't ask, and you don't have to tell us.

The deal works – but only until it is disturbed from the outside. In the film, Major Strasser of the Third Reich shows up at Rick's to search for the underground leader, lifting the curtain to expose the little secrets.

In real life, the exposure of corporate malfeasance – whether in artificial off-balance-sheet entities, abusive corporate governance or executive looting – has the same effect.

The basic bargain needs to evolve, in the community of financial statement creators, auditors and users: What amount of information can be conveyed as meaningful and valuable? What level of assurance can reasonably be provided, and at what cost to issuers and risk to auditors?

The standard auditor's report flies a warning flag that is unmistakable: fair presentation “in all material respects” leaves a hostage to fortune that is open ended. How big is “really” big? Who decides? And under what criteria?

The professional accounting literature on materiality is opaque.

It starts thus: “The phrase 'in all material respects' … indicates the auditor's belief that the financial statements taken as a whole are not materially misstated.”

The loop of both language and logic closes in the very next paragraph, and never reopens: “Financial statements are materially misstated when they contain misstatements whose effect, individually or in the aggregate, is important enough to cause them not to be presented fairly, in all material respects.”

Oh.

The standard-setters have been terrified of quantifying what is meant by “material,” and for good reason. For a stable, mature enterprise with a dependable operating history, the likelihood of material error in principal operating accounts should be minimal. And normally, the level of required audit work is set accordingly.

But the discovery that a chief financial officer has deliberately falsified things, even by “a little bit,” ought to figure very large, since it opens the prospect that he has concealed a really big problem somewhere else.

But now we're back to “how big is big?” And how do you write those rules?

One way is to change the basic nature of the bargain. Why not a footnote along the following lines:

“Management has prepared the company's financial statements, and the auditors have planned and conducted their examination and issued their report, on the basis that events and transactions the aggregate effect of which is less than $XX million, or YY% of the Company's total assets, are deemed not material.

“In addition, in conducting their examination and issuing their report, the auditors have not addressed, examined or searched for events or transactions individually smaller than $ZZ million.”

Companies and their auditors already have the responsibility to set and apply thresholds of materiality. The U.S. Securities and Exchange Commission is leading a brigade of securities regulators around the world in search of improved corporate governance and financial statement assurance. This disclosure would be consistent with the obligation of corporate officials to attest to the fairness of the resulting statements.

Besides, there is precedent. The debate on treating executive stock options as expenses has largely been made moot, without legislation or regulation, by the market-motivated behavior of a quorum of large companies. The market can probably handle and value materiality disclosure, too.

Informed in detail, for a change, about what is covered and what is not, shareholders and lenders would no longer have the ability to second-guess the handling of “the small stuff.”

But as a trade-off, if uncomfortable they could force a recalibration of those thresholds, influencing the scope of the auditor's work and its associated cost.

And if so, share prices would reflect the level of investor comfort with a company's materiality disclosure, right out in the open, enabling companies and their auditors to adjust their performance and be evaluated on the results of their performance.

Investors have lived like Captain Renault. In good times they have closed their eyes and taken their winnings. Under pressure, they profess shock at the presence of the roulette wheel and stalk away, even while holding a ticket in the shareholder litigation sweepstakes.

In this newly righteous era, all parties need to open their eyes and change these rules – lest the nightclub and the gaming table be closed down completely.

Jim Peterson's e-mail address is [email protected].