FASB's Proposal to Change the Definition of Materiality

In September 2015, FASB issued two proposed documents that, if adopted, could change the way the concept of materiality is assessed and applied regarding information to be disclosed in the financial statements. The first proposal would amend Chapter 3 of FASB Concepts Statement 8, Conceptual Framework for Financial Reporting, to eliminate inconsistencies between the framework and the legal concept of materiality by including an explicit statement defining materiality as a legal concept that can be established or changed only through legislative, executive, or judicial action. The proposal states that FASB observes—but does not promulgate—definitions of materiality, and also includes a general restatement of the U.S. Supreme Court’s current definition of materiality.

The second proposal would amend U.S. GAAP by 1) clarifying that FASB observes but does not define materiality; 2) advising that materiality should be applied to quantitative and qualitative disclosures individually and in the aggregate with respect to the financial statements taken as a whole, and thus some, all, or even none of the disclosure “requirements” in a given standard may be material (i.e., some disclosure requirements may be immaterial); and (3) clarifying that the omission of immaterial information is not an accounting error.

What This Is All About

Both proposals are part of FASB’s Disclosure Framework Project, which is intended to establish an overarching framework that would make financial statement disclosures more effective, better coordinated, and less redundant. Although reducing the volume of notes to financial statements is not FASB’s primary goal, the board hopes that a sharper focus on the disclosure of important information will result in reduced volume in most cases. Improving disclosure effectiveness will, as FASB views it, require development of a framework that promotes 1) consistent decisions by the board about disclosure requirements and 2) appropriate exercise of discretion by reporting entities concerning the information to be disclosed. The decision process is intended to aid FASB in identifying the types of disclosures to be considered and will require judgment by FASB of the costs, negative consequences, and benefits associated with each potential disclosure at the standard level.

Proposed Change in the Definition of Materiality

As FASB Concepts Statement 8 now reads, information is material if omitting or misstating it could influence decisions users make on the basis of the financial information of a specific reporting entity. Moreover, that passage is followed immediately by this explanation: “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.” If the U.S. Supreme Court’s definition of materiality were to be adopted, as FASB proposes, information in the context of antifraud provisions of U.S. securities laws would be 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.” While the main text of the Concepts Statement would no longer address the notion that materiality is an entity-specific aspect of relevance, the basis for conclusions, as proposed to be amended, would state that “a standard setter does not consider materiality when developing standards because it is an entity-specific consideration” (emphasis added).

FASB believes that there really is no difference between the existing definition of materiality and the proposed one. Rather, according to Board member Thomas Linsmeier, switching to the Supreme Court definition would just change the wording and conform the definition to the one actually used in practice, one that is cited in PCAOB Auditing Standard 11, Consideration of Materiality in Planning and Performing an Audit (Tammy Whitehouse, “FASB Ideas on Materiality Reform Draw Heat, Questions,” Compliance Week, November 17, 2015, http://bit.ly/1LeX0VR).

Not everyone, however, accepts that FASB’s proposal is merely a benign clarification that will formally bring the definition of materiality more in line with the way the concept is actually applied. The opposition comprises two broad categories of critics and skeptics: 1) those who believe that allowing preparers to have more discretion will result in fewer important disclosures in financial statements because companies will, when given the opportunity, always opt to disclose less rather than more (i.e., more information will be deemed immaterial); and 2) those who believe that, by applying the Supreme Court’s definition of materiality, the decision regarding what constitutes a material disclosure will shift from preparers and auditors to lawyers.

As to the first objection, Amy Borrus, interim executive director at the Council of Institutional Investors, believes that the proposals represent a sweeping change that would make financial statements much less valuable as a source of information for investors (Gretchen Morgenson, “FASB Proposes to Curb What Companies Must Disclose,” New York Times, January 2, 2016, http://nyti.ms/1JpFtPd). Meanwhile, the second position was succinctly expressed in a comment letter to FASB by Peter S. Kennedy, a partner in the accounting firm of Cover & Rossiter. Kennedy wrote that making materiality a legal concept is a significant flaw that will subordinate the judgment of the preparer and the auditor to attorneys, regardless of their capacity or area of expertise.

What Investors Think

Of course, all of this is presumably being done in the name of providing investors with important disclosures that are not obscured by a sea of unimportant ones. But what do investors actually think? That depends on who is being asked—and on how those doing the asking interpret the answers. A recent survey by the CFA Institute on the impact of the enhanced use of materiality in financial reporting disclosures reveals that “a vast majority (76%) of respondents do not currently observe the inclusion of obviously immaterial information in disclosures” (http://cfa.is/1ops4gJ). That same survey, however, also revealed that only 20% of respondents believed that the enhanced use of materiality will result in a significant reduction in information disclosed. Therefore, 80% of respondents presumably believe that the enhanced use of materiality will not result in less disclosure.

Furthermore, a recent study conducted by KPMG, which included a survey of 6,500 members of the Financial Executives International (FEI) and a review of relevant academic research on disclosure complexity, revealed that 1) complexity in financial reporting confuses investors and prevents them from making optimal decisions, 2) the proliferation of required disclosures accompanying financial reports makes it difficult for investors to decipher a company’s performance and factors driving that performance, and 3) the notes to the financial statements are the most significant contributor to disclosure complexity (http://bit.ly/1QTKhMK).

Will It Change Practice?

The real issue is how—or even if—a switch to the Supreme Court’s definition of materiality in the context of disclosure will change practice. In my opinion, it will not significantly alter practice, because the Supreme Court’s definition is, by and large, the way materiality is currently applied by preparers and auditors, however inevitably murky the thought process might be. I believe that, as FASB has argued, the change will do nothing more than formalize the view most practitioners already take when deciding if a disclosure is material. I do not think it will, as some critics suggest, have any noticeable effect on the volume of disclosures included in notes to financial statements, nor will it result in accountants and auditors ceding their judgment about materiality to attorneys.

In the aforementioned article in Compliance Week, Michael Scanlon, a partner in the law firm of Gibson, Dunn & Crutcher, states that FASB’s proposal is plainly a clarification. And Dan Goelzer, a partner in the law firm of Baker & McKenzie, goes even further. He maintains that, while the words differ between the existing and proposed definitions, in practice there is only one definition of materiality that applies to financial statement disclosures and the rest of the SEC filing, and that is the Supreme Court’s.

Moreover, as evidence that immaterial information in financial statement notes currently abounds—and is likely to continue unabated even if FASB grants preparers more discretion concerning the materiality of disclosures—consider that, in the KPMG survey of FEI members cited above, 83% of respondents from public companies indicated that potential objection by the SEC and other regulators, including state regulators, might cause them to provide disclosure that would otherwise be deemed immaterial.

Is all this much ado about nothing?

Allan B. Afterman, PhD, CPA is the author of numerous treatises on financial reporting and SEC practice and has consulted with governments on the establishment of national securities laws and financial reporting standards. He is a former adjunct professor in the Booth School of Business at the University of Chicago, and was assistant to the national director of SEC practice at a major public accounting firm.