Materiality in Financial Reporting

An Integrative Perspective

Francesco Bellandi

• Publisher: Emerald Publishing Limited
• Year: 2017
• Print ISBN: 9781787437371
• eBook ISBN: 9781787438439
• Topic: Business
• Subtopic: Accounting Standards
• Index: Business

Financial reporting is a strategic means of communication: management has an opportunity to interpret, and the power to deliver, what is materially important to the organization's stakeholders. Understanding materiality means steering the company in the right direction, and many internal management battles regarding what and how to disclose in external financial reporting run on the verge of materiality.

This book offers an integrated perspective of materiality from the angles of accounting (IFRS, US GAAP and SEC Rules and Regulations), auditing, internal control over financial reporting, management commentary, financial analysis, management control, forensic analysis, sustainability reporting, corporate responsibility, assurance standards, integrated reporting, and limited legal considerations. 

In Materiality in Financial Reporting: An Integrative Perspective, the author adopts a practical, operational approach to show how strategy, processes, and communication can be used to devise a consistent corporate governance system of materiality.

Part I

Introduction and Background

Abstract

Part I introduces the background of why materiality matters in financial statements. One of the main reasons for determining whether a fact is material is to check whether its misstatement overtakes the watershed which makes financial statements not comply with the relative financial reporting framework.

This part also introduces one of the themes of the book: the interaction of the views of the different subjects involved in materiality assessment, i.e., users, preparers, auditors, regulators, and the related conflicts of interest. Materiality plays a different role in this depending on who is looking at it.

The part also comprises an overview of the main projects underlying the current debate about materiality, that is, the International Accounting Standards Board’s Disclosure Initiative, the Financial Accounting Standards Board’s Disclosure Framework and the SEC’s Disclosure Effectiveness Initiative, including a list of their main steps and documents issued to date.

Keywords: Accounting; Compliance; Disclosure; Effectiveness; IASB; IFRS; Impracticability; Initiative; Maturity; Override; SEC; Undue; US GAAP

Main Focus of Part I

1. Why Does Materiality Matter in Financial Statements?

First and foremost, materiality in financial reporting is the focus of the lens of financial statement users in making their economic decisions. The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) conceptual frameworks contemplate this as the main argument, as discussed in Paragraph II.1 below.

However, in practice, materiality is so important is for its implications for preparers of financial statements and auditors. In fact, International Financial Reporting Standards (IFRS) presumes that compliance with IFRS results in financial statements achieving fair presentation of the financial position, financial performance, and cash flows of an entity. IFRS compliance means that the financial statements adhere to all the requirements of IFRS. The notes must state an explicit and unreserved statement to this respect. Any departure from IFRS requirements would undermine such compliance of the whole financial statements, unless:

1. the management concludes and discloses that in an extremely rare circumstance compliance with IFRS would be so misleading to conflict with the objective of the financial statements specified in the Framework;
2. applying an IFRS requirement has a material effect, but the IASB has explicitly provided for an impracticability exception (for its meaning, see Paragraph 1.n below), and the company is in such an impracticability situation and gives the specific disclosures as required;
3. applying an IFRS requirement has a material effect, but the IASB has explicitly provided an exception based on an undue cost and effort basis (for its meaning, see Paragraph 1.m below);
4. the entity does not provide a specific disclosure required by the IFRS or does not apply a required accounting policy or does not correct an error, because such information or the effects of applying the policy or the error is immaterial. However, the entity cannot use this argument if it does so to achieve a particular presentation of the financial position, financial performance, or cash flows (IASB, 2014, IAS 8, paras. 8, 41, BC24; IASB, 2016, IAS 1, paras. 15, 16, 19, 31, BC36).

The first situation would be extremely rare. The second and third situations are strictly defined by the IASB, not by preparers. Therefore, the management can only resort to a materiality argument to avoid a departure from Generally Accepted Accounting Principles (GAAP) having serious consequences. Paragraph V.9.a below discusses immaterial misstatements.

An entity that describes its financial statements as prepared in conformity with US generally accepted accounting principles must also apply all relevant authoritative accounting pronouncements. This concept is similar to compliance to IFRSs. US GAAP does notexplicitly require a statement of compliance, as compliance is ordinarily taken for granted. Although it does not mandate an exact placement, it encourages a separate section before the notes or as a first note (FASB, 1993, FASB Interpretation no. 40, paras. Summary, 2, 5, 16; FASB, 2016, FASB ASC 235-10-05-3, 235-10-50-1, 235-10-50-6). However, US GAAP does not have an overriding case as described in the first point above. US GAAP also has some exceptions due to impracticability or undue cost or effort.

Symmetrically, auditors express an opinion on the financial statements to present fairly the financial position, financial performance, and cash flows of the entity, but they attest that this holds true in all material respects. Drawing a line on what is material permits auditors, on one hand, to assess and respond to financial statements compliance with GAAP and, on the other hand, defend themselves against claims concerning their audit work.

2. Powerful and Dangerous

Formally, materiality is assessed from the eyes of the users of financial statements, yet the management decides it. What lenses does the management use? If challenged, the management can easily say that an item is not material and in most occurrences a different opinion would likely be subjective as that of the management.

Readers of financial statements cannot be aware of something that is not recognized, not measured, or not presented if this fact is not disclosed. They cannot be aware of something that is not disclosed.

In theory, the management would be able to justify virtually everything based on materiality, also because a fact cannot be challenged until another party becomes aware of it. If this happens, the management would be most of the time able to discharge its liability on the grounds of professional judgment.

From all these perspectives, it is evident why a loose concept of materiality is powerful but dangerous at the same time. It presupposes a high level of maturity of management and a strong sense of business ethics, a solid system of checks and balances in corporate governance, and an effective regulatory enforcement.

3. The Disclosure Framework

Much of the recent development on materiality takes its origin from the Disclosure Framework project (FASB, 2012, File no. 2012-220). The FASB added this project in its agenda in July 2009 and issued an Invitation to Comment in 2012. It pursued a field study in 2013.

The FASB and the AICPA’s Center for Audit Quality-sponsored forums on financial statement disclosure effectiveness at Columbia University’s Center for Excellence in Accounting and Security Analysis on October 4, 2012 and at Stanford University Graduate School of Business on October 8, 2012 (Center for Audit Quality, 2012).

Several organizations have contributed with their independent analyses and studies, including the EFRAG, the IAASB, the ASB, the FRC, the ICAEW, the CPA Institute, and others as mentioned in several sections of this book.

Concurrently, the FASB is carrying out the Simplification Initiative, which consists in a series of a narrow-scope short-term project to simplify accounting standards and reduce their cost and complexity. The current projects include:

• – Balance Sheet Classification of Debt;
• – Nonemployee Share-Based Payment Accounting Improvements;
• – Accounting for Financial Instruments — Hedging;
• – Liabilities and Equity — Targeted Improvements.

4. The Disclosure Initiative

In the IASB’s world, the Disclosure Initiative is the analog to the Disclosure Framework. Regarding materiality, the project has produced certain amendments to IAS 1 and the Practice Statement on materiality. Further discussion on the definition of materiality is expected to be part of the Principles of Disclosure project within the Disclosure Initiative.

Both the FASB’s Disclosure Framework and the IASB’s Disclosure Initiative projects intent to improve the overall disclosures and the notes to the financial statements through enhanced effectiveness of information. It can be argued that this is the underlying motif of every system of information, and in fact virtually all financial reporting standards and management reporting systems worldwide deal with sorting out a hierarchy of qualities of accounting and financial information. Materiality is only one of several aspects treated in the Disclosure Initiative, centered into the difficulties in applying materiality in practice which have been mostly portrayed as a conduit to ineffective disclosure (IASB, 2017, PS 2, para. BC2).

Unlike the position of the FASB, where the impossibility to arrive to an accounting definition of materiality would likely cut any further discussion short, the IASB anticipated that this will not significantly affect the short-term conclusions drawn in the IASB (2017), PS 2 (IASB, 2017, PS 2, para. BC15).

5. The Disclosure Effectiveness Initiative

The Disclosure Effectiveness Initiative is a review by the SEC Staff of disclosure requirements, their presentation and delivery as required by the Jumpstart Our Business Startups Act. In December 2013, the SEC issued a Staff Report to Congress about the review of its disclosure requirements in Regulation S-X and Regulation S-K to facilitate timely and material disclosures. The Fixing America’s Surface Transportation Act (2015) required the SEC to carry out a study on the modernization and simplification of the disclosure requirements in Regulation S-K.

Several documents have been issued in this context, including:

• – SEC Staff’s Report on Review of Disclosure Requirements in Regulation S-K — “S-K Study” (The US Securities and Exchange Commission [SEC], 2013);
• – SEC Release no. 33-10064, Business and Financial Disclosure Required by Regulation S-K, April 13, 2016 (SEC, 2016);
• – SEC Release no. 33-10110, Proposed Rule, Disclosure Update and Simplification, July 13, 2016 (SEC, 2016);
• – Report on Modernization and Simplification of Regulation S-K, November 23, 2016.

On September 25, 2015, the SEC announced that it is seeking public comment on the effectiveness of financial disclosure of Regulation S-X. So far, this has produced the Release no. 33-9929, Request for Comment on the Effectiveness of Financial Disclosures about Entities Other than the Registrant, September 25, 2015. The SEC will also review the differences and possible ways of aligning the disclosure requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934, working with the FASB to address overlapping requirements in US GAAP and SEC rules, and improve the delivery and navigability of information through technology.

Some of other prior documents on the topic include:

• – Report of the Task Force on Disclosure Simplification, March 5, 1996;
• – Report of the Advisory Committee on the Capital Formation and Regulatory Processes, July 24, 1996;
• – Final Report of the Advisory Committee on Improvements to Financial Reporting in the United States Securities and Exchange Commission, August 1, 2008.

6. Objectives of the Book

The objective of this book is twofold. First, it intends to review the different angles of the literature of materiality and integrate them into an overall systemic perspective. Second, the book proposes new ways of looking at materiality that originate from the above integration of diverse existing disciplines. This entails the consideration of accounting standards, auditing standards, internal control over financial reporting, management commentary, financial analysis and management control, forensic analysis, sustainability reporting, corporate responsibility, assurance standards, integrated reporting, and limited legal considerations.

To accomplish the first objective, the book deals with both theory and practice. It pursues a theoretical analysis of the conceptual frameworks and of the definitions of materiality. It compares the actors involved in materiality decisions and their roles. On the practice side, it analyzes existing guidance on the application and assessment of materiality and contrasts it to identify gray areas. It shows real-world illegitimate uses of materiality to misstate financial results.

To achieve the second objective, the book first creates a taxonomy of the materiality attributes that are embedded in the different definitions. Then it elaborates the existing views to materiality or creates new ones, to show that this subject can be seen from different angles and applied to different contexts. It proposes attention to the unstated recognition and measurement problems of materiality and the often-found hidden agenda of management in manipulating financial results. It shows the leading practice of zero materiality in bookkeeping and advocates a good faith approach in genuinely separating the understanding of users’ perspective from applying the highest standard of due diligence in accounting practice. In integrating disciplines that are generally seen separately, it derives practical suggestions on how to assess and judge materiality, and explains how the management can reuse tools that other actors, such as auditors or regulators, adopt to address materiality issues. Finally, it makes a systematic reorganization of materiality determination processes and leading practice that are at the forefront of future developments.

Part II

Conceptual Bases of Materiality

Abstract

Part II contrasts the views of materiality in the Conceptual Frameworks of the IASB, FASB, IPSAS, and other framework such as the Integrated Reporting. In particular, it analyzes at what level and how differently that concept interacts with the qualitative characteristics of financial information in each of those frameworks. It looks at its pervasiveness and entity specificity, the interlock with the concept of relevance, reliability and faithful representation, completeness, understandability, neutrality, and drills down to the link to recognition.

This part then compares the definitions of materiality in different standards and contexts, to then draw a taxonomy of materiality and its attributes, such as the subject matter, thecontext of assessment, the addressees, the assessor, and the materiality test. A large part of the analysis involves the comparison between legal definitions of materiality and characterizations in the accounting, financial, and larger management contexts.

Keywords: AA1000; CDSB; framework; GRI; IPSAS; ISO; qualitative characteristics; relevance; reliability; significance; supreme court; understandability; WBCSD

Main Focus of Part II

1. Materiality in the Conceptual Frameworks

1.a. The Objective of Materiality

This section illustrates several points of contact between the concept of materiality and the qualitative characteristics of useful accounting or financial information. Indeed, usefulness of information is the primary objective of financial statements in the common Conceptual Framework, a...

Table of contents

• Cover
• Title Page
• Part I Introduction and Background
• Part II Conceptual Bases ofMateriality
• Part III Actors and Models ofMateriality
• Part IV Application of Materiality
• Part V Assessing Materiality
• Part VI The Materiality Determination Process
• Part VII Where Standard Specifically Require Materiality Judgments
• Part VIII Accounting Materiality in the Real World
• References
• Index