Journal of Asset Protections and Financial Crime, 2(3). MATERIALITY ...

Journal of Asset Protections and Financial Crime, 2(3).

MATERIALITY THRESHOLDS DEFINED BY COURTS: THE UK EVIDENCE

BY

H. Gin Chong Reader in Accountancy at Southampton Institute of Higher Education. Holds an MBA of Bath University with 10 years of working experience with an international accounting firm in Malaysia. Has a research track record in materiality in auditing, and received the 1993 Larry Sawyer Best Paper award for the paper `Auditors and Materiality'.

AND

Professor Gerald Vinten, Whitbread Professor of Business Policy, University of Luton, Luton

The authors are grateful to Jemery Cooper, Ian Gray, John Innes, Carol Masters, and Benjamin Y.K. Tai, participants of the National Audit Conference at Preston in March 1994 and the European Accounting Association Congress at Venice in April 1994, and the anonymous referee for their helpful comments.

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Journal of Asset Protections and Financial Crime, 2(3). MATERIALITY THRESHOLDS DEFINED BY COURTS: THE UK EVIDENCE

ABSTRACT

Materiality is an ill-defined yet important concept in auditing. However, lack of an auditing guideline exposes auditors to possible litigations due to failure to detect material mis-statement in the financial statements. This paper assesses decisions by UK courts on materiality thresholds. The results from twenty eight selected cases failed to reveal any consistency in the adoption of materiality thresholds. A guideline is urgently needed by the Auditing Practices Board to increase consistency in decisions on material transactions/ events.

Key words: Auditors, courts' decisions, materiality thresholds, true and fair view.

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Journal of Asset Protections and Financial Crime, 2(3). Introduction

The notion of risk seems to be well recognised and taken into account by those concern with asset protection and financial crime. The concept of materiality, although representing the opposite side of the coin, suffers from relative neglect. This is surprising since the two live in symbiosis with risk as a percentage probability, and materiality is an absolute figure. There are types of materiality levels relating to fraud. For example, the Serious Fraud Office only deals with assets and financial crime in excess of £5 million. This leads fraudsters to manipulate such materiality level to their own advantage. If they do not want the more severe attention of the Serious Fraud Office, with their heightened investigation power, then they would insure that the fraud is left with £5 millions or less. The crown prosecution service works on two levels, both risk and materiality. They are unwilling to take on cases unless there is at least a 50% chance of success and equally they have materiality threshold as to the likely cost to the prosecution, and they need to consider these two factors together. Similarly, under the Money Laundering Regulations 1993, with the need of financial institutions to report account of 15,000 ECU and above, there have been a tendency for the proliferation of account just under this amount1. Of course, it is possible to use computer interrogation software to extract such suspicious account. It is possible that accounting materiality level will be set at too high a level to highlight certain prevalent fraud. Although auditors is under the responsibility to take action on the discovery of fraud2, particularly if a financial service institution is involved, the fact remains that the materiality level will not assist the protection of fraud in the first place. There is considerable ambiguity and divergence, both in the accounting pronouncement and in the legal cases in the definition of materiality, and it is the purpose of this article is to inform on the nature of the current debate, and to indicate its relevance to those involved in the asset protection and financial crime.

Expectation gap and materiality `At one time, the audit was made primarily to inform management of irregularities and inefficiencies in business... that function remains one of the principal reasons for 236

Journal of Asset Protections and Financial Crime, 2(3). the audit. Gradually, a need for independent audits was generated by public ownership of business enterprises and by requirements of the stock exchanges... investors, investment specialists, stockholders and lenders demanded more reliable information. It is now well recognised that the audited statements are made for the use of third parties who have no contractual relationship with the auditor. Moreover, it is common knowledge that companies use audits for many proper business purposes, such as submission to banks and other leading institutions that might advance funds and to suppliers of services and goods that might advance credit... The auditor's function has expanded from that of a watchdog for management to an independent evaluator of the adequacy and fairness of financial statements issued by management to stockholders, creditors and others...'3

These were the observation made by Judge Schrieber of the New York Supreme Court in 1983. Ten years later, courts on both sides of the Atlantic have changed their minds and insisted that there must be a contractual relationship between third parties and the auditors, otherwise the third party `could not maintain an action against [the auditors]'4. This seems to be welcome news to the auditing profession, but may not receive full endorsement by users of financial statements. Users keep pushing the auditing profession to absorb full responsibility and liability for any future corporate failure. The widening gulf of the expectation performance gap 5, and ever-increasing complex business structures which have led to complicated business transactions have forced auditors to their maximum limit of guarding against possible litigation. In view of this, auditors need to exercise a high level of due professional care and integrity on all their audit assignments to discharge their duties 6. To be cost effective, they have to be selective in their sampling7 as well as to focus attention on material and exceptional items recorded in their clients' underlying records. In this respect, materiality is an important element in both the planning and evaluation stages of an audit. It serves as the yardstick in deciding the extent of testing in the planning stage, and the basis to assess the adequacy and relevance of available evidence, and its effect on the truth and fairness8 of the financial statements, in the evaluation stage. Expressing an audit opinion on a set of financial statements implies compliance with the concept of materiality in discharging the auditors' duty9. Despite the importance of materiality to auditors and the increasing number of legal cases faced by auditors alleged to discharge their professional duties, there is no systematic study of materiality thresholds defined by the courts and the criteria upon which these thresholds were 237

Journal of Asset Protections and Financial Crime, 2(3). established. To remedy this, the paper first assesses the implications of materiality in both the academic and legal perspectives, and then compares materiality thresholds adopted by the auditing profession and those determined in the courtrooms.

Materiality concept Different commentators have expressed different levels of feeling and concern on materiality10. Materiality has been described as the cornerstone of accountancy11, the Achilles' heel of the accounting profession12, `fundamental tenet of securities law and accounting literature'13, `grey area in auditing'14, `... a matter for professional judgement'15,`... the norm which determines the nature, timing and extent of audit work...'16, and `... the degree of importance of an item(s) to users of accounting information...'17. It is a core18, critical19, elusive20, ill-defined21, illusive22, important23, meaningless24, mystery25, nebulous26, psychological27 and unknown28 concept. This peculiar concept caused extensive confusion and concern to both the accounting and auditing profession. One of the obvious reasons for this is the lack of a guideline on materiality. Lacking a guideline, auditors are being torn between meeting the increasing needs and expectations of users and being cost-effective in their auditing techniques. Too much auditing may not only cause undue distress to both auditors and their clients, but also having too many details disclosed in financial statements may distract users from focusing attention on crucial information in decision making. On the other hand, too small sample sizes in sampling would worry auditors in case their clients go into liquidation within a short space of time after a clean audit report was issued. The auditors need to strike a balance between the two. Materiality has been defined by the Auditing Practices Board (APB) as `... if its (an item(s)) omission or misstatement would reasonably influence the decisions of a user of the financial statements' (SAS 220, 1993, para 3), without any reference to quantitative measurements in view of `materiality is not capable of general mathematical definition as it has both qualitative and quantitative aspects' (para 3) and `the assessment of what is material is a matter of professional 238

Journal of Asset Protections and Financial Crime, 2(3). judgement.' (para 4). Studies29 have shown strong support for the APB to issue a guideline on materiality30. Similar calls to meet the needs of users were reflected in the courts' decisions.

In the legal context, materiality has been defined as `any fact affecting the investor's decision to buy, sell or retain securities'31, `a fact which would materially affect the judgment of the other party to the transaction'32, `any fact influencing the reasonable and prudent man in an investment decision'33, `any fact having a "significant propensity" to influence the investment decision' 34, `a fact is material if it might have an impact on the decisional process of a recipient'35 and `any omission of facts which has a substantial likelihood of affecting the average prudent investor's decision'36. Two matters could be drawn from the above definitions. Directors need to ensure that all material facts are properly disclosed in the financial statement to enable users to arrive at sensible decisions. This, of course, depends on the level of materiality. However, courts failed to define the extent to which an item or transaction would constitute having significant impact on users' decision making. Secondly, there exists a deeper and sharper definition of users in the legal context compared to those in the accounting context37. The legal definition includes users from one extreme of `reasonable shareholders'38 who are commonly regarded as existing shareholders and having interest in the operation and stewardship of a business undertaking to another which includes a `reasonable man'39, a `reasonable and prudent man'40 and a `recipient'41; while the accounting context covers a wider meaning which includes both natural person and business undertakings42. Not surprisingly, lack of a proper guideline from the accounting and auditing professions means that auditors expose themselves and subject to courts' whim and mercy in deciding the extent of disclosure or non-disclosure of material facts in the financial statements, and even who should constitute an `ordinary recipient'. This shows a lack of competence on the part of both the accounting and auditing profession to set their own materiality threshold and failure to identify users' needs. Instead of taking an active role in leading the auditing and accounting profession, the APB itself becomes a passive force in receiving guidance and instructions from legal outcomes. The legal definition of `recipients' presumably, includes members of the general public and 239

Journal of Asset Protections and Financial Crime, 2(3). people in the street so long as they have a sound mind, with or without any interest in the financial position of a business undertaking. A lot of resources would definitely be wasted in meeting the needs of this group of users. Generally, not everyone is interested in the financial operations and performance of a company and, presumably, a `reasonable man' test may yield different results from a `reasonable investor' test43 in view of the investors' general interest in stock market reactions, level of expectations of the performance of a company, dividend yield, earnings per share and effects of political and environmental risk compared to `reasonable men'. Between the above two extremes of interested investors and people in the street, the courts have identified a group of users who are in the `middle of the road'. These are `average prudent investors'44, `reasonable investors'45, `ordinary prudent investors'46 and `ethical investors'47. Even though these phrases are interchangeable and should include existing, potential and `imaginary'48 investors in a business undertaking, all of them share a common perspective, that is once the intention of using the information for decision making purposes is removed, they would function as the model of reasonableness under normal circumstances. Undoubtedly, there is still a slight emphasis that needs vary between groups of users. The concept of materiality is determined by the impact on the average prudent investors and stakeholder whereas the concept of reliance is determined by the impact on a particular investor in the given situation. As far as `ethical' investors are concerned, they have a wider need and interest in information related to `ethical' issues like the environment, civil rights, social and political aspects which may not normally be of much concern to average and prudent investors. `Average prudent' investors of today have more of a resemblance to institutional than to individual investors. There has been an increase in economic and financial knowledge and awareness since the 1930s. The availability and easy access to information could have an effect on investors generally, and so the make up of `average' investors. For example, portfolio theory has recently led some to believe that the most important `fact' about shares is the beta coefficient49. However, it should not be assumed that investors only lust for investment returns, since in fact they are also concerned with other issues50 as well. The definition of materiality would be expanded to the extent that such 240

Journal of Asset Protections and Financial Crime, 2(3). informational requirements exceed those of the `average prudent' investors. Similarly, variations in the standard of certainty alter the definition of materiality.

Language of the courts There are occasions where courts are confused with the issues of materiality. In two separate occasions, courts have defined a fact to be material, even though it did not cause investors to change their mind about a particular transaction51. In other words, an average prudent investor could add a particular fact to the aggregate of facts before arriving at a particular decision. However, this implication is rather inconsistent with the decision by the court that `materiality standards vary according to situations, contexts and companies'52. There exists vagueness and inconsistency in dealing with the impact of a fact on the decision process of average prudent investors and usage of legal terminology. Words like `might'53, `would'54, `significant propensity'55 and `significant likelihood'56 were enunciated as the appropriate degree of certainty. Although both `might' and `would' carry the identical purpose of making polite requests or appeals, in terms of probability or effect, `might' seems to be the test that would require the least probability of an effect on the decisional process of the investors. It is suggestive of a mere possibility57 and permission58. `Would' appears to require the highest degree of certainty amongst the above, suggestive of it being more probable than not, if not absolute certainty, and `used to describe a hypothetical action or event in the past'59. The `significant propensity' standard looks to fall some place within a middle range, more than a mere possibility but not necessarily more than probable. `A substantial likelihood' could also be included in the middle range, and to a certain extent, could interchange with `significant propensity'. On the other hand, `likelihood' arguably connotes a greater degree of certainty, `a probability' rather than `propensity' which is only an `inclination or tendency'60. Obviously, a shift from a `would' standard to a `might' standard tends to increase the scope of materiality. To shift from `would' to `substantial likelihood' falls short of `would' as a standard of certainty, the definition of materiality is expanded61. 241

Journal of Asset Protections and Financial Crime, 2(3). Regarding the usage of the word `might', it is normally deemed material if it `might' have an impact on the decisional process of average prudent investors. In Affiliated Ute Citizens v. United States [1972, 406, U.S. 128, 153-4], `all that is necessary is that the facts withheld be material in the sense that a reasonable investor might have considered them important in the making of his decisions'. However, in Reeder v. Mastercraft Electronics Corporation [1973, 363 F. Supp. 574, 581 S.D.N.Y.], courts held that for `omission'62 cases where the defendant can demonstrate non-reliance63, that is even material facts had been disclosed, plaintiff's decision as to the transaction would not have been affected, liability will not be imposed64. In Kohler v. Kohler Co. [1963, 319 F.2d 634 7th Cir], the court indicated that a material fact was one which `might' affect the value of a corporation's stock or securities. Although both the Affiliated Ute Citizens' and Kohler's cases use the term `might', the tests employed differ. The former refers to the impact on the decision making process of an investor, whereas Kohler's case emphasises the impact of materiality on the value of the shares. A fact might affect the share prices, but not necessarily investors' decision on whether to buy, hold or sell their investment; that is the value itself may affect the price which investors prepared to pay, but not necessarily that they would actually purchase them. In Gladwin v. Medfield Corp. [1976, CCH Fed. Sec L. Ref 95787 5th Cir] the judge found that the company's failure to reveal purchases in nominee names of 4.9 percent of the company's stock was a material omission in violation of rule 14a-9, despite the argument that although the information would tend to affect a reasonable shareholder in determining how to vote, it was unlikely to influence him to vote against management. In response, the court stated that `materiality does not depend on which way the information is likely to influence the shareholders to vote, rather it depends on whether the information is likely to influence the decision to vote.' The phrase `influence the decision to vote' is quite disturbing because it implies that the court is focusing on whether the information influences the shareholders' decision to vote or not to vote, rather than the shareholders' decision on how to vote. Materiality thresholds In view of the above, this section of the paper attempts to test two separate hypotheses: 242

Journal of Asset Protections and Financial Crime, 2(3). H1: There is no consistency in the usage of descriptive words on material transactions or situations; and H2:

There are no specific materiality thresholds adopted by courts in the UK in arriving at legal decisions.

With these in mind, we selected twenty eight cases from the 1990/91 and 1991/92 editions of British Companies Cases (BCC). The purpose of this exercise was to survey descriptive words applied by courts in describing the (im)materiality of a particular situation, item or transaction. Again, results confirmed a lack of consistency in the usage of words in describing the materiality of an item or transaction. Apart from using the word `material'65, courts tend to use words describing one extreme like `adequacy'66, `ample surplus'67, `ample margin'68, `considerably higher'69, `dramatic'70, `enormous'71, `fairly substantial'72, `majority'73, `significant'74, `substantial'75, `very substantial'76, `very large'77 and `very very large'78 to `extremely small'79, `not very substantial'80 and `very little'81. Figure 1 maps words used by UK courts to describe the significance of a transaction or situation. This wide range of words used by courts again showed courts' ignorance of the existence of the word `materiality' and difficulties in describing a particular transaction or situation with precision. This inconsistency in the usage of words merely muddling the water in establishing materiality thresholds for both the legal and auditing professions. In this respect, H1 is accepted without reservation. Of course, it is not the courts' duty to establish specific words to describe the extent of impact or materiality of any particular transaction or situation. However, consistency in the usage of words would definitely assist all professions (accounting, auditing and legal) to set the views on what the courts may have in mind when deciding cases. Apart from inconsistency of the usage of words, the samples also show that there is a lack of consistency in the usage of bases in determining materiality thresholds by courts. This could be due to the varying nature of individual cases. In view of this complication and confusion, we look at the criteria used by courts in determining the materiality thresholds, first on the revenue items, and then the balance sheets. The degree of inconsistency in the recognition of materiality thresholds by the courts has long 243

Journal of Asset Protections and Financial Crime, 2(3). been established. In Escott v. BarChris Construction Corporation [1968, 283 F. Supp 643 S.N.D.Y], a 100% increase (from $0.33 to $0.65) of earnings per share (EPS) is considered immaterial while in the Financial Ind. Funds Inc. v. McDonnell Douglas Corporation [1971, 474 F.2d 514, D.C. Cir.], a 85.88% decline of EPS (from $0.85 to $0.12) is considered material. Surprisingly, the period over which these changes taken place is the same in both cases, that is over a period of six months. The Caparo case shows a different approach to the whole question of assessing the materiality threshold. A 55.9% price drop of Caparo's share from 143p within three months is considered `dramatic' 82. Apart from EPS and share prices, net assets and net loss were used as indicators for investors' decision making. Even though the net assets are only £11,124 and the company is facing a net loss of £48,094 these are considered `material' in a takeover bid83. Turnover was used as a measurement on the performance84, to assess the excessiveness of directors' remuneration85 and to compare the extent of capital reserves86. An average increase of turnover by 121% per annum over a four-year period is considered `enormous'87 while a 7% difference between sales forecasted by directors and the administrators is deemed to be `not material'88. For capital reserve, it is considered `very small' if it is less than 1.5% of turnover89. In Re. Keypack Homecare, directors' remuneration of £25,377 which represents 5% of turnover is considered `excessive' [p. 120] and `fairly high' [p. 120] while £35,000 is considered `justifiable' when compared to £50,783 net profit90 despite the amount of directors' remuneration between the two cases is merely £10,000. Regarding the increment of the directors' remuneration, an increase of directors' remuneration by 53% in a profit-making year is considered `very large'91 while a nominal increase in remuneration by 7% in a loss-suffering year is considered `very high'92. On the issue of liquidators' fee, £5,784 is considered `not very large'93 while £31,784 is treated as a `substantial sum'94 despite a £2,500 interest charged for late payment for corporation tax, and a recovery of 38.6p per pound of debt are considered `substantial' 95. Despite all these confusion, there are some consistency in that turnover and net profit/loss tend to be the `favourite' determinants for revenue items by UK courts. 244

Journal of Asset Protections and Financial Crime, 2(3). Courts seem to take a different view on balance sheet items. Holding of 0.3% of issued share capital of a company is considered `extremely small'96 compared to 49% which is treated as a `large percentage'97. An injection of £40,000 as working capital of an ailing company is deemed to be `reasonable adequacy'98. Total liabilities were used as bases to compare the extent of assets' deficiencies, Crown debts (which include PAYE, VAT, National Insurance Contributions), and the amount guaranteed. Crown debts which represent less than 3.3% of total liabilities are considered `not significant' 99 but are deemed `significant' if they are more than 42% of total liabilities100. However, Crown debts which are between £1,724 and £2,620 are considered `not significant'101, but if they exceed £37,000 they are deemed `substantial and significant'102. Directors' guarantee for liabilities of £268,000 is considered a `very very large sum'103 while £1,132,179 arising from profits on realisation of capital is merely `substantial'104. In the case of liquidation, surplus (or deficiency) in the distribution is normally used as a denominator for materiality. A 46% surplus of net assets realised is an `ample margin'105 while an 89% deficiency is treated as `substantial'106 even a cash balance of £4,300 is considered `very substantial' 107. The above survey shows that there exists no `fixed rule' on the part of the courts in determining materiality thresholds. It could well be because surrounding circumstances and relevant facts were taken into consideration before a judgement is delivered. Both qualitative and quantitative measures are obviously observed in all individual cases108. In this respect, H2 is again accepted as there are no obvious precise rules on how courts decide the cases. It is quite frequent that legal cases have little support of arithmetical data and figures to enable us to establish the materiality thresholds with certainty and judgements were delivered by judges' own fiat109. This could be due to judges tending to concentrate on the legal aspect, rather than the financial effects. This, of course, forced us to concentrate on the twenty eight selected cases out of a total of 236 over the two year period of 1990 and 1991, and it is relatively difficult to derive the absolute bases and thresholds of measuring 245

Journal of Asset Protections and Financial Crime, 2(3). materiality. Again, it is not the judges' duties to ensure that their judgements contain full financial details and facts, but merely sufficient to support their opinions.

Concluding remarks It would be interesting to assess the materiality thresholds adopted by different level of courts, from Chancery Division, Courts of Appeal and House of Lords, when deciding similar situation(s). The bases used in each case could be of value to future research and for the development of accounting standards and auditing guidelines. Comparison between the materiality thresholds decided by courts could be made between countries having their own auditing guidelines on materiality and those which do not. This would enable one to draw a conclusion as to whether auditors really practised what they have preached in the auditing guidelines and auditing manuals (of individual auditing firms), and whether having a materiality guideline is really a worthwhile exercise. The above selected cases exclude those settled out of court110 and those under the investigations conducted under section 432(2) of the Companies Act 1985 by the Department of Trade and Industries (DTI)111. It would be valuable to compare decisions arrived at by courts, and those by DTI. Obviously, a larger sample size would enable one to draw a more representative conclusion on the materiality thresholds normally adopted by the legal profession. The results of these investigations could eventually serve as references to the plaintiff as to whether it is of any costbenefit to pursue legal actions against the other parties. Users of financial statements could draw a line where they may stand a good chance of winning in any particular case against the auditors and/or directors. This will definitely reduce `unnecessary' legal cases coming through the courtrooms, and saving courts' resources, both money and time. There is no apparent close relationship between individual legal cases and the materiality criteria adopted by courts (see table 3), judges are not to be blamed for failing to select one specific approach to describe the extent of significance or impact of any transaction or situation; the buck stops with the accounting and auditing profession itself. Similarly, this applies to materiality 246

Journal of Asset Protections and Financial Crime, 2(3). thresholds. Any further delay or failure to draw up its own mathematical measurement on materiality would soon invite courts to decide the fate for the auditing profession. It is not surprising that Justice Rogers in Cambridge Credit Corporation Ltd v. Huchinson [985, 9 ACLR, 563] issued the following stern remark to the auditing profession, and auditors who could not decide for themselves,

`...if an auditor is uncertain or suspicious about a breach of law of relevance to the accounts, he is under an obligation to obtain legal advice.' Practitioners will now be aware of the importance not only of risk, but of it, Siamese twin, materiality. Materiality level are often set for the reporting of asset loss. The reason for this is that the cost of highlighting minor loss is not worth the administrative efforts. Where the materiality level is exceeded, such reporting does enable operational decision to be made. For example, areas of internal control weakness can be the subject of managerial attention. It is also possible to decide whether to self-insure, to contact out the risk, to take out external insurance cover, or to establish a captive insurance company. The trouble with the existing state of play of materiality is that it may not fully serve the need to minimise the risk of fraud. Materiality, like religion and politics, seems to be a subject not to be discussed fully in respectable company. It is because of the lack of definition of materiality that the way is free for fraudsters to exploit the opportunistic circumstances in which they may find themselves. We hope that in this article we have raise issues that will need to eventual resolution and clarifications that will facilitate the work of all those involved in asset protection and prevention, minimisation and detection of financial crime.

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Journal of Asset Protections and Financial Crime, 2(3). TABLE 1: GUIDELINES RECOMMENDED BY ACCOUNTING BODIES ACCOUNTING BODY

MATERIALITY GUIDELINES RECOMMENDED

Australia Accounting Research Foundation (1974) Materiality in financial statements, Statement of Accounting Standards No.5, DS7, October, pp.531-533; New Zealand Society of Accountants (1985) `Materiality in financial statements', Statement of Standard Accounting Practice No.6, The Accountants' Journal (New Zealand), August, pp.67 & 68.

`an item is: (a) material if it is >10% of the appropriate base; (b) immaterial if it is