Fraud Files: When 'Immaterial' Financial Errors Hide Real Problems

Fraud Files: When 'Immaterial' Financial Errors Hide Real Problems
Fraud Files: When 'Immaterial' Financial Errors Hide Real Problems

Pick a random handful of SEC filings in which public companies disclose errors or irregularities in their previously reported numbers, and it's a good bet that you'll see the word "immaterial" more than once. When companies use that word, what they're trying to say is that their numbers were wrong by such relatively small amounts that the errors don't really matter.

But there's a big problem on Wall Street: Many times, companies improperly label their errors immaterial when they aren't. Sure, the numbers involved might be small in relation to the overall revenues of the company, but the size of an error isn't all that counts when it comes to determining what is -- or is not -- material.

Take, for example, our friends at Citigroup (C). In July, Citigroup disclosed that it "misclassified" $9 billion of its debt as sales. Doing so made the bank's balance sheet look better, and it's not uncommon for banks to shift around debt just prior to a reporting period to make things seem rosier. But Citigroup says what it did was unintentional, and notes that "[t]he impact of these transactions was never large enough to have a material impact on Citigroup's financial statements or our published regulatory capital ratios, including our leverage ratios."

I don't disagree that $9 billion may be a small figure relative to Citigroup's overall financials, but I can argue that the substance behind the booking of the transactions likely makes them material. The SEC makes it clear that materiality cannot be addressed only in numeric terms. The qualitative aspects of the situation must also be considered. The SEC says:

"But quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations. Materiality concerns the significance of an item to users of a registrant's financial statements. A matter is "material" if there is a substantial likelihood that a reasonable person would consider it important."

For example, suppose the CFO of a company gets caught stealing $10,000 via his expense reports. The company's annual revenue is $1 billion, so in comparison, this theft is a minuscule amount. However, the situation must be analyzed further. The fact that a company's head of finance is committing theft is certainly important, and likely has implications for the finance and accounting functions within the company as a whole. If an executive is dishonest with $10,000, isn't there a high likelihood of dishonesty in other financial matters? That alone makes the situation material to the company.

Small Shifts Can Turn a Loss Into a Profit

If we look again at the situation at Citigroup, we see that we cannot only consider the dollars at stake in their alleged accounting mistake, but we must also evaluate other factors surrounding the financial statements before making a sweeping generalization that the error was immaterial.

Two of the points that the SEC says must be considered in evaluating materiality are:

  • whether the misstatement masks a change in earnings or other trends, and;

  • whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.

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This aspect of the test is where companies often make a mistake in their claims that an error or irregularity is immaterial. A dollar figure may be relatively small, but when it's large enough to "help" a company beat expectations or change the trend from a series of quarterly losses into a quarterly profit, then it becomes material.

Companies have relied too long on the excuse that a transaction was too small to matter. Look at the case of (OSTK). There is a lengthy, documented history of accounting irregularities at the company since 2000. In the fourth quarter of 2008, Overstock improperly reported revenue, and therefore overstated earnings by a relatively tiny amount. However, that small overstatement was large enough to cause Overstock to report a profit, rather than the loss that should have been reported.

More recently, Green Mountain Coffee Roasters (GMCR) disclosed an accounting error that caused the company to overstate its net income by a cumulative $4.4 million or $0.03 per share since 2007. The company says that this amount is not material, but when you consider that the SEC recently opened in inquiry that the company believes is related to its revenue recognition practices, it might not be so immaterial after all.

What is the lesson to be learned from this? Don't rely on public companies' assertions that their accounting shenanigans ... er, "errors" ... don't matter. Don't automatically believe management when they say those so-called mistakes are immaterial. Evaluate all of the information surrounding the errors and adjustments, and make your own call about whether a given financial misstatement really matters. Many times, it does.