More background on FASB’s proposed changes to materiality
Previously mentioned FASB has released two exposure drafts to change the definitions of materiality. I am just beginning to understand the issue. Most of the significance plays out in the world of publicly traded companies, which is light years removed from my practice. Most readers of this blog likely stay far away from that world. Yet what goes in that distant galaxy will have a large impact on private companies.
Here are a few articles to fill you in on the implications and behind-the-scene issues. Will also touch on the current definitions of materiality and how to dispose of immaterial misstatements.
10/26 – Edith Orenstein at LinkedIn – FASB’s Moved to Supreme Court Definition of Materiality Debated in Court of Public Opinion
Here are two of the major impacts of the proposed changes. First, increasing the cut off of what is material. Second, how to dispose of departures from disclosure requirements that are below the level of material and above the threshold of trivial.
The conceptual framework exposure draft will change the definition of materiality. Instead of providing a narrative on what constitutes materiality, there is deference to what the courts have decided, whatever that may be at the moment. The current description is that 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.
The courts are working with a different definition. 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.
Going from could to substantial likelihood increases the cutoff for deciding what is material. Going from influence decisions to alter total mix of information is also going to move some items from material to immaterial.
Ms. Orenstein points out that implementing this change will require conforming changes in PCAOB audit rules and the ASB’s Statements on Auditing Standards.
Second major issue I want to mention is what to do with those items between the material and trivial cutoffs.
You can find the audit literature at AU-C section 450. Misstatements are defined as a
… difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be presented fairly in accordance with the applicable financial reporting framework.
Notice the definition includes disclosures. In extremely condensed summary, that means any difference between the financial statements and what is required by the applicable financial reporting framework is a misstatement.
At one end of the spectrum, trivial items can be ignored. Remember the threshold for trivial is a small percentage of material. We are talking 2% or 5% of what might be considered material. We’re looking at really, really tiny differences.
At the other end of the size scale, material misstatements should be corrected by management. If not, the matter needs to be addressed in the accountants’ report. We are talking qualified, adverse, or disclaimer opinions.
What about the in between items? Those that are less than material yet more than trivial? In the audit literature those need to be determined to be immaterial by management, listed and asserted to be immaterial by management in the representation letter, and communicated by the accountant to those charged with governance.
As a general practice, I think in the private company world the requirement to include any passed entries in the rep letter and board letter has resulted in the extinction of all passed adjusting entries. My perception is that anything above the trivial cutoff gets posted.
Notice this also includes disclosures. Missing or incorrect disclosures need to roll into the same reporting methodology.
Apparently, in the public company world any passed items go to the audit committee.
The exposure draft has another change which would define immaterial disclosure issues as not being an accounting error. This means those items could be passed by management and not communicated to the audit committee in the public company world. Under the SASs, such passed disclosures would not require inclusion in the representation letter and board communication letter.
So there’s a two prong impact: in terms of recognition, presentation, and disclosure, some items would move from material to immaterial; in addition any disclosure departures which are less than material but more than trivial would not have to be communicated to those charged with governance (for private companies) or the audit committee (for public companies).
Please check out the comments in the article from various people on the impact of the changes.
10/7 – Tom Selling at The Accounting Onion – Materiality: The FASB is Shrinking the Envelope – A lot of inside-baseball stuff on where the changes are coming from. (When I say inside-baseball here, I mean behind-the-scenes background that is beyond my ability to interpret and beyond my interest level to put in the effort to comprehend.
Quite appropriately, he points out that all SFASs ever issued have contained a comment that the provisions do not need to be applied to immaterial items. The ASC also contains the same point.
10/19 – Francine McKenna at MarketWatch – Investor advocates protest proposals limiting disclosure – There was lots of pushback from the SEC’s Investment Advisory Community meeting in October. Responses from observers mentioned in the article agree the proposals would reduce the amount of disclosures.
10/25 – Tom Selling at The Accounting Onion – FASB’s Proposed Materiality “Clarifications” are Backfiring – He suggests the IAC meeting was actually an unsuccessful effort at damage control by FASB.
To summarize and dramatically overstate the different opinions I’ve seen so far, there is one school of thought seems to believe the exposure drafts would result in gutting disclosures in financial statements. I’m not sure there would be much of a visible impact on disclosures.
I stay as far away from the PCAOB world as possible, so I don’t have any idea what the nuances are from that universe. That means that after a thousand words I still do not quite know what to make of the proposed changes to materiality.
What do you think?