With materiality decisions underpinning what is – and is not – disclosed in financial reporting, the recent pair of proposals on materiality issued by the Financial Accounting Standards Board on materiality are a big deal.
Released on Sept. 24 with a comment deadline of Dec. 8, the proposals may be quietly lurking as many companies focused on quarter-end and are prepping for year-end. However, the proposed amendment to Concepts Statement 8, Chapter 3, on materiality, together with the companion proposed Accounting Standards Update: Notes to Financial Statements: Assessing Whether Disclosures Are Material, deserve significant attention due not only to the potential immediate impact on footnote disclosures, but also due to the potential longer-term impact that may reach to recognition and measurement as a result of the change to the conceptual framework. (Although the Concepts Statements are not “authoritative,” they are aimed at providing the conceptual underpinning for accounting standard-setting and to assist when there is not a specific directive in an accounting standard.)
As such, materiality impacts the entire scope of financial reporting and related discussions that take place between management, the auditor and the audit committee – not to mention oversight by, and enforcement or litigation actions taken by the Securities and Exchange Commission, the Public Company Accounting Oversight Board, and the plaintiff’s bar.
Proposals part of disclosure framework project
The dynamic duo of materiality proposals were released as part of FASB’s Disclosure Framework project, which is proceeding concurrently with the SEC’s Disclosure Effectiveness project. Of note is that although early dialogue around both projects included a call for reducing disclosure overload, the SEC’s project in particular has morphed, as reported last year by The Wall Street Journal in “SEC Changes Tack in Disclosure Overload Project,” to increase emphasis on the effectiveness of disclosure, which could potentially increase – or decrease — the current volume of disclosures.
Former SEC Commissioner Troy Paredes and outgoing SEC Commissioner Dan Gallagher have consistently called for the need to retain focus on simplifying disclosures and combat disclosure overload. Paredes repeated this argument in an article he published in July entitled “Information Overload and Mandatory Securities Regulation Disclosure,” and the point was also emphasized in Commissioner Gallagher’s opening remarks at a meeting of the SEC Advisory Committee on Small and Emerging Companies last month, when he said:
“I would hope to see consideration of recommendations relating to the Division of Corporation Finance’s Disclosure Effectiveness review more broadly. This will be a vital subject for the Committee to monitor closely — we’ve already seen this project transition from Disclosure Overload to Disclosure Effectiveness, and some would like to take this as a perfect opportunity to advance pro-regulatory ends.”
Quoting from George Orwell’s 1984, Gallagher continued, “War is peace, ignorance is strength, and disclosure effectiveness is more disclosure. If more disclosure were the price we must pay in order to make information useful for small business investors, then we would now have excellent disclosure. Not to state the obvious, but we do not have excellent disclosure. And we all know that eliminating or scaling disclosures is a more fruitful path to that end.”
The FASB’s materiality proposals, while aimed at an overarching goal of high-quality financial reporting, include the notion of reducing complexity and aiding simplification as well. As stated in FASB’s press release, the proposed ASU on determining materiality for footnote disclosures “is intended to promote the appropriate use of discretion by organizations when deciding which disclosures should be considered material in their particular circumstances.”
Nuts and bolts of proposed changes
The proposed amendment to the Conceptual Framework (specifically, to amend Statement of Financial Accounting Concepts No. 8 (CON 8), Conceptual Framework for Financial Reporting, Chapter 3, Qualitative Characteristics of Useful Financial Information) proposes to:
- Delete FASB’s current definition of materiality in CON 8, Chapter 3, which currently states: 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.
- Replace it with the following definition of materiality: 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 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. Consequently, the Board cannot specify or advise specifying a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.
Proposed Accounting Standards Update (ASU): Notes to Financial Statements: Assessing Whether Disclosures Are Material proposes to add the following language to FASB’s Accounting Standards Codification, Topic 235, Notes to Financial Statements — Overall Disclosure — Assessing Whether Disclosures Are Material:
- Materiality is applied to quantitative and qualitative disclosures individually and in the aggregate in the context of the financial statements taken as a whole.
- Therefore, some, all, or none of the requirements in a disclosure Section may be material.
- Materiality is a legal concept.
- The omission of immaterial disclosures is not an accounting error.
Feedback from FASB
FASB spokesperson Christine Klimek provided some feedback to the MACPA’s CPA Success Blog in response to some questions we had about the materiality proposals. As emphasized at the end of this post, FASB is keen to receive constituents’ feedback on conceptual and practical application of its proposals.
MACPA: Besides making the disclosure decision process easier, do you anticipate the change will drive a reduction in disclosures?
Klimek: The objective of the project is to improve the effectiveness of disclosure. It is important to note that the Board is looking at the subject broadly by developing 1) a decision process for the Board in which the considerations about requirements are more comprehensive and consistent, and 2) guidance for reporting organizations which promotes the use of discretion when complying with those requirements.
For the most part, the assessment of materiality would reduce the volume of disclosures. In some cases, the volume of disclosures would stay the same. In other cases, the volume of disclosures might increase.
Some FASB Accounting Standards Codification (ASC) Subtopics include guidance that companies should provide more disclosure if the disclosure requirements aren’t sufficient. Additionally, there is an SEC rule to include any additional material information that may be necessary to make the required statements not misleading in light of the circumstances.
MACPA: Why did FASB move to adopt the Supreme Court’s definition of materiality?
Klimek: The FASB does not promulgate a definition of materiality. However, the Board currently observes a summary definition that is consistent with the Supreme Court definition. We were told the definition of materiality in the Conceptual Framework was not consistent with the legal concept. Although the Conceptual Framework is not “authoritative,” we decided to amend the definition in Concepts Statement 8 to be more consistent with the legal notion of materiality as defined by the Supreme Court, concurrent with our decision to insert the notion of materiality into Topic 235, Notes to Financial Statements.
In other words, we’re not changing any current practice. All we are doing is aligning internal guidance about materiality with the legal definition. The proposed Concepts Statement only would apply to what the FASB should consider as it sets standards, and would not change how preparers or auditors do materiality assessments.
MACPA: Do you believe this change will drive more or less litigation?
Klimek: Because we have stated that materiality is a legal concept, we have not told constituents to do anything different than what they are legally obligated to do.
MACPA: Do you believe FASB’s use of the word “qualitative” in addition to “quantitative” in the proposed definition will increase or decrease the amount of disclosures?
Klimek: In our field study related to note disclosures, what we heard was that when people think about materiality, they primarily think about disclosures that have numbers. In other words, they were more comfortable with assessing materiality of quantitative disclosures. Now, we are trying to say that “material” is a legal concept — it’s about information, not just numbers. For example, plenty of companies disclose the fact that land doesn’t depreciate, but is this information useful to a reasonable resource provider?
MACPA: I find it significant that the word “decision” is not present in FASB’s characterization of the Supreme Court definition; it seems to move away from FASB’s objective of financial reporting being “decision-useful.” Have you gotten any feedback on that point?
Klimek: We did not receive any feedback on that point. However, we always are interested in receiving feedback in comment letters in order to improve the proposals.
MACPA: Do you believe the sentence in the proposed Accounting Standards Update, “Therefore, some, all, or none of the requirements in a disclosure may be material,” may decrease comparability between companies?
Klimek: This certainly will affect “uniformity.” However, I believe you can still be “comparable” if one company has something material to disclose and one does not.
MACPA: Although the proposed changes to Topic 235 specify they are only to be applied to footnote disclosures, do you believe some people can potentially look to the proposed changes to the Conceptual Framework and apply the Supreme Court definition of materiality to recognition and measurement decisions?
Klimek: Paragraph 105-10-05-6 has always said that provisions of the Codification need not be applied to immaterial items. That language has always been there, originally in the “materiality box” in the back of individual standards. I don’t believe if someone went to the Conceptual Framework to look at what the Board observes, it would drive them to make different decisions than what they should have been making if they were assessing materiality.
MACPA: FASB’s proposal states, as detailed in the basis for conclusions, that auditing standards currently require companies and their auditors to report to the audit committee any omission of a disclosure deemed immaterial as an “error.” The proposal then provides explicit language that omission of immaterial disclosures does not have to be reported as an “error.” Is this the first time FASB is inserting language to this effect in GAAP, and is there a belief that the audit standard setters (AICPA for private companies, PCAOB for public company audits) will amend their standards to conform accordingly?
Klimek: The proposal states that the omission of immaterial information is not an error. It does not state what must be reported. That is not within the FASB’s purview. Through the comment process, we may be informed about changes in practice based on the statement that this sort of omission is not an error.
MACPA: Presumably, conforming to the Supreme Court’s definition will be familiar to public companies, what about private companies and not-for-profits?
Klimek: It is important to note that the Board is not promulgating the definition of materiality. The Board is observing what the current definition is in the current legal environment. That said, the initial feedback we received from members of the Private Company Council and attorneys is that the changes to the Codification are useful in promoting the exercise of discretion. We also received feedback that the definition that the Board observes is applicable to organizations regardless of capital structure.
It will be interesting to see how a reference to materiality as a legal concept works for not-for-profits, not from a credit perspective, but from a donor perspective. That’s something we hope to learn during the exposure period.
As I mentioned, we are interested in all feedback from all constituencies. We did a pretty extensive field study, consulted the right people from preparers, users, regulators auditors, and attorneys of various types. We’ve met with all the stakeholder groups that meet here regularly. The staff continues to engage with those folks, but we want to hear from everybody.
In my view, besides watching for potential conforming amendments from auditing standard-setters (AICPA and PCAOB), I will be interested in seeing if any comment letters or dialogue at conferences take place on whether constituents believe there is a basis to seek a safe harbor from the SEC for any disclosures removed as a consequence of applying FASB’s new guidance (when finalized), or more generally in response to calls from the SEC for companies to simplify their disclosure, while maintaining or enhancing “effective” disclosure.
On the flip side, chances for a safe harbor may be next to nil, based on recent comments expressed by members of the SEC’s Investor Advisory Committee on the materiality proposal, as reported by MarketWatch in “Investor Advocates Protest Proposals Limiting Disclosure.”
I will also be very interested in any comments that may be filed by committees of the American Bar Association or the Association of Corporate Counsel, particularly in light of the move to reference the Supreme Court’s definition of materiality as the single, go-to definition in applying FASB standards.
If you don’t usually involve your general counsel and outside counsel in analyzing FASB proposals, this would be a good one in which to do so. FASB (and the SEC, PCAOB and AICPA) also find it extremely helpful to receive practical feedback from constituents (companies, auditors, investors, creditors, and other members of the public), and the earlier that feedback can be provided (e.g at the proposed rule stage), the more useful those comments can be in helping FASB craft a final standard that balances the needs of constituents, including cost-benefit considerations.