Custom research: methods and applications

Custom Research

Cousteau's decision to waive the material error may seem, in the context of the subsequent SEC litigation release, to have been an error on the part of the auditor. Indeed, the responsibility of the auditor is to detect and report material errors

There is, however, some leeway in practice, for the auditor to do as Cousteau did and determine that the error was not material. Despite that leeway, the financial markets depend on the accuracy of the information provided by the financial statements and approved by the auditor. Evidence of fraud, to the investor and to regulatory authorities, is always material. This points to a gap between the fundamental assumptions upon which our capital markets are designed and the real world practice of auditors. This paper will argue that given this gap, Cousteau was not in the wrong. If current auditing practice allows for auditor judgment on issues of materiality, then Cousteau retains the right to exercise that judgment.

Materiality

The concept of materiality is central to the auditing role. The notion of materiality "recognizes that some matters, either individually or in aggregate, are relatively important for true and fair presentation of financial information in conformity with recognized accounting policies and practices."

There is no set definition for materiality, but there are standards. In the U.S., the SEC governs materiality. It has been argued by Sauer

that the SEC has diverged from the primary precedent set regarding materiality in TSC Industries vs. Northway (1976). In that case, the court ruled that information is material if a "reasonable investor" would have regarded it as "having significantly altered the 'total mix' of information available to the public"

. As such, it is not the size of the monetary value but rather the type of information and its import to the fair presentation of financial information.

The vagueness of the term "reasonable investor" leaves the precise interpretation of TSC vs. Northway up to individual courts in cases where fraud is suspected. The SEC, on the other hand, interprets materiality in its own way, which Sauer argues in his article has become increasingly divergent from the relevant court decisions on the subject. Also weighing in on the issue is the PCAOB, which has loosely attempted to guide auditors, although their guidance is also considered by Sauer to be weak.

Current Practice

Sauer points out that auditors are instructed by the SEC, when they uncover illegal acts to take steps to ensure that the company corrects the figures, and failing that they must either then resign the engagement or inform the SEC of the illegality. Studies have shown, however, that auditors waive approximately 50% of the material errors they uncover

. While waiving material errors increases auditor risk, it is not specifically illegal. While it runs against SEC rules, those rules have yet to specifically define the limits of materiality for auditors. This leaves the auditors in the position of defining materiality. Materiality is always taken into the context of the entire set of financial statements and publicly available information about the company.

Thus, while there is today a trend towards auditors resigning engagements, Sauer argues that this merely reflects increased auditor risk as a result of the increase in variance between the legal precedents and SEC rulings. Current practice of auditors with respect to materiality, therefore, does not reflect changes in the laws regarding financial statement fraud. It still holds in law that there is considerable leeway for auditors to determine materiality, pending the court's view of the "reasonable investor." It should be noted that courts prefer to use proxies for the "reasonable investor," and there is little consistency with respect to the proxies chosen.

Responsibility

The vagueness of materiality in law belies the importance of the issue to the function of modern capital markets. A key tenet of the modern capital market system is the efficient market hypothesis. In this hypothesis, stock prices accurately reflect all known, publicly available information about a security

. Among the most important pieces of information are the financial statements. A share of stock represents a claim on that company's assets or earning. Therefore, to properly value that share, the financial statements must accurately reflect the firm's assets, liabilities and earnings.

Although Sarbanes-Oxley has attributed a greater degree of responsibility for the accuracy of financial statements to the executives of the firm in question, the auditor still plays a critical role in guaranteeing the accuracy of the financial statements. Reflecting this, the role of the auditor has shifted over time from the evaluation of financial transactions to the evaluation of management practices

. The auditor, therefore, bears a certain degree of responsibility for holding management accountable to the needs of the financial markets. Among the financial market stakeholders are the shareholders, the owners of the company. Another stakeholder group is the potential owners, those who are examining the company for purchase.

Cousteau's View

The view that Cousteau took is that the fraudulent statements were not automatically material by virtue of their fraudulent nature. The materiality of the fraudulent statements is determined only in the context of all publicly available information. The first point in defense of Cousteau is that he has the leeway as auditor to make that determination. He bears a certain degree of auditor risk in making such a determination, but the decision to bear that risk is well within his legal rights. Indeed, the studies that conclude some 50% of material errors are waived shows that many auditors take the same stance. That half of the practitioners of the profession appear, by their own actions, to support Cousteau's view, indicates that this view has merit. Cousteau did undertake the first step, which is to confront management with the fraud, and ask that they address the issue. When they did so in a half-hearted manner, he had the right at that point to either end the engagement or contact the SEC. However, it does not flow from that, however, that he was obligated to do so. Indeed, it is the auditor's prerogative to report or not, depending on the materiality of the fraud.

The question of whether or not the fraud was material to the financial statements must also be examined in the context of the relevant stakeholders and the auditor's role in the integrity of the nation's capital markets. The relevant stakeholders in this instance were the current and prospective shareholders. The current shareholders' interests were served by the fraud, since share value increased. The fraud may have been material, but the current shareholders were not going to complain. The prospective shareholders, for their part, opted not to purchase the company. The alleged purpose of the fraud was to overstate revenues to entice potential buyers. Yet, said buyers failed to materialize. It is reasonable to take these potential buyers as the "reasonable investor," since they were in theory at least sufficiently interested in the company to examine it. That they passed indicates that the "reasonable investor" was not misled by the fraud. This supports Cousteau's contention that the fraud did not, in the context of all publicly available information about the firm, was not material to the overall integrity of the financial statements.

Conclusion