What are the circumstances when the financial statements are considered to be materially misstated?

A. Target Companies

B. Allocation Of Expenses And Related Disclosure In Financial Statements Of Subsidiaries, Divisions Or Lesser Business Components Of Another Entity

C. Unaudited Financial Statements For A Full Fiscal Year

D. Foreign Companies

E. Requirements For Audited Or Certified Financial Statements

F. Financial Statement Requirements In Filings Involving The Formation Of A One-Bank Holding Company

G. Removed by Financial Reporting Release (FRR) 55

H. Removed by FRR 55

I. Financial Statements Of Properties Securing Mortgage Loans

J. Application Of Rule 3-05 In Initial Public Offerings

K. Financial Statements Of Acquired Troubled Financial Institutions

L. Removed by SAB 103

M. Materiality

N. Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements

Footnotes

1

FASB ASC paragraph 740-10-30-27 (Income Taxes Topic) states: “The consolidated amount of current and deferred tax expense for a group that files a consolidated tax return shall be allocated among the members of the group when those members issue separate financial statements. . . . The method adopted ... shall be systematic, rational, and consistent with the broad principles established by this Subtopic. A method that allocates current and deferred taxes to members of the group by applying this Topic to each member as if it were a separate taxpayer meets those criteria.”

2

Item 801 of Regulation S-K.

3

Rule 3-13 of Regulation S-X.

4

Rule 15d-2 would be applicable if the annual report furnished with the Form S-4 was not for the registrant’s most recent fiscal year. In such a situation, Rule 15d-2 would require the registrant to file a special report within 90 days after the effective date of the Form S-4 furnishing audited financial statements for the most recent fiscal year.

5

Unaudited statements of income and cash flows should be furnished for the earliest period.

6

[Original footnote removed by SAB 114.]

7

[Original footnote removed by SAB 114.]

8

The Emerging Issues Task Force (“EITF”) was formed in 1984 to assist the Financial Accounting Standards Board in the early identification and resolution of emerging accounting issues. Topics to be discussed by the EITF are publicly announced prior to its meetings and minutes of all EITF meetings are available to the public.

9

FASB ASC paragraph 310-10-05-9.

10

The equity kicker (the expected residual profit) would typically not be separated from the host contract and accounted for as a derivative because FASB ASC subparagraph 815-15-25-1(c) exempts a hybrid contract from bifurcation if a separate instrument with the same terms as the embedded equity kicker is not a derivative instrument subject to the requirements of FASB ASC Topic 815.

11

Expected residual profit is defined in the ADC Arrangements Subsection of FASB ASC Subtopic 310-10 as the amount of profit, whether called interest or another name, such as equity kicker, above a reasonable amount of interest and fees expected to be earned by the “lender.”

12

FASB ASC Subtopic 360-20 establishes standards for the recognition of profit on real estate sales transactions. FASB ASC paragraph 360-20-40-18 states that the buyer’s initial investment shall be adequate to demonstrate the buyer’s commitment to pay for the property and shall indicate a reasonable likelihood that the seller will collect the receivable. Guidance on minimum initial investments in various types of real estate is provided in FASB ASC paragraphs 360-20-40-55-1 and 360-20-40-55-2.

13

FASB ASC paragraph 360-20-40-19 states that the buyer’s continuing investment in a real estate transaction shall not qualify unless the buyer is contractually required to pay each year on its total debt for the purchase price of the property an amount at least equal to the level annual payment that would be needed to pay that debt and interest on the unpaid balance over not more than (a) 20 years for debt for land and (b) the customary amortization term of a first mortgage loan by an independent established lending institution for other real estate.

14

Rule 3-14 states that the financial statements of an acquired property should be furnished if the acquisition took place during the period for which the registrant’s income statements are required. Paragraph (b) of the Rule states that the information required by the Rule is not required to be included in a filing on Form 10-K. That exception is consistent with Item 8 of Form 10-K which excludes acquired company financial statements, which would otherwise be required by Rule 3-05 of Regulation S-X, from inclusion in filings on that Form. Those exceptions are based, in part, on the fact that acquired properties and acquired companies will generally be included in the registrant’s consolidated financial statements from the acquisition date.

15

Rule 3-09(a) states, in part, that “[i]f any of the conditions set forth in [Rule] 1-02(w), substituting 20 percent for 10 percent in the tests used therein to determine significant subsidiary, are met . . . separate financial statements . . . shall be filed.”

16

Regarding the composition of the borrower’s investment, FASB ASC paragraph 310-10-25-20 indicates that the borrower’s investment may include the value of land or other assets contributed by the borrower, net of encumbrances. The staff emphasizes that such paragraph indicates, “. . .recently acquired property generally should be valued at no higher than cost . . .” Thus, for such recently acquired property, appraisals will not be sufficient to justify the use of a value in excess of cost.

17

Registrants are reminded that in filings on Form 8-K that are triggered in connection with an acquisition of an investment-type arrangement, separate audited financial statements are required for any such arrangement that individually constitutes 10% or more.

18

An acquisition which was relatively significant in the earliest year for which a registrant is required to file financial statements may be insignificant to its latest fiscal year due to internal growth and/or subsequent acquisitions. Literally applied, Rules 3-05 and 1-02(w) might still require separate financial statements for the now insignificant acquisition.

19

For example, nursing homes, hospitals or cable TV systems. This interpretation would not apply to businesses for which the relative significance of one portion of the business to the total business may be altered by post-acquisition decisions as to the allocation of incoming orders between plants or locations. This bulletin does not address all possible cases in which similar relief may be appropriate but, rather, attempts to describe a general framework within which administrative policy has been established.  In other distinguishable situations, registrants may request relief as appropriate to their individual facts and circumstances.

20

If audited pre-acquisition financial statements of a business are necessary pursuant to the alternative tests described here, the interim period following that entity’s latest pre-acquisition fiscal year end but prior to its acquisition by the registrant generally would be required to be audited.

21

As a matter of policy the staff accepts financial statements for periods of not less than 9, 21 and 33 consecutive months (not more than 12 months may be included in any period reported on) as substantial compliance with requirements for financial statements for 1, 2 and 3 years, respectively.

22

Combined significance is the sum of the significance of D’s investment test (13%), E’s earnings test (9%) and F’s earnings test (11%).

23

The audited pre-acquisition period need not correspond to the acquiree’s pre-acquisition fiscal year. However, audited periods must not be for periods in excess of 12 months.

24

AU 312 states that the auditor should consider audit risk and materiality both in (a) planning and setting the scope for the audit and (b) evaluating whether the financial statements taken as a whole are fairly presented in all material respects in conformity with GAAP. The purpose of this SAB is to provide guidance to financial management and independent auditors with respect to the evaluation of the materiality of misstatements that are identified in the audit process or preparation of the financial statements (i.e., (b) above). This SAB is not intended to provide definitive guidance for assessing “materiality” in other contexts, such as evaluations of auditor independence, as other factors may apply. There may be other rules that address financial presentation. See, e.g., Rule 2a-4, 17 CFR 270.2a-4, under the Investment Company Act of 1940.

25

As used in this SAB, “misstatement” or “omission” refers to a financial statement assertion that would not be in conformity with GAAP.

26

Concepts Statement 2, paragraph 132. See also Concepts Statement 2, Glossary of Terms — Materiality.

27

TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). See also Basic, Inc. v. Levinson, 485 U.S. 224 (1988). As the Supreme Court has noted, determinations of materiality require “delicate assessments of the inferences a `reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him....” TSC Industries, 426 U.S. at 450.

28

See, e.g., Concepts Statement 2, paragraphs 123-124; AU 312A.10 (materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative considerations); AU 312A.34 (“Qualitative considerations also influence the auditor in reaching a conclusion as to whether misstatements are material.”). As used in the accounting literature and in this SAB, “qualitative” materiality refers to the surrounding circumstances that inform an investor’s evaluation of financial statement entries. Whether events may be material to investors for non-financial reasons is a matter not addressed by this SAB.

29

See, e.g., Rule 1-02(o) of Regulation S-X, 17 CFR 210.1-02(o), Rule 405 of Regulation C, 17 CFR 230.405, and Rule 12b-2, 17 CFR 240.12b-2; AU 312A.10 - .11, 317.13, 411.04 n. 1, and 508.36; In re Kidder Peabody Securities Litigation, 10 F. Supp. 2d 398 (S.D.N.Y. 1998); Parnes v. Gateway 2000, Inc., 122 F.3d 539 (8th Cir. 1997); In re Westinghouse Securities Litigation, 90 F.3d 696 (3d Cir. 1996); In the Matter of W.R. Grace & Co., Accounting and Auditing Enforcement Release (“AAER”) 1140 (June 30, 1999); In the Matter of Eugene Gaughan, AAER 1141 (June 30, 1999); In the Matter of Thomas Scanlon, AAER 1142 (June 30, 1999); and In re Sensormatic Electronics Corporation, Sec. Act Rel. No. 7518 (March 25, 1998).

30

Concepts Statement 2, paragraph 131.

31

Concepts Statement 2, paragraphs 131 and 166.

32

Concepts Statement 2, paragraph 167.

33

Concepts Statement 2, paragraphs 168-169.

34

Concepts Statement 2, paragraph 170.

35

Concepts Statement 2, paragraph 125.

37

As stated in Concepts Statement 2, paragraph 130:

Another factor in materiality judgments is the degree of precision that is attainable in estimating the judgment item. The amount of deviation that is considered immaterial may increase as the attainable degree of precision decreases. For example, accounts payable usually can be estimated more accurately than can contingent liabilities arising from litigation or threats of it, and a deviation considered to be material in the first case may be quite trivial in the second.

This SAB is not intended to change current law or guidance in the accounting literature regarding accounting estimates. See, e.g., FASB ASC Topic 250, Accounting Changes and Error Corrections.

38

The staff understands that the Big Five Audit Materiality Task Force (“Task Force”) was convened in March of 1998 and has made recommendations to the Auditing Standards Board including suggestions regarding communications with audit committees about unadjusted misstatements. See generally Big Five Audit Materiality Task Force. “Materiality in a Financial Statement Audit — Considering Qualitative Factors When Evaluating Audit Findings” (August 1998).

39

See Concepts Statement 2, paragraph 169.

40

If management does not expect a significant market reaction, a misstatement still may be material and should be evaluated under the criteria discussed in this SAB.

41

Intentional management of earnings and intentional misstatements, as used in this SAB, do not include insignificant errors and omissions that may occur in systems and recurring processes in the normal course of business. See notes 37 and 49 infra.

42

Assessments of materiality should occur not only at year-end, but also during the preparation of each quarterly or interim financial statement. See, e.g., In the Matter of Venator Group, Inc., AAER 1049 (June 29, 1998).

43

See, e.g., In the Matter of W.R. Grace & Co., AAER 1140 (June 30, 1999).

46

The auditing literature notes that the “concept of materiality recognizes that some matters, either individually or in the aggregate, are important for fair presentation of financial statements in conformity with generally accepted accounting principles.” AU 312.03. See also AU 312.04.

47

AU 312.34. Quantitative materiality assessments often are made by comparing adjustments to revenues, gross profit, pretax and net income, total assets, stockholders’ equity, or individual line items in the financial statements. The particular items in the financial statements to be considered as a basis for the materiality determination depend on the proposed adjustment to be made and other factors, such as those identified in this SAB. For example, an adjustment to inventory that is immaterial to pretax income or net income may be material to the financial statements because it may affect a working capital ratio or cause the registrant to be in default of loan covenants.

51

FASB ASC paragraph 105-10-05-6 states that “[t]he provisions of the Codification need not be applied to immaterial items.” This SAB is consistent with that provision of the Codification. In theory, this language is subject to the interpretation that the registrant is free intentionally to set forth immaterial items in financial statements in a manner that plainly would be contrary to GAAP if the misstatement were material. The staff believes that the FASB did not intend this result.

52

15 U.S.C. 78m(b)(2) - (7).

55

Criminal liability may be imposed if a person knowingly circumvents or knowingly fails to implement a system of internal accounting controls or knowingly falsifies books, records or accounts. 15 U.S.C. 78m(4) and (5). See also Rule 13b2-1 under the Exchange Act, 17 CFR 240.13b2-1, which states, “No person shall, directly or indirectly, falsify or cause to be falsified, any book, record or account subject to Section 13(b)(2)(A) of the Securities Exchange Act.”

56

15 U.S.C. 78m(b)(7). The books and records provisions of section 13(b) of the Exchange Act originally were passed as part of the Foreign Corrupt Practices Act (“FCPA”). In the conference committee report regarding the 1988 amendments to the FCPA, the committee stated:

The conference committee adopted the prudent man qualification in order to clarify that the current standard does not connote an unrealistic degree of exactitude or precision. The concept of reasonableness of necessity contemplates the weighing of a number of relevant factors, including the costs of compliance.

Cong. Rec. H2116 (daily ed. April 20, 1988).

57

So far as the staff is aware, there is only one judicial decision that discusses Section 13(b)(2) of the Exchange Act in any detail, SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724 (N.D. Ga. 1983), and the courts generally have found that no private right of action exists under the accounting and books and records provisions of the Exchange Act. See e.g., Lamb v. Phillip Morris Inc., 915 F.2d 1024 (6th Cir. 1990) and JS Service Center Corporation v. General Electric Technical Services Company, 937 F. Supp. 216 (S.D.N.Y. 1996).

58

The Commission adopted the address as a formal statement of policy in Securities Exchange Act Release No. 17500 (January 29, 1981), 46 FR 11544 (February 9, 1981), 21 SEC Docket 1466 (February 10, 1981).

61

For example, the conference report regarding the 1988 amendments to the FCPA stated:

The Conferees intend to codify current Securities and Exchange Commission (SEC) enforcement policy that penalties not be imposed for insignificant or technical infractions or inadvertent conduct. The amendment adopted by the Conferees [Section 13(b)(4)] accomplishes this by providing that criminal penalties shall not be imposed for failing to comply with the FCPA’s books and records or accounting provisions. This provision [Section 13(b)(5)] is meant to ensure that criminal penalties would be imposed where acts of commission or omission in keeping books or records or administering accounting controls have the purpose of falsifying books, records or accounts, or of circumventing the accounting controls set forth in the Act. This would include the deliberate falsification of books and records and other conduct calculated to evade the internal accounting controls requirement.

Cong. Rec. H2115 (daily ed. April 20, 1988).

62

As Chairman Williams noted with respect to the internal control provisions of the FCPA, “[t]housands of dollars ordinarily should not be spent conserving hundreds.” 46 FR 11546.

64

Section 10A(f) defines, for purposes of Section 10A, an “illegal act” as “an act or omission that violates any law, or any rule or regulation having the force of law.” This is broader than the definition of an “illegal act” in AU 317.02, which states, “Illegal acts by clients do not include personal misconduct by the entity’s personnel unrelated to their business activities.”

65

An unintentional illegal act triggers the same procedures and considerations by the auditor as a fraudulent misstatement if the illegal act has a direct and material effect on the financial statements. See AU 110 n. 1, 317.05 and 317.07. Although distinguishing between intentional and unintentional misstatements is often difficult, the auditor must plan and perform the audit to obtain reasonable assurance that the financial statements are free of material misstatements in either case.

66

Although the auditor is not required to plan or perform the audit to detect misstatements that are immaterial to the financial statements, SAS 99 requires the auditor to evaluate several fraud “risk factors” that may bring such misstatements to his or her attention. For example, an analysis of fraud risk factors under SAS 99 must include, among other things, consideration of management’s interest in maintaining or increasing the registrant’s stock price or earnings trend through the use of unusually aggressive accounting practices, whether management has a practice of committing to analysts or others that it will achieve unduly aggressive or clearly unrealistic forecasts, and the existence of assets, liabilities, revenues, or expenses based on significant estimates that involve unusually subjective judgments or uncertainties.

67

In requiring the auditor to consider whether fraudulent misstatements are material, and in requiring differing responses depending on whether the misstatement is material, SAS 99 makes clear that fraud can involve immaterial misstatements. Indeed, a misstatement can be “inconsequential” and still involve fraud.

Under SAS 99, assessing whether misstatements due to fraud are material to the financial statements is a “cumulative process” that should occur both during and at the completion of the audit. SAS 99 further states that this accumulation is primarily a “qualitative matter” based on the auditor’s judgment. The staff believes that in making these assessments, management and auditors should refer to the discussion in Part 1 of this SAB.

68

Auditors should document their determinations in accordance with SAS 96, SAS 99, and other appropriate sections of the audit literature.

70

Report of the National Commission on Fraudulent Financial Reporting at 32 (October 1987). See also Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (February 8, 1999).

71

AU 325.02. See also AU 380.09, which, in discussing matters to be communicated by the auditor to the audit committee, states:

The auditor should inform the audit committee about adjustments arising from the audit that could, in his judgment, either individually or in the aggregate, have a significant effect on the entity’s financial reporting process. For purposes of this section, an audit adjustment, whether or not recorded by the entity, is a proposed correction of the financial statements....

73

The FASB Discussion Memorandum, “Criteria for Determining Materiality,” states that the financial accounting and reporting process considers that “a great deal of the time might be spent during the accounting process considering insignificant matters.... If presentations of financial information are to be prepared economically on a timely basis and presented in a concise intelligible form, the concept of materiality is crucial.” This SAB is not intended to require that misstatements arising from insignificant errors and omissions (individually and in the aggregate) arising from the normal recurring accounting close processes, such as a clerical error or an adjustment for a missed accounts payable invoice, always be corrected, even if the error is identified in the audit process and known to management. Management and the auditor would need to consider the various factors described elsewhere in this SAB in assessing whether such misstatements are material, need to be corrected to comply with the FCPA, or trigger procedures under Section 10A of the Exchange Act. Because this SAB does not change current law or guidance in the accounting or auditing literature, adherence to the principles described in this SAB should not raise the costs associated with recordkeeping or with audits of financial statements.

74

For purposes of these facts, assume the registrant properly determined that the overstatement of the liability resulted from an error rather than a change in accounting estimate. See the FASB ASC Master Glossary for the distinction between an error in previously issued financial statements and a change in accounting estimate.

75

Topic 1N addresses certain of these quantitative issues, but does not alter the analysis required by Topic 1M.

76

Concepts Statement 2, paragraph 132. See also Concepts Statement 2, Glossary of Terms — Materiality.

77

See definition of “error in previously issued financial statements” in the FASB ASC Master Glossary.

78

FASB ASC paragraph 250-10-45-23.

79

If a registrant’s initial registration statement is not effective on or before November 15, 2006, and the registrant’s prior year(s) financial statements are materially misstated based on consideration of the guidance in this Staff Accounting Bulletin, the prior year financial statements should be restated in accordance with FASB ASC paragraph 250-10-45-23. If a registrant’s initial registration statement is effective on or before November 15, 2006, the guidance in the interpretive response to Question 3 is applicable.