An effort to align the accounting world’s definition of materiality with how the idea is widely understood in legal circles is sparking a fierce debate in corporate accounting circles, with potentially big consequences for financial reporting.
The issues involved—convergence with international accounting rules and the interplay of accounting and auditing standards—has led to the emergence of some extreme views on what happens to materiality if the Financial Accounting Standards Board proceeds as it has proposed.
The crux of the controversy is this: FASB wants to strike language in its conceptual framework that says, “Information is material if omitting or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.” The conceptual framework is essentially guidance that FASB provides to itself, as a basis for writing accounting rules. The board would also change the definition of materiality in Topic 235 of the Accounting Standards Codification, which addresses financial statement footnotes.
Instead, FASB would say materiality is a legal concept established by legislative, executive, or judicial action. In essence, FASB would defer to the prevailing U.S. Supreme Court definition of materiality: “Information 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.”
The idea is to convey that some, all, or none of the requirements in a disclosure may be material, FASB says. The change would also state explicitly that an omission of immaterial information is not an accounting error.
That “definition gap” in materiality started back in 2010, when FASB agreed to its current definition of the word as part of its effort to converge conceptual frameworks with the International Accounting Standards Board, according to FASB member Tom Linsmeier.
“We subsequently recognized that we introduced language that was inconsistent with how materiality is defined legally within the United States,” he says. “That created some noise in the system.”
The definition now proposed is consistent with the Supreme Court description, which is followed by the Securities and Exchange Commission and the Public Company Accounting Oversight Board, Linsmeier says. “So in a very real sense, we’re only conforming the definition to that which is used today.”
IASB recently proposed some clarifications of its own to its definition of materiality, but it is not intended or expected to change requirements under International Financial Reporting Standards.
“We properly recognized that we introduced language that was inconsistent with how materiality is defined legally within the United States. That created some noise in the system.”
Tom Linsmeier, Member, FASB
Michele Amato, a partner at regional audit firm Friedman, says key differences in the language could lead to different interpretations over time. “The difference between ‘would’ and ‘could’ is rather interesting,” she says. “The legal definition is a higher threshold than the current definition.”
Members of the SEC’s Investor Advisory Committee such as Joe Carcello and Damon Silvers teed up those differences in a recent meeting, challenging the assertion that the change in language is only a clarification. “When you change the broad terms of the definition of materiality, you’re potentially making a very large change,” said Silvers. “More information or more disclosure is better than less, in general. The clear drift of this is in the other direction.” He challenged SEC Chief Accountant Jim Schnurr to “intervene,” saying his office “fairly or not, will be held responsible for what happens here.”
Schnurr said he wouldn’t comment on the proposals so as not to “poison the well” while they are still open for public comment. But he tried to ease concern that the changes would lead to more legal analysis of disclosures, or significantly less disclosure overall. “I don’t think this was intended to do what you suggested, which is to reduce disclosure,” he said at the advisory committee meeting. “It’s acknowledging where practice is today.”
Dan Goelzer, a partner with law firm Baker & McKenzie, says there’s a difference between what happens in practice and what FASB has written in its concept statements, which the board uses to guide its standard setting process. “If you literally read the words, yes they are different,” he says. “But if you ask most securities lawyers, they would say there’s just one definition of materiality, and it’s the Supreme Court definition. And that same definition applies to footnotes of the financial statements and the rest of the filing with the SEC.”
Below, CW’s Tammy Whitehouse clarifies the language to be striked from FASB’s materiality standard and provides the replacement definition.
Language FASB proposes to strike from FASB’s Conceptual Framework:
Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report.
Language proposed to replace it:
Materiality is a legal concept. In the United States, a legal concept may be established or changed through legislative, executive, or judicial action. The Board observes but does not promulgate definitions of materiality. Currently, the Board observes that the U.S. Supreme Court’s definition of materiality, in the context of the antifraud provisions of the U.S. securities laws, generally states that information 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.
Michael Scanlon, a partner with law firm Gibson Dunn, says FASB’s proposal is plainly a clarification. “I don’t think you can say with a straight face that having two materiality standards would be a good development for investors,” he says. “You’d really have to be a fan of chaos to think this simple, straightforward approach should be otherwise.”
Accounting and Auditing Standards Collide
FASB’s proposed change to the Accounting Standards Codification comes with another twist, linked to the PCAOB and its auditing standards.
FASB’s objective in reviewing its disclosures requirements is to find ways entities could apply more judgment about what should be disclosed to investors. That includes giving management the latitude to decide to not disclose something it deems immaterial. Corporate filers, however, complain that in practice they cannot cut many immaterial items they would like to omit, because that clashes with requirements on audit firms to report omissions like that to the company’s audit committee as an error.
“FASB learned during outreach that companies and management are reluctant to omit from their disclosures information that was clearly immaterial but otherwise required by another accounting standard, because the auditors would deem it an error because it was an omission,” explains Linda MacDonald, senior managing director at FTI Consulting and a former FASB staff member. “FASB is saying in this proposal if it’s an omission because it’s not material, it’s not an error, therefore not something auditors would be required to communicate to the audit committee.”
Goelzer, a former acting chairman of the PCAOB, agrees that FASB’s proposal is directed at taming the audit effect. “In some ways, this was somewhat launched by the PCAOB inspection program,” he says. “It’s an auditing standard, and it is strict about making sure the communications to the audit committee … do occur. It has focused people on the fact that any disclosure omitted on the grounds that it’s immaterial has to be reported to the audit committee. That acts as a deterrent to omitting anything on the grounds of materiality.”
It’s not clear that audit firms following PCAOB standards—Audit Standard 16, Communication With Audit Committees, to be precise— would change what they do even if the FASB proceeds as proposed, says Mark Winiarski, a member in the professional standards group at audit firm Mayer Hoffman McCann. “The auditor still has an obligation to report those misstatements, except those that are trivial, to management and the audit committee,” he says.
FASB so far has received few letters on the proposals, which are open for public comment through Dec. 8. Erik Bradbury, a professional accounting fellow at Financial Executives International, says companies should study the proposals and weigh in with their views. “The jury is still out in terms of how helpful these will be,” he says.