Overview of the Rules Under GIPS 2020
The error correction rules for firms are in provision 1.A.20 of GIPS 2020, which notes that firms must correct material errors in GIPS composite reports and must:
- Provide the corrected GIPS composite report to the current verifier
- Provide the corrected GIPS composite report to current clients and any former verifiers that received the GIPS composite report that had the material error
- Make every reasonable effort to provide the corrected GIPS composite report to all current prospective clients and prospective investors that received the GIPS composite report that had the material error. The firm is not required to provide a corrected GIPS composite report to former clients, former investors, former prospective clients, or former prospective investors.
The rules for pooled fund reports mirror those for composite reports and can be found in Provision 1.A.21.
This provision seems pretty straightforward, except for one item. How does a firm determine if an error is material or not?
In order to help explain the GIPS Standards, in the past the CFA Institute has issued GIPS Handbooks, which provide guidance and examples. Under GIPS 2020 for firms, the Handbook has been renamed Explanations of the Provisions. Many people still refer to this as the Handbook, and we will too in this article.
In the GIPS 2020 Handbook (or just Handbook for short), error correction and materiality guidance is presented for provisions 1.A.20 and 21. The Handbook also notes that an error, which can be qualitative or quantitative, is any component of a GIPS report that is missing or inaccurate.
In order to determine whether an error is material, the Handbook goes on to note that firms should start with the following:
An error (or item) is material if the magnitude of the omission or misstatement of performance information, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed by the omission or misstatement.
This is a good definition as it gets to the crux of the matter whether or not the judgment of a reasonable person relying on the information would have been changed. This definition is consistent with the framework used in the accounting profession as well as frameworks used when weighing legal and SEC matters. Although quantitative measures are important, note that this is not a purely quantitative model and that judgment (qualitative analysis) is required in order to make a final determination.
We suggest that firms expand upon this materiality definition to create a framework. This can be done by adding the following:
Materiality is influenced by the perception of the needs of GIPS report users who rely on those reports to make judgments about an investment manager’s performance. Users are viewed as a group, not as specific individuals.
In determining if an error could influence the judgment of a user (as defined above), users are assumed to:
- Have an appropriate knowledge of business and economic activities and performance reporting and a willingness to study the information in the GIPS reports with an appropriate degree of diligence;
- Understand that GIPS reports are prepared to levels of materiality;
- Recognize the differences in different methods for calculating and reporting performance;
- Make appropriate decisions on the basis of information in the GIPS reports.
Perspective of Materiality
Materiality considerations should include the entire GIPS report, rather than one line, number, or disclosure viewed in isolation. In addition, errors need to be evaluated along with other known errors (including uncorrected errors from prior periods). This article discusses this further below.
Quantitative and Qualitative Considerations
Although materiality is commonly expressed in quantitative terms, determination of materiality is a matter of professional judgment that includes both quantitative and qualitative considerations.
Why Can’t Materiality Just Be Quantitative?
We see a wide variety of approaches to materiality in practice, including some firms which adhere to simple numerical thresholds without taking into consideration context, multiple errors in one statement, non-numerical errors, and other concerns which require judgment.
When defining materiality, firms should consider many factors. Setting a single basis point limit (such as 20 basis points) as the sole determinant of materiality can be dangerous.
Materiality is a relative concept. For example, 20 basis points may be material on a return of 25 basis points; however, on a returns of 700 basis points, 20 basis points does not seem as significant. Also, such absolute factors are impossible to apply to all non-return figures and disclosures in a presentation.
Below we have listed several different types of errors. Many of the errors are the same quantitatively, but the reasons for the errors and impact on a presentation are different for each example. Is each error material or immaterial? These potential error scenarios illustrate that there are many types of issues that can trigger errors, and that a fixed, absolute definition of materiality is not flexible enough to effectively evaluate all potential errors and the impact to the users of a performance presentation. A relative framework, which involves judgment, is needed.
- The composite return is off by 19 basis points.
- The composite return is overstated by 19 basis points and correcting the difference would cause the manager to go from outperforming the benchmark to underperforming the benchmark.
- The composite return is overstated by 19 basis points while the index return is understated by 19 basis points.
- Every number on the presentation is 100 percent correct, but the notes are misleading.
- The current year composite return is overstated by 19 basis points. Suppose every prior year composite return in the presentation has the same misstatement.
- The composite return was overstated by 19 basis points to manipulate company bonus allocations to portfolio managers.
- The composite return is off 19 basis points as a result of mispricing of the underlying securities; this caused the account to trigger a performance fee. Without the mispricings the account would not trigger the performance fee.
- A U.S. manager’s composite presentation containing mutual funds only shows gross returns and the investment manager is registered with the SEC. All returns presented are correct, the presentation contains the required disclosures, but the SEC requirement to show net returns for composites containing mutual funds has been violated.
Bringing It All Together
We suggest that firms consider the following approach in evaluating whether errors are material.
- Set quantitative thresholds and qualitative factors that trigger an error review. Trigger criteria don’t necessarily mean that an error is material. Rather, trigger criteria causes a review of the error by the firm. Trigger criteria might include:
- Returns off by more than X%
- Benchmark returns off by more than X%
- Dispersion off by more than X%
- When composite or fund AUM is off by more than X%
- When firm AUM is off by more than X%
- Number of accounts is off by more than X%
- Incorrect or missing disclosures
- Any other error or combination or errors that the performance team believes should be evaluated for materiality
- Create a committee responsible for evaluating error materiality. Consider including the following team members on the committee:
- Performance professionals who are familiar with the GIPS Standards.
- Compliance professionals who are familiar with regulatory requirements and rules, such as those promulgated by the SEC.
- Investment professionals who understand the investment products being represented by the GIPS reports.
- Use the materiality framework noted above to evaluate the errors. This might include the following:
- Recalculate the returns and quantify the error in the GIPS report. Any additional errors (including those from prior years that are still uncorrected) should be included in the analysis. The result is that the committee should be able to look at the current GIPS report with all errors identified. Maybe this is just one return. Maybe it’s the past 5 years’ returns and benchmark data. The point is to view the GIPS report as a whole when determining whether it’s misleading. Just analyzing one number, viewed in isolation, is generally not an effective method for determining whether the GIPS report is materially misstated. It is generally helpful to analyze errors both individually and in the aggregate.
- Determine if the error(s) are material based on the materiality definition and framework presented earlier in this article.
- For numeric errors, consider evaluating the error on both an absolute and relative basis. For example, 20 basis points may be material on a return of 25 basis points; however, on a returns of 700 basis points, 20 basis points does not seem as significant.
- For disclosure items (such as missing or incomplete disclosures), consider the impact of the error on a user of the GIPS report. Perhaps omitting a disclosure that indicates that the returns are calculated in USD is deemed to be immaterial, while omitting the required composite description is material.
- Document the committee’s decisions and reasoning.
- Follow the firm’s error correction policies:
- For material errors – the firm’s policies must follow the correction and distribution requirements of Provisions 1.A.20 and 21, including the redistribution of corrected reports to verifiers, clients, and prospective clients and investors who received the GIPS report that contained the material error. Also, the GIPS Standards require firms to disclose errors deemed material for a minimum of one year in the related GIPS report.
- For immaterial errors – the firm has more flexibility on whether to correct or leave the error uncorrected. Some firms do not make any changes under the rationale that it’s simply not material. Other firms correct the presentations. The key is to follow the firm’s policies and procedures consistently.
- Maintain a log, which should include:
- A description of each error.
- Whether or not it was material.
- For material errors, to whom the corrected GIPS reports were sent.
- Any new policies and procedures implemented in order to minimize the risk of similar errors occurring in the future.
GIPS 2020 has introduced numerous changes to improve the standards. The Handbook provides additional practical guidance to help firms implement the GIPS Standards. While we have offered this overview of error correction and materiality determination, it is important to understand how to implement these policies in your organization. For more guidance about error correction, materiality, or any other part of GIPS 2020, please ccontact us.
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