Professor James Park’s paper makes at least two excellent contributions to the literature on materiality in financial reporting: (1) the relevant viewpoint for testing materiality is the reasonable investor, as under current law, here taken to mean the investor engaged in fundamental valuation analysis, not necessarily proxied by aggregate market reaction models and (2) an important basis for assessing materiality, using current law’s “total mix of information” conception, is whether a misstatement is persistent as opposed to isolated.   The paper also offers valuable implications of these insights for preferring vicarious or individual liability arising from material financial misstatements. 

            The paper thus addresses the pervasively important issue of assessing materiality in financial reporting. This subject is particularly topical amid high levels of financial restatements in the past five years.  The subject also is receiving formal policy attention.  For example, the SEC’s Advisory Committee on Improvements to Financial Reporting (CIFR) http://www.sec.gov/about/offices/oca/acifr.shtml, in its Final Report  http://www.sec.gov/about/offices/oca/acifr/acifr-finalreport.pdf, released last Friday, addresses this territory.   The paper admirably enriches the field of law and accounting.  I had the pleasure previously to comment to Professor Park on his paper and here can register just a few additional modest observations. 

            First, Part II of the paper explores how to enhance analytical understanding of the prevailing legal notion of a reasonable investor. It notes the prevalent invocation of market reaction models to assess materiality from the reasonable investor’s viewpoint.  It explores how materiality should be conceived if one instead locates the reasonable investor in traditional fundamental valuation analysis. As a devotee of value investing practiced by luminaries such as Warren Buffett, I particularly appreciate this orientation shift.

            The most powerful implication of Professor Park’s insightful analysis “reveals a basic flaw in the current tests for assessing materiality.” Those tests concentrate too heavily on size (quantitative materiality, often using a 5% of net income rule of thumb) and certain specific notions of qualitative materiality, especially managerial motivations.  Professor Park concludes this illuminating discussion by observing that this prevailing result obscures a vital aspect of materiality assessments: the relative persistence or isolation of a misstatement.

            Excellent as the discussion is, a modest addition could note inherent, methodological, limitations on market reaction studies.  For financial misstatements, these studies are conducted in relation to subsequent restatements of previously misstated financials.  Problems include measurement difficulties arising from the time lag between market knowledge of a forthcoming restatement and its ultimate resolution;  the bearing on market price of matters other than the misstatement and restatement; and disclosure accompanying a restatement that may provide offsetting pricing effects.

            Second, Part III of the paper proposes explicitly to examine persistence versus isolation as a central factor in materiality evaluations.  The paper wisely puts this proposal in terms of legal presumptions.  This shows the proposal’s distinctiveness and adds flexibility to promote its utility.  Persistence yields a presumption of materiality, even if less than 5%; isolation yields a presumption of immateriality, even if greater than 5%.    Both are rebuttable.  If it is unclear whether a misstatement is persistent or isolated, then law continues to resort to examine the totality of circumstances (under the “total mix” conception). 

            Thus Professor Park rightly acknowledges that the notion of persistence-isolation will not always be dispositive. The main point is that it can help in a wide range of contexts where it affects the total mix of information available to reasonable (fundamental valuation) investors.  Notably, in my view, this contribution makes explicit a component of qualitative materiality analysis that has been obscured but deserves a prominent place.  Professor Park’s prescription to take explicit account of persistence versus isolation is thus valuable.

            Professor Park’s proposals are also consistent with CIFR’s recommendations and provide an intellectual basis to accept those recommendations.  CIFR recommends retaining the reasonable investor standard, while placing more emphasis on actual investor valuation analytics as opposed to the prevailing heavy reliance upon market reaction studies.  It recommends giving explicit attention to the persistence or isolation of a misstatement (at least so long as an isolated item “does not alter investors’ perceptions of key trends affecting the company”).

            Given the nature of high-quality legal scholarship compared to advisory committee reports, Professor Park’s analysis is richer and more complete than the briefer CIFR recommendations.  Accordingly, when the SEC and others study CIFR’s Final Report, they would benefit from reading Professor Park’s elaboration of these two important propositions.

            That said, worth appreciating is how CIFR’s Final Report does not propose to eliminate market reaction studies from analysis nor to elevate the persistence-isolation inquiry above other ways to assess materiality.   After all, there are many different types of misstatements, some important to investors and some not.  The persistence-isolation spectrum is one useful ground for gleaning that distinction.  But it may not be the only one. 

            Other ways to probe materiality in financial reporting concern the measure or classification at stake.  For example, revenue recognition is generally a more important category than non-core expenses.  Even isolated revenue recognition errors may be important in ways that persistent misstatements in non-core expenses are not.  Similarly, misstatements concerning recurring operating expenses often are more important than those concerning many reclassifications.  More broadly, of potential importance, especially when adopting a reasonable investor’s fundamental valuation viewpoint, some misstatements, even if persistent or large, may not drive investor models, metrics or conclusions.  In these contexts, the notions of persistence or isolation may be less useful.   

            Finally, neither Professor Park nor CIFR are offering particularly radical or revolutionary suggestions.  Indeed, CIFR explains that its diagnosis and recommendation arise less from problems in the legal or regulatory standard than in applications in practice.  Current law’s reasonable investor and total mix tests of materiality are coherent and prevailing SEC are appropriate.  But CIFR says too many materiality judgments do not adopt those standards in practice.  CIFR says its suggestions are a “modest clarification of the existing guidance to conform practice to the standard” and “not a major revision to the concepts and principles embodied in existing SEC staff guidance.”  Practical and sensible,

Professor Park’s paper is an important contribution to the law and accounting literature and a good source of analytical support for CIFR’s recommendations. 

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