SAB 99 Materiality: Quantitative and Qualitative Factors for Auditors

Staff Accounting Bulletin No. 99, Materiality, is the SEC staff's August 1999 statement on how registrants and their auditors should judge whether a misstatement is material. It was written for public companies. Auditors of private companies still read it, because it is the clearest published argument for a point that AU-C 320 and AU-C 450 also make: a dollar threshold is where the analysis starts, not where it ends.

This guide covers what SAB 99 says, the qualitative factors it lists, how aggregation and netting work, and how to apply the thinking in a nonissuer audit.

What is SAB 99?

SAB 99 is an interpretive release from the staff of the SEC. It is not a rule and not a GAAS standard. It sits in Topic 1, Section M of the Staff Accounting Bulletin series and has two parts: how to assess materiality, and how to treat immaterial misstatements that are intentional.

Its starting point is the long-standing legal and accounting definition. Under the FASB's formulation, an omission or misstatement is material if, in light of the surrounding circumstances, it would probably have changed or influenced the judgment of a reasonable person relying on the information. The Supreme Court's securities-law formulation, which the bulletin quotes, asks whether there is a substantial likelihood that a reasonable investor would view the item as significantly altering the total mix of information available.

What does SAB 99 say about the 5% rule?

The bulletin acknowledges a rule of thumb used in practice: treat a misstatement of less than 5% of a chosen benchmark as immaterial unless there are egregious circumstances such as self-dealing or misappropriation by senior management. The staff then says that exclusive reliance on this or any percentage threshold has no basis in the accounting literature or the law. A percentage can be a useful first screen. It cannot replace a review of all relevant considerations, and the staff notes there are many situations in which a misstatement below 5% is material.

For an auditor this has a direct consequence. The materiality calculation sets the planning number. It does not decide whether a particular uncorrected item is acceptable.

The qualitative factors in SAB 99

The bulletin lists circumstances that may make a quantitatively small misstatement material. The list is illustrative, not exhaustive. Paraphrased, the factors are whether the misstatement:

1. arises from an item that can be measured precisely, or from an estimate with inherent imprecision
2. masks a change in earnings or other trends
3. hides a failure to meet analysts' consensus expectations
4. changes a loss into income or income into a loss
5. concerns a segment or other portion of the business that management has identified as playing a significant role in operations or profitability
6. affects the registrant's compliance with regulatory requirements
7. affects compliance with loan covenants or other contractual requirements
8. increases management's compensation, for example by satisfying bonus or incentive criteria
9. involves concealment of an unlawful transaction

The bulletin also says that market reaction is only relevant where a significant reaction is expected, and that depending on it alone is too blunt an instrument.

Factors 3 and 5 are about public-company reporting, but the rest travel well to private entities. Covenant compliance, bonus calculations, loss-to-profit swings, regulatory thresholds and trends are the qualitative questions a lender, an owner or a bonding company would ask about a small client.

Aggregating and netting misstatements

SAB 99 sets out a two-step approach that matches what AU-C 450 requires of the auditor:

• Evaluate each misstatement individually.
• Then evaluate the aggregate effect of all misstatements on the financial statements and on subtotals such as gross profit, operating income and working capital.

Three points follow from the bulletin:

• A material misstatement cannot be cured by netting. A material overstatement of revenue stays misleading even if an equal overstatement of expense leaves net income unchanged.
• Individually immaterial items can be material together when they affect the same line, subtotal or ratio.
• Care is needed when netting an estimate against a precisely measured item, because the estimate carries its own uncertainty.

Prior-period misstatements also matter. A misstatement that is small in each year can accumulate on the balance sheet until the current-year correction would be material. This is the reason the file should carry forward a summary of uncorrected items from the prior year.

Intentional immaterial misstatements

The second half of SAB 99 deals with small misstatements made on purpose, for example to manage earnings. The staff says registrants should not assume such items are immaterial. Intent does not by itself make a misstatement material, but it can be strong evidence that it is. The bulletin adds that an intentional misstatement can violate the books-and-records provisions of the Exchange Act even when it is immaterial.

For private-company auditors the lesson is the one in AU-C 240: a misstatement that looks trivial in amount is not trivial if it appears to be deliberate. See fraud risk assessment under AU-C 240.

How to apply SAB 99 thinking in a nonissuer audit

1. Set the quantitative levels first. Document overall materiality, performance materiality and the clearly trivial threshold, with the benchmark and reason.
2. Identify the qualitative sensitivities at planning. Ask about covenants, bonus plans, regulatory ratios, owner or lender focus areas, and whether results sit close to breakeven. Write them down, because they change which items you cannot leave uncorrected.
3. Accumulate misstatements on the summary of uncorrected misstatements. Record the effect on each affected line, subtotal and key ratio, not only on net income.
4. Run the qualitative checklist on the total, not just on large items. A $9,000 item that tips a covenant needs more attention than a $40,000 item that does not.
5. Document the conclusion for each uncorrected item, including why it is acceptable or why you asked for correction. The uncorrected misstatements entry and the guide to adjusting entries show how this fits the file.
6. Reassess before the report date. If the aggregate approaches materiality, revisit materiality and the scope of procedures as AU-C 450 requires.

Worked example (illustrative numbers)

A client has pre-tax income of $1,000,000. The firm's planning benchmark is 5% of pre-tax income, so overall materiality is $50,000. The audit finds an unrecorded accrued expense of $40,000, which is 4.0% of pre-tax income.

Quantitatively the item is below materiality. Now apply the qualitative questions. The bank loan requires a current ratio of at least 1.20.

Correcting the entry takes the client from compliance to a covenant breach (2,400,000 ÷ 1,980,000 = 1.212; 2,400,000 ÷ 2,020,000 = 1.188). Under the covenant factor in SAB 99, a misstatement that affects compliance with a contractual requirement can be material even though it is under 5% of income. The auditor asks management to record the entry and considers the effect on the debt classification and going concern assessment. If management refuses, the item cannot be treated as an immaterial passed adjustment without a documented basis.

Common mistakes

• Stopping at the percentage and never documenting the qualitative review.
• Netting a misstatement in one account against an offsetting one elsewhere without evaluating each separately.
• Ignoring unrecorded items carried over from prior years.
• Treating a small misstatement as harmless when the evidence suggests management made it deliberately.

Frequently asked questions

Does SAB 99 apply to private companies?

SAB 99 is SEC staff guidance directed at registrants. It does not bind a nonissuer audit. Auditors of private entities still use its reasoning because AU-C 320 and AU-C 450 take the same position that qualitative circumstances matter alongside amounts.

Is 5% of pre-tax income the rule for materiality?

No. SAB 99 describes 5% as a rule of thumb that some practitioners use and states that exclusive reliance on any percentage has no basis in the accounting literature or the law. Benchmarks and percentages are professional judgments the auditor documents.

Can small misstatements ever be material?

Yes. The bulletin's qualitative factors, such as turning a loss into income, affecting covenant compliance or increasing management bonuses, can make a small misstatement material.

What is the difference between SAB 99 and SAB 108?

SAB 99 addresses how to judge materiality. SAB 108 addresses how registrants quantify the current-year effect of misstatements carried over from earlier years. Both are SEC staff guidance for registrants.

Sources

• SEC, Staff Accounting Bulletin No. 99, Materiality (Topic 1.M), August 12, 1999: https://www.sec.gov/interps/account/sab99.htm
• AICPA, AU-C Section 320, Materiality in Planning and Performing an Audit
• AICPA, AU-C Section 450, Evaluation of Misstatements Identified During the Audit
• AICPA, AU-C Section 240, Consideration of Fraud in a Financial Statement Audit
• SEC, Staff Accounting Bulletin No. 108, September 2006 (Topic 1.N)

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