In November, the Financial Accounting Standards Board (FASB) ended work on its controversial proposal to redefine “materiality” as it applied to U.S. Generally Accepted Accounting Principles (GAAP). The changes would have given businesses more flexibility in determining the information to include in their financial statement footnotes. But investors feared that the changes would also keep much of the information they find useful from being made public.
Here’s more on materiality and why the FASB decided to drop this project.
Materiality is one of the gray areas in financial reporting. Essentially, it’s the threshold used to determine what needs to be disclosed. Auditors may also apply the concept of materiality when auditing a company’s financial statements.
FASB Statement of Financial Accounting Concepts (CON) No. 2, Qualitative Characteristics of Accounting Information, defines materiality in the context of “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.” This definition is consistent with the definition used by the Securities and Exchange Commission and the American Institute of Certified Public Accountants.
The guidance on materiality under existing U.S. GAAP also matches the International Accounting Standards Board’s definition. Under this definition, 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.”
There’s no specific quantitative threshold for materiality under either U.S. or international guidance. But a general rule of thumb some private company auditors use for deciding when to inquire about a change is if a line item changed by more than $10,000 and/or 10% from the previous accounting period.
What changes were proposed?
In September 2015, the FASB issued Proposed Accounting Standards Update (ASU) No. 2015-310, Notes to Financial Statements (Topic 235): Assessing Whether Disclosures Are Material. The proposal would have aligned U.S. GAAP’s definition of materiality with the legal interpretation used by regulators and the courts.
The U.S. Supreme Court’s description of materiality is a “substantial likelihood” that omitting the information would be viewed by a reasonable investor or creditor as having “significantly altered” the total information available to make a decision. In the FASB’s view, by establishing a minimum threshold for materiality, the proposal would have guaranteed that financial statement footnotes would include information that was useful and not cluttered with boilerplate.
However, the proposal stirred up an unforeseen amount of controversy. In the view of many investors, the proposal offered businesses too much leeway to decide what was important, and it gave them the freedom to omit potentially vital data.
Likewise, in a joint letter to the FASB, the Consumer Federation of America and Americans for Financial Reform criticized the FASB for characterizing the proposal as a “benign” change designed to clarify the application of the word “materiality” and help businesses improve the effectiveness of their disclosures. The letter said, “There is no question in our mind that the proposed change would be seized on by some companies to justify reducing the amount of information they provide to investors and other users of financial reports.”
During a November meeting, FASB members explained that this criticism was unexpected and unintended. “To me, this is a good example of when something is not broken, don’t try to fix it,” FASB Vice Chairman James Kroeker said.
FASB member Christine Botosan added, “It’s not within our purview to define materiality, and even if we did, it’s not enforceable because we don’t have a mechanism to enforce it.”
Will the FASB continue its disclosure project?
Although many analysts and investors said that the FASB’s proposed change to the materiality guidance went too far, the FASB hasn’t entirely abandoned its effort to reduce “disclosure overload.” The project will remain on the FASB’s agenda as long as businesses continue to complain that they’re required to provide too much unhelpful, boilerplate information in the footnotes — and investors continue to have difficulty sifting through the footnotes to find information that’s important to their investment decisions.
It’s easy for companies to get bogged down by “disclosure overload.” The concept of materiality can help owners and managers identify what’s most…