Concept of Materiality, A Cornerstone in Accounting

The concept of materiality is a cornerstone in accounting, and the Financial Accounting Standards Board (FASB) issued two exposure drafts that aim to address the concept of materiality on September 24, 2015.

What is the Concept of Materiality?

The concept of materiality is a fundamental principle in accounting. The concept dictates that trivial matter can be disregarded, while all important matter needs to be disclosed. Materiality in and of itself refers to the level of detail that is required or appropriate for different financial reports.

But materiality also refers to the importance of errors in a filing.

The concept of materiality works to report important financial data. The concept is an accounting convention, but issues arise when ascertaining what level of detail is needed for proper disclosure.

For example:

  • Too much detail can obscure true financial issues
  • Too much detail could be difficult for a non-accountant to read
  • Too much detail could lead to unnecessary preparation lengths

Non-material items can then be assessed as distracting and pointless in a financial report because they work to obscure the bigger picture of the financial documents. When removing non-material items, it allows for case analysis for decisions and planning.

If material items are omitted from a financial document, it can cause bad decisions and planning to be made.

FASB’s Proposals of Clarity

Materiality is part of the FASB’s disclosure framework, which aims to improve the effectiveness of disclosures in notes to financial statements. Exposure drafts work to:

  • Assist organizations in determining which disclosures are “material.”
  • Assist the FASB in understanding the reporting environment.

The FASB revisited the matter because the framework is inconsistent with the legal concept of materiality. The United States Supreme Court established the legal concept 40 years ago, and inconsistencies can have a negative impact on businesses.

An issue businesses and accountants face is determining the “size” of an item that can be omitted. In many cases, accountants will use the following guidelines:

  • An item that is 5% of profit will be considered material
  • An item of 0.5% of sales revenue or higher is material
  • Balance sheet matters worth 0.3% - 0.5% of total assets are material
  • Balance sheet matters where the matter is more than 1% of total equity

Accountants utilizing different criteria for their definition of materiality can cause statements to become skewed. The FASB wants to make the definition clear for materiality, and one of the two proposals set forth by the FASB requires:

Filers to use the definition of materiality as set forth by the U.S. Supreme Court.

Stakeholders requested that the FASB take measures to clarify materiality and “eliminate inconsistences” among the framework and the legal concept of materiality. The proposals are an effort to correct these issues.

Public companies are required under federal law to disclose all material information in accordance with the definition as found in TSC Industries Inc. v. Northway Inc. in 1976. In essence, the definition from 1976 classifies material information as:

  • Material that if disclosed would have a high likelihood of significantly altering the information made available to the reasonable investor.

An example of this may be a company’s $600,000 loss in materials. If the company only has $3 million in revenue and suffered a loss equal to 20% of the company’s revenue, this would certainly be considered material. The decisions of investors and the company must weigh this loss in future decisions and forecasts.

FASB Chairman Russel Golden reaffirms that the proposal will:

  • Improve disclosure effectiveness
  • Focus on the material items
  • Omit the immaterial items

The exposure draft of the FASB will amend Chapter 3. In the draft, the FASB clearly states that it does not define materiality and puts the US Supreme Court’s definition in place.

The second exposure draft places amendments on Topic 235 Notes to Financial Statements. The draft works to promote use of discretion by organizations. The appropriate use of discretion is being promoted in reference to the decision of which disclosures ought to be considered material.

Key points in the exposure draft are:

  • Materiality being a legal concept.
  • The omission of immaterial information not being an accounting error.
  • Reaffirm that materiality is applied individually, and in the context of financial statements as a whole in a quantitative and qualitative manner.

The proposals do not aim to change the concept of materiality. Rather, the amendments and proposals aim to amend existing standards in the framework to lessen immaterial disclosures found in the notes of financials.

A clear definition of this can be seen as: the disclosure, taken as a whole, with “some, all, or none of the requirements in a disclosure may be material.”

The proposals are met with uncertainty and assert that the FASB’s proposals will make financial statements less valuable to investors. The Council of Institutional Investors further commented on the matter, and asserts that this is not a matter of clarification and that the amendments will harm investors directly.

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