Long-awaited guidance from the Securities and Exchange Commission on materiality, which sources expect out in the next week, may not impact bankers in the short term, but it could increase their auditing costs in the long term.

The forthcoming guidance is expected to discuss qualitative things like important ratios or subtotals in the financial statements, and the net interest margin rather than just net income. The guidance reflects the SEC’s increased scrutiny on what it calls earnings management, which bankers will have to consider going ahead. A celebrated example of the SEC’s concerns are what it identified as excessive loan-loss reserves, ones that the bank regulators saw instead as prudent. That issue has the attention of a newlyformed joint working group of the SEC and banking regulators (see story, p. 2).

"The SEC believes some companies are using the cover of materiality to record improper entries," said Robert Herz, a partner at PriceWaterhouseCoopers and the chair of the American Institute of Certified Public Accountants’ SEC Regulations Committee, and formerly an SEC advisor. Many bankers said they do not have a problem with the SEC’s disapproval on that score, having heard warnings in SEC officials’ speeches for a long time.

But they do wonder if the issue will become a problem for the auditors because the implication behind the forthcoming guidance is the SEC’s guidance dips to a lower materiality threshold than the auditing firms have in their own internal policies.

"The problem is they have to do more work," one banker said. He said the issue has made auditors so nervous that over time it will drive up the cost and work level required to complete a bank’s annual audit. The idea of the materiality guidance in the first place is to reduce the work and cost of the audit. For example, if revenue and expense are both overstated by $5 million, the net is not overstated at all because the two offset each other. The auditors might choose to say it is not material because the net income is not misstated. But bankers fear that the SEC may call it a misstatement because the revenue was misstated.

"It’s not absolute assurance; it’s fair presentation. The implication there is (that) it’s reasonable and you can rely on it," said Roger Dean, controller at Fifth Third.

Tom Ray, director of audits and attest standards at the American Institute of Certified Public Accountants, agreed that the new guidance could have an effect on the audit, but said he did not expect it would force auditors to go looking for items that are smaller and less material than they do now. Rather, he said, the guidance should help auditors and bank management to evaluate the matters that the audit tests identify.

Dean said that he believed the SEC has gotten overly concerned about sensitivity of markets to trends and high (price-to-earnings) ratios. While the idea of making sure investors know what is material to the business is admirable, he said, the SEC is painting the picture of abuses with too broad a brush. Because the question of what is material can be argued to be in the eye of the beholder, and the audience he and most bankers deal with–analysts– will not easily be swayed by the kind of alterations the guidance might prevent, it could be less than useful.

"The analyst community we deal with usually looks at us over time and at long-term performance, and (it looks for) good long-term management. So I don’t have any motivation to paint some rosy picture of one item in my financials because you can’t sustain it and that’s not what my audience is worried about. The issue is what does it take to change somebody’s opinion of your performance. The answer to that is it depends on the investors." Dean said that his investors do not care so much about revenue as they examine expenses.

The idea of what is material to shareholders has been loosely understood as anything that would affect earnings between 3% and 5%. If not material, an item or piece of news does not have to be disclosed.