This is the second of three posts today. In this one, I want to talk about materiality — in general, and the recent proposals issued by the FASB. (The first post, a related one, is here.)
Materiality vis-à-vis GAAP
Before we consider the FASB’s current conceptualization of “materiality,” we need to first understand what it means by “relevance.” Stripping away the excess verbiage, we have:
“Relevant financial information is capable of making a difference in the decisions made by users.” [¶ QC6, italics added]
Indeed, an information economist would say much the same. A system (financial and otherwise) that produces a set of signals is worth paying for if and only if there is some possibility that receipt of (at least) one of the signals from the system can push a decision maker to take a different action. This seems like a technical way to state the obvious, but we need this concept of relevance to consider the FASB’s current language on “materiality.”
“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.” [¶ QC11]
Thus, the materiality concept in CON 8 is identical (albeit with different verbiage) to the relevance concept. Yet, few have really cared very much about that until now, because it never comes up in FASB standard setting. This is for a number of reasons.
First, the FASB has never needed the concept of materiality to promulgate its standards. Prior to the advent of the Accounting Standards Codification, to the best of my information and belief, every one of the Statements of Financial Accounting Standards issued explicitly stated that its provisions need not be applied to immaterial items. And for the past 5 – 6 years, the Accounting Standards Codification, the sole source of “authoritative” GAAP, has stated the same (see ASC Topic 105).
Hence, although materiality is given lip service in CON 8, it is an extra-GAAP consideration. The FASB has never actually provided a definition of materiality. And in practice, preparers and their auditors consider materiality before determining whether the ASC must be applied. If the auditor’s report is to be believed, the basis for determining whether an item is material is “fair presentation” — a concept that neither auditing or accounting standard setters clearly have avoided tackling.
Second, it will also be important to keep in mind that none of the eight concepts statements contain a single word of authoritative GAAP; they don’t even have a designated place among literature that could be considered “nonauthoritative” sources of GAAP. For example, there is nothing in the rules of GAAP that would preclude an issuer from looking to other nonauthoritative guidance on materiality — or any other topic addressed in a CON. Consequently, if changing the concept of materiality in the concepts statements is meant to provide guidance to issuers, authoritative GAAP (Topic 105 of the ASC) clearly permits issuers to ignore it when they want to.
With this background in mind, let’s consider the FASB’s proposals. A proposed amendment to Concepts Statement No. 8 would replace the extant ersatz definition of “materiality,” with a reference to the Supreme Court’s “definition,” which itself is only a collection of contentious interpretations of (overly?) broad statute for deciding specific cases; and will surely change as new cases are tried.
In addition, Proposed ASU No. 2015-310 would amend the Accounting Standards Codification to provide as follows:
- An entity may omit disclosure requirements if they are “immaterial” individually or in the aggregate in the context of the financial statements. (Self-evident — nothing new.)
- Omitting a disclosure of immaterial information would not be an accounting error. (Self-evident — nothing new.)
- Materiality is now a legal concept (without specifically referring to CON 8).
“Respondents … have requested these amendments to eliminate inconsistencies between the framework and the legal concept of materiality.”
“Respondents” is FASB-speak for issuers and their auditors. Of course these “respondents” would prefer a strictly legal definition of materiality! That way, when sued by misled investors, they will smugly claim that they relied on some “independent” legal opinion (paid for by the misled shareholders) that an omitted disclosure was not “material” as defined by previous Supreme Court cases.
Setting aside the obvious circular logic, everybody knows that strict application of the law does not always result in “fair presentation.” Under the bus with the cornerstone of the auditor’s report!
“Respondents to past requests for comments on other proposed Accounting Standards Updates often have stated that while certain proposed disclosures may be relevant to other entities, those disclosures do not provide relevant information in their own circumstances.”
Why wouldn’t the FASB simply remind these respondents that there is nothing in current GAAP, the PCAOB’s auditing standards or the securities laws, that bars an issuer from omitting immaterial disclosures?
Perhaps, some issuers would prefer that auditors and audit committees take a chill pill and pass on the omission of a small subset of the disclosures companies have been providing so as to adhere to the letter of GAAP; but I don’t see the big deal. Methinks that the ability to hide behind a legal opinion (think about the way that Lehman hid behind a legal opinion to justify its misleading Repo 105 accounting) is the real driver of these proposals.
“Respondents … requested that facilitating discretion and assessments of materiality be addressed in the FASB Accounting Standards Codification®.”
Actually, I think that this reason is designed to provide cover for the real “respondent,” for surely, an FASB proposal addressing materiality — long the SEC’s bailiwick — could not be floated without the explicit approval of the SEC.
Columbia Law School professor John Coffee recently made the following trenchant observation in a somewhat similar context — the forces aligned against the reappointment of the PCAOB chair:
“The current Chief Accountant, James Schurr [sic], is a retired Deloitte partner who seems to have taken the protection of the industry as his priority. He has publicly criticized Doty [PCAOB chair] and the PCAOB as ‘too focused on its disclosure effort and not enough on … the nuts and bolts of conducting audits.’ This is silly…” [footnote omitted, emphasis added]
IMHO, it is indeed Mr. Schnurr (with the approval of the SEC chair) who is driving the assault on materiality. It is of a piece with his publicly-expressed resentment of the accomplishments of the PCAOB under its current chair.*
“A reduction in volume of immaterial information would improve the effectiveness of the notes to financial statements.”
Please. If the FASB were truly interested in reducing the volume of disclosures, it would start with basing narrative disclosures on reconciliations of the beginning and ending balances of balance sheet accounts. And as to the effect of the proposals on disclosures in ’33 Act prospectuses, there will be absolutely no effect: the attorneys for the underwriters simply would not let it happen.
* * * * * * *
Instead of shrinking the envelope on materiality, it would nice to see the FASB push it for once. But, to be fair, the rare occasions when the FASB actually attempted more than marginal progress, they were summarily beaten back by the likes of Mr. Schnurr’s former employer and its clients: e.g., the vote to require loan measurement at fair value resulted in the firing of the FASB chair and the re-stacking of the Board to ensure that it would be reversed; and the proposal to require reconciliations of balance sheet accountants in the notes to the financial statements have been buried so deep in the agenda that it will never again see the light of day.
*I am a member of the Standing Advisory Group of the PCOAB. All of the opinions I have expressed in this post are my own.