As I described in a previous post the FASB has two related proposals on the table related to materiality and financial statement notes:
- An amendment to Concepts Statement No. 8 to replace its ersatz definition of “materiality” — nothing but a re-phrasing of its description of “relevant” information — with a reference to the Supreme Court’s “definition” — itself a fluid collection of decisions in specific cases. Many of these cases have little or nothing to do with financial statements or note disclosures.
- 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. (This is already self-evident.)
- Omitting a disclosure of immaterial information would not be an accounting “error.” (See below for how “error” has been added to the FASB’s lexicon of doublespeak.)
- Without referring to CON 8, due to its lack of authoritativeness, a material omission of a disclosure would be nothing more or less than a question of applying the law of the land.
My objective in this latest post is to report that my concerns expressed earlier have been validated by numerous comment letters to the FASB by or on behalf of investors. I also think it would be helpful to readers if I review recent and relevant history of disclosure standards development.
2007 — The FASB’s Investors Technical Advisory Committee (since renamed to the Investor Advisory Committee) submitted a letter to the FASB requesting that it “fast track” a project to produce a systematic approach to disclosures. ITAC outlined its views in significant detail and hoped the FASB would use them as a basis for improving the clarity and completeness of disclosures. ITAC estimated that the work could be done in a “one to two year timeframe.”
2009 — The FASB announced that it would undertake a “disclosure framework” project. The first document produced, an exposure draft of a chapter in the conceptual framework on financial statement notes, took five years to produce. It has not been finalized, and it barely touches on ITAC’s concerns and suggestions.
For example, and consistent with my own recommendations expressed in numerous posts (here is one of the latest), the ITAC called for roll-forwards of assets and liabilities. Not considered. Moreover, rather than calling for initiatives to reduce disclosures, the ITAC unmistakably envisaged that the FASB would focus on enhancing information content. And most germane to the current proposals, nothing in the ITAC letter suggested that the FASB should be re-thinking how the concept of materiality would be applied to disclosures. Whether issuers were being overburdened by having to make too many close calls on materiality was not on ITAC’s list of high-priority improvements to U.S. GAAP.
2010 — The FASB issued Concepts Statement No. 8, which in relevant part replaced the meandering and ineffectual discourse on materiality with this:
“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.” [QC 11]
As I described here, the board freely acknowledged in CON 8 that its definition of “materiality” is merely a restatement of the concept of “relevance,” and of no use whatsoever in helping the board resolve accounting standards questions. In essence, materiality is a determination made at the entity level, so at least the Board rightly punted on providing any sort of substantive guidance.
2010 — The SEC unanimously ratified PCAOB Auditing Standard No. 14, which provides detailed guidance to auditors for evaluating the materiality of financial statement items, including disclosures.* It also calls for auditors to: (1) accumulate uncorrected “errors” unless “clearly trivial” (i.e., an amount well below immaterial); (2) evaluate the accumulated errors (whether a B/S or P&L amount, or a disclosure); and (3) share their evaluations with management.
2012 — PCAOB AS 16, also unanimously ratified by the SEC, requires the auditor to share its schedule of unadjusted errors, as compiled in accordance with AS 14, with the audit committee.
September 2015 — The FASB issued its proposed amendment to Concepts Statement No. 8 and proposed ASU, both referenced above. My analysis, which is corroborated by high-level PCAOB staffers was that if these proposals are finalized, the audit committee could excuse itself from evaluating aggregated immaterial disclosures (per AS 16) so long as the unadjusted differences are immaterial — in a strictly legal sense. In effect, the PCAOB’s “clearly trivial” criteria would be rendered inoperative by FASB rule making.
October 2015 — Discussion of the FASB proposals was added to the meeting agenda of the SEC Investor Advisory Committee. Francine McKenna wrote a fairly restrained account of the committee’s concerns for Market Watch, while David Dayen in Naked Capitalism was more strident. Both articles left the distinct impression that the Committee members were adamant that investors were being given the short end of the stick.
Today — Now that the comment period on the proposals has run its course, the FASB will begin its re-deliberations. I didn’t do an extensive analysis of the 100 or so comment letters, but the pattern became quickly evident to me: issuers and their auditors generally view the proposals favorably (there are some notable exceptions among audit firms); but investors and their advocates, including the following, are virtually unanimous in their disfavor:
- Public Citizen
- Council of Institutional Investors
- R.G. Associates (publisher of accounting analysis for investors)
- Consumer Federation of America
- Investor Environmental Health Network
- CFA Institute
- SEC Investor Advisory Committee
(That’s a lot of investors!)
So, given the bimodal feedback, whose counsel will the FASB heed? Considering how the 2007 proposals of the FASB’s own advisory committee essentially fell on deaf ears, I can’t confidently predict a favorable outcome for investors. But, for what it’s worth, the SEC’s Investor Advisory Committee letter was pretty comprehensive in its criticisms. They let them have it with both barrels:
“The changes set out in the Proposals are not, however, clarifications but entail significant and substantive alteration to the current definition [of materiality]. The approach taken … is explicitly designed to reduce disclosure and in doing so has the potential to adversely affect the quality of financial disclosure.” …
“We believe that the Proposals need to be entirely reconsidered, with any future proposals preceded by the development of a more complete record that sets out the concerns giving rise to, and the consequences of, any change in the definition [of materiality].”
“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. 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.” [italics added]
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And for what it’s worth, here are my own recommendations. First, the current FASB definition of materiality is essentially a placeholder. They should leave it that way — and they should abandon the doublespeak about what is technically an “error.” It is the auditor who reports to investors that the financial statements of the issuer are “fairly presented”; hence it should be left to the PCAOB to provide guidance to the auditor for assessing whether a departure from U.S. GAAP materially affects fair presentation. As for guidance to issuers, they will perforce read the PCAOB’s guidance and then form their own judgments on the same basis as the auditor.
The SEC’s Office of the Chief Accountant (which has been openly and unfairly critical of the PCAOB while the FASB is permitted to do what and when it pleases) should compare what the FASB has been doing about disclosures with the 2007 recommendations from the FASB’s Investor Advisory Committee. The SEC’s Chief Accountant should request from the FASB a status report explaining: the lack of progress to-date on the disclosure framework; and the apparent lack of follow-through on the committee’s recommendations.
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*I am a member of the PCAOB Standing Advisory Group. The opinions expressed in this post are my own.