The New Materiality Debate: What Difference Does It Make?

 

After years spent advising Big 4 partners on what constitutes “material” in the world of accounting and auditing, I’m intrigued to see renewed focus on the concept of materiality. It seems like everyone is talking about it. The Financial Accounting Standards Board (FASB) recently issued two exposure drafts that will change the definition of materiality; investor advocates are complaining about the FASB proposals’ negative impact on the public; and the press is writing about the debate.

So, what’s new?

What’s new is the attempt by standard-setters to streamline disclosures in financial statements by eliminating unnecessary and duplicative disclosures that have built up over time. There’s really no serious debate about the problem of financial statement disclosures having too many pages (just compare the size of today’s average Form 10-K annual report with a comparable one from 25 years ago). The debate is about the causes of disclosure overload and what, if anything, to do about it.

Why Investors Should Care

In addition to accurate numerical financial results, investors need sufficient, high-quality information from financial statement disclosures (e.g., footnotes containing critical accounting policies or future committed cash outflows relating to borrowings and leases) in order to make effective investment decisions. Investor advocates contend the overall quality of financial information will decrease under the FASB’s proposals because the resulting reductions in disclosures will go too far.

The Causes of Disclosure Overload

In my view, the primary reasons why annual reports have ballooned in size over the years are pretty simple: (a) standard-setters and regulators have created a lot of new accounting principles and related required disclosures, many of which overlap and are duplicated within a single document containing a company’s financial statements; and (b) preparers are afraid to omit anything they might later be challenged on by auditors, the SEC, or plaintiffs’ attorneys.

So where does the concept of materiality enter the debate?

The definition of materiality itself is blamed. Actually, it’s the conflicting definitions that are cited as a root cause. The FASB has long defined something as material “if omitting it or misstating it could influence decisions that users make on the basis of financial information of a specific reporting entity.” The Supreme Court has applied the concept that something is material if “there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information.”

See the difference: could versus would. Well, maybe that’s important to securities lawyers, but I don’t think it makes any real difference to practicing accountants. I doubt the definition is really a big contributor to the problem.

The auditing standards are blamed. There is a provision in the Public Company Accounting Oversight Board’s (PCAOB) Auditing Standard No. 16, Paragraph 18, that is sometimes cited as a problem. The literal application of the provision requires auditors to report to the audit committee any immaterial required disclosures omitted from the financial statements. In all my years of advising on materiality, I never encountered any registrant or auditor concerned about that part of the paragraph. They were always concerned about uncorrected errors in the numbers but not about insignificant disclosures. So, again, I question if the auditing standards are a big part of the problem.

Fear of regulators or litigation. This is a big deal. The potential costs of reducing disclosures outweigh the benefits of not having to prepare disclosures that are later determined by regulators or plaintiffs to be important with full benefit of hindsight. Preparers of financial statements choose to incur the time and expense of preparing repetitive or immaterial disclosures over the risk of future sanctions or lawsuits. Materiality is a judgment call that’s always easier to second-guess than to make in real time.

Suggested Solutions

The FASB wants to get out of the business of defining materiality. The FASB proposes eliminating the accounting definition of materiality from the accounting concepts statements and, instead, referring everyone to the court’s ever-evolving definition. This seems reasonable. One definition is enough and, most of the time, battles over materiality are fought in courts, so we might as well apply their rules. Again, it won’t change the day-to-day judgments of accountants and their auditors much.

The other place materiality gets debated is with regulators such as the SEC, but I could never figure out where regulators stood on the topic. In some instances, small errors in the financial statements were a big deal to them, and in others, they didn’t seem to care about very large percentage errors. More consistency from the SEC on what it deems material would be helpful. Perhaps another look at Staff Accounting Bulletin No. 99 is needed.

The FASB wants to say, “The omission of an immaterial disclosure is not an accounting error.” This seems like a blinding glimpse of the obvious, but if it helps, go ahead and include it in the accounting standards.

Change PCAOB Auditing Standard No. 16. If the FASB clarifies that omitting an immaterial disclosure is not an accounting error, then it makes sense not to require reporting one to the audit committee.

The problem of too much unnecessary, duplicative, and confusing disclosure in financial statements is real and needs to be addressed. I believe the FASB’s efforts are helpful, and their proposed rules should be adopted. They should provide some measure of clarity and safe harbor to the preparers of financial statements. Because the disclosure decisions made by preparers and auditors are unlikely to change much under a new definition of materiality, concerns of investor advocates are probably unwarranted, and investors need not panic. This doesn’t represent the end of good transparency. However, the FASB’s proposed changes are unlikely to move the needle significantly toward decreasing the length and repetitive nature of disclosures in financial statements.

The concept of materiality isn’t the real issue here — but the debate sure is interesting.

 

About The Author

Jeff Johanns

Jeff Johanns is an accounting lecturer at the McCombs School of Business. He is a former U.S. Assurance Risk Management Leader...

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