SEC Committee Ups Ante in Fight Against FASB Materiality Changes

It is probably fair to say that business leaders often pay more attention to the Securities and Exchange Commission’s efforts to “facilitate capital formation” and “maintain fair, orderly, and efficient markets,” than the third pillar of its mission statement: investor protection. These mandates, however, are blurring and connecting in ways that could substantially change how companies approach financial reporting and raising capital.

An area where investor advocacy will either compliment or conflict with business concerns is the subject of overhauling disclosure regimes. While the SEC slogs through its own ambitious review of Regulation S-K and S-X disclosures, accounting standards are ripe for retooling. Simmering tensions came to a boil last week during a meeting of the SEC’s Investor Advisory Committee as members took the Financial Accounting Standards Board to task for proposals that would redefine its approach to materiality.

FASB, tasked with establishing and improving General Accepted Accounting Principles, came under fire for its “Concepts Statement No. 8,” a plan to harmonize the accounting world’s approach to materiality with legal definitions developed in the courts and validated by the Supreme Court. In short [and for a detailed explanation see Tammy Whitehouse’s Nov. 17 story, “FASB Ideas on Materiality Reform Draw Heat, Questions”], the proposal would strike existing language:

“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.”

The excised text would be replaced with a new approach that borrows heavily from language used by the Supreme Court in interpreting the antifraud provisions under the securities laws:

“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.”

FASB would also change the definition of materiality as it applies to financial statement footnotes.

That plan found little favor with the Investor Advisory Committee when it met on Jan. 20. Near the end of that day-long session, it approved a letter expressing numerous concerns. “The changes set out in the proposals are not clarifications, but entail a significant and substantive alteration to the current definition,” it says. “The approach taken in the proposals is explicitly designed to reduce disclosure and in doing so has the potential to adversely affect the quality of financial disclosure.”

“We are not trying to say that more disclosure is always better. The right disclosures and the right level of disclosure is what we are trying to get to.”
Steven Wallman, CEO, Foliofn

“Granting issuers greater latitude to use discretion in evaluating the materiality of disclosures in the absence of a framework is fraught with the risk that disclosures that are unfavorable to the issuer are disproportionately viewed as immaterial and as a result excluded from the financial statements,” the letter adds. “Such a result is not in the best interest of investors and is anathema to investor protection, capital formation, and the efficient functioning of the capital markets.”

An approach based on legal precedent creates a need for comparability, said committee member Roy Katzovicz, chairman of Saddle Point Group, a private investment firm. “If and when the Supreme Court does change the prevailing legal standard for fraud it is something that would be embedded over time,” he said. “We don’t think lawyers’ analysis should be the touchstone of whether or not something ought to be disclosed. We prefer the accounting profession have its own standard and it could be higher and better than the legal standard, even if it is articulated by the Supreme Court.”

The letter says the proposal does not adequately discuss the impact of the change on the disclosure process, including increased costs. By clarifying the legal nature of the definition, issuers seeking greater comfort on the proper application of the legal concept of materiality “will presumably have an increased incentive to seek the views or opinions of counsel.”

The Committee also argues that: “The Supreme Court’s interpretation of materiality has arisen in the context of the antifraud provisions under the federal securities laws. We believe that the existing terminology used by FASB provides a better framework for determining the content of financial disclosure.”

MATERIAL ISSUES

The following is an excerpt from a comment letter by the Securities and Exchange Commission’s Investor Advisory committee to the Financial Accounting Standards Board, urging rejection of proposed changes to concepts of “materiality” embodied in FASB’s Conceptual Framework for Financial Reporting and FASB’s guidance on Notes to Financial Statements.
The “Conceptual Framework” Proposal raises a number of concerns.
First, the Proposal characterizes the changes as an effort to “clarify” the concept of materiality. In fact, the Proposal does not clarify but substantially alters the definition in a manner that will narrow its application. The Proposal strikes the reference to “relevance,” leaving application of the concept entirely unclear, focuses on “resource provider” rather than “user” and replaces the need to determine whether information “could influence decisions” with the need to determine whether the information “would” have “significantly” altered the “total mix.”
Second, the “Conceptual Framework” Proposal does not adequately discuss the impact of the change on the disclosure process, including the increased costs that will likely result. In particular, the Proposal does not sufficiently take into account that, by “clarifying” the legal nature of the definition, counsel will likely have an increased role in the process. Whatever the current role, issuers wanting greater comfort on the proper application of the “legal concept of materiality” will presumably have an increased incentive to seek the views or opinions of counsel. Particularly if this type of review becomes common, the additional costs may be significant. Beyond costs, the risk exists that, by replacing the current, differentiated professional accounting standard with a case-law driven legal standard, close questions of judgment will ultimately devolve to lawyers rather than accountants.
Third, the Proposal justifies the revision as necessary to “eliminate inconsistencies” between the current definition with the one developed by the Supreme Court under the antifraud provisions. The Proposal does not explain the basis for this determination of inconsistency. To the extent that “inconsistent” means incompatible, the current definition is not inconsistent. The current definition is broader than the one used in the antifraud provisions. Thus, information captured by the Supreme Court’s definition is captured in the existing definition.
Source: SEC

The letter provides two primary suggestions for addressing the “flawed” proposals: maintain FASB’s current definition of materiality; or withdraw the proposals and “precede any future proposals with a more complete record that sets out both the concerns requiring any changes to the definition of materiality and the implications of any such changes, and that more clearly alerts the public to the consequences of such revisions.”

Kurt Schacht, chairman and managing director of the CFA Institute, described the current definition of material information—if omitting or misstating it could influence decisions users make—as a “very elegant” solution. “Why are they changing it? To reduce disclosure,” he said.

Members of the committee stressed that these concerns should not suggest a perpetual demand for the status quo.

“We are not trying to say that more disclosure is always better,” said Steven Wallman, chairman of the Market Structure Subcommittee and CEO of Foliofn, Inc. “The right disclosures and the right level of disclosure is what we are trying to get to. We can fine tune disclosure because the world continues to change and we need to make sure the rules can be updated as well.”

There were hopes expressed that FASB would develop a more inclusive process as debate on these, and future proposals, unfolds. “This is huge and hasn’t been thought about carefully,” Damon Silvers, associate general counsel for the AFL-CIO said of the materiality framework. “They haven’t been, in a serious way, in front of the accounting and auditing world. If you look back over the past couple of decades of securities regulation and accounting and auditing, this is precisely the sort of thing that people profoundly regret later if it hasn’t been thoroughly processed upfront.”

Other discussions at the meeting may may be a barometer of where the SEC devotes energy in the weeks and months ahead.

Crowdfunding, the JOBS Act mandated darling of small business capital formation advocates, is much closer to being a reality, according to SEC Chairman Mary Jo White. Regulation Crowdfunding was finalized in October and is effective in May; funding portals can begin to register with the Commission later this month.  Also on the horizon is a possible update to the SEC’s longstanding accredited investor definition. A review, mandated by the Dodd-Frank Act, analyzed various approaches for modifying the definition, a process in the midst of a public comment period.

There may also be consideration, and likely debate, over whether rules pertaining to fixed income markets need to be reconsidered, possibly aligned more closely to regulations that guide equity markets.

Both the Municipal Securities Rulemaking Board and Financial Industry Regulatory Authority have proposed rules, and a common approach, for requiring the disclosure of markups and markdowns on so-called riskless principal transactions. “It is my hope that the positive momentum created by these two developments will carry over to an additional area of the fixed income markets where enhancements are needed: pre-trade transparency,” SEC Commissioner Michael Piwowar said. “Issues related to transparency in the fixed income markets are precisely where the Commission should focus its attention.”