You see the sentence all the time: “The provisions of this Codification need not be applied to immaterial items.”
That sentence is in the Accounting Standards Codification (ASC) at ASC 105-10-05-6. Prior to the ASC’s creation in 2009, every standard issued by the Financial Accounting Standards Board ended with boxed reminder, “The provisions of this statement need not be applied to immaterial items.” So that little sentence, in slightly different from, has been around for more than 40 years.
They are 12 simple words whose meaning, in general terms, is pretty well understood and universally accepted. The sentence tells us we don’t need to include unimportant things in financial statements, and that’s a pretty important reminder. After all, without the concept of materiality, the amount of information we would theoretically need to consider in preparing financial statements would be endless.
Despite the importance, simplicity, and longevity of those words, it’s become clear recently that although we all agree on the concept the sentence is trying to get across, we don’t entirely know what it means. There is confusion about how to apply the concept of materiality in many aspects of accounting. It’s gotten bad enough that FASB is currently trying to address it in multiple ways, and the Securities and Exchange Commission and the Public Company Accounting Oversight Board may also need to weigh in to help.
What Is an Item?
About three years ago, I attended a roundtable discussion on disclosure effectiveness, held as a sort kick-off to FASB’s disclosure framework project. I was surprised by the discussion there related to a question of how materiality should be assessed in regard to footnote disclosure. Obviously, if the financial statement balance of an item with disclosure requirements attached to it is immaterial, then the disclosure need not be provided. I had also believed that even if the financial statement item itself was material, it could be that one or more of the required disclosures for that item could be considered immaterial.
At the roundtable, however, I realized many believe that so long as the financial statement item is material, any disclosures described as mandatory for that item must be provided without regard to the perceived materiality of each disclosure. For example, required disclosures about goodwill include a roll-forward of the goodwill balance showing certain types of changes. Some believe that so long as the company has a material amount of goodwill, the full roll-forward must be provided; others believe that the roll-forward or some of the detail could be omitted based on materiality considerations.
Essentially, the diversity stems from uncertainty about what the word “item” means in ASC 105-10-05-6. If “item” means the financial statement line item, the entire detailed goodwill roll-forward would need to be provided if goodwill is material. On the other hand, if “item” means the piece of information to be disclosed, then each individual disclosure, including the components of the roll-forward, could be evaluated to determine whether that piece of information is material.
FASB has proposed a solution to resolve this diversity, where it would state that materiality is to be evaluated disclosure-by-disclosure, essentially clarifying that an “item” is any particular piece of information that might be in the financial statements. Hopefully, resolving this confusion will help companies feel comfortable taking unimportant things out of the footnotes.
What Is an Error?
Another piece of FASB’s proposal on evaluating materiality of disclosures is to state bluntly that the omission of immaterial disclosures is not an error. One might question why such a statement is even necessary, since an immaterial error doesn’t pose an issue anyways. The answer actually deals more with audit practice than accounting practice.
Amid this cacophony of definitions, FASB has proposed something surprising—at least to me. In an exposure draft of a change to its conceptual framework, FASB is proposing to remove entirely its definition of materiality—concluding that materiality is a legal concept, and not an accounting one.
Auditors, with help from the PCAOB, generally insist that all errors that are more than trivial be tracked, accumulated, and reported to the audit committee. Departures from Generally Accepted Accounting Principles, even those done intentionally based on an assessment of materiality, are, today, still regarded as errors. Therefore, even those who believe that a disclosure may be omitted if considered immaterial sometimes determine that it is easier just to make the disclosure; rather than to go through the effort to document the decision, report it to the audit committee, and deal with the auditor’s evaluation.
By declaring that the omission of a required disclosure due to immateriality isn’t an error at all, FASB is attempting to relieve the burdens on the company and auditor, and (again) encourage companies to use judgment in deciding whether an item is material and therefore should be disclosed.
What Is a Promise?
The issue of how to handle departures from GAAP based on materiality has also reared its head in regard to the new revenue recognition standard. That standard, when issued, didn’t include a specific scope-out for small promises to customers. FASB thought that the general application of judgment regarding materiality should be sufficient. It turns out, however, that although there wasn’t any disagreement that a number of promised items in revenue contracts would be immaterial, there was (and is) concern about what would need to be done to support the conclusion that those items were immaterial.
As mentioned above, items not accounted for according to the Codification based on materiality are generally evaluated as errors today and, due to auditing practice, that means that quantification of the effect of not accounting for small items may well be required. The fear, then, is that the work necessary to support the conclusion that a “promised good or service” is immaterial would be onerous. That fear led many to call for FASB specifically to provide that small items can be ignored, in which case ignoring them would not be deemed an error. FASB has decided to do this, creating a specific scope-out for small promises to customers.
While FASB is relieving a specific burden with this guidance, the solution suggests even more problems. First, of course, is the issue that if this clarification was necessary for the revenue standard, it is apparently needed in every other area of accounting in which small items are often ignored for simplicity. In other words, the overarching statement about immaterial items quoted at the beginning of this column apparently is insufficient, just as it is apparently insufficient for footnote disclosures.
Further, FASB has chosen to relieve the stress by stating that the revenue requirements need not be applied to items that are “immaterial in the context of the contract.” While that phrase may not be internally problematic, it means that the Codification now acknowledges another level of materiality, as we generally believe that materiality is evaluated in the context of the financial statements. The use of the same term in a different way seems likely to add to the confusion, not relieve it.
What Is Material?
And that brings us to the main question: how to decide whether something is material. FASB has a definition in its conceptual framework. The SEC published a long Staff Accounting Bulletin on the subject in 1999, and then another one in 2006. The Supreme Court of the United States has discussed how materiality should be evaluated under securities law. Auditors deal with materiality in several different situations; first, they need to establish a materiality level to plan the audit; then, they consider the materiality of any errors they identify, much like the company does.
All of the definitions of materiality are generally trying to get at the same thing: whether a piece of information, an error, an omission, a statement and, so forth, is important. But the definitions have differences—some nuanced, some obvious:
Whether an item is material if it “could” affect judgments, or only if it “would;”
Whether the item is to be evaluated in the context of the financial statements, the whole filing, the “total mix” of information (including press releases, for example), or just a particular contract (such the revenue example noted above);
Which decisions materiality is evaluated in reference to: buying or selling the stock? voting on shareholder matters? setting management compensation?
Amid this cacophony of definitions, FASB has proposed something surprising—at least to me. In an exposure draft of a change to its conceptual framework, FASB is proposing to remove entirely its definition of materiality—concluding that materiality is a legal concept, and not an accounting one. Essentially, FASB is suggesting that accountants either can’t or shouldn’t decide how to evaluate whether something is important enough to disclose; we should instead look to the legal environment for guidance on how to make that evaluation.
As I’ve spent the last this column explaining, we accountants have certainly shown in the recent past that we’re confused about materiality. But I didn’t think things were so bad that it was time we give up trying to explain the concept in accounting terms. Is it really better to leave the discussion of materiality to everybody but the accounting standard setter?