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Materiality from a different point of view.

The number of financial statement restatements has grown substantially in the last several years. There are many factors that have contributed to this growth.

The business environment is certainly far more complex today than it was in the past. Transaction structures have changed; more sophisticated risk management products have evolved and companies have expanded globally. Additionally, the economy--once based on "bricks and mortar"--is now focused on services, information, technology and intangible assets. As complexity in the business environment has increased, the level of complexity in financial reporting has also grown. The greater complexity in financial reporting creates challenges in "getting it right the first time."

The level of restatements is also being driven by a legal/regulatory view of financial statement materiality, which has significantly lowered the threshold at which corrective action in the form of restatement is required. Although the capital markets appear to be digesting many of these restatements without significant upset, this muted market reaction may also be a signal that restatements are being processed for immaterial items--items that do not significantly alter an investor's view of the total mix of information.

This may not be in the best interests of investors or the markets. If left unchecked, the level of restatements has the potential to seriously erode the confidence in our system of financial reporting and, ultimately, drive a decline in the competitiveness of the U.S. capital markets.

The time is right to take a fresh look at materiality; all capital market stakeholders should come together and make the investment in developing improved and understandable principles to guide materiality determinations.

A Fresh Look

The U.S. Supreme Court has stated that an item is generally considered to be material if there is a substantial likelihood that a reasonable investor would view it as significantly altering the "total mix" of available information. The question of whether or not a financial statement error or omission is material is not a new one. It is, however, a complicated one and an important one.

The restatement process is costly, with some of the costs readily quantifiable and others, not. Some of the less visible--but no less important--costs include the opportunity cost of diverting attention away from growing the business or focusing on operational improvements. Other "intangible" costs of restatement include the need for investors to digest restated information and diminished confidence in the marketplace. In the end analysis, investors must bear all of these costs.

Accordingly, it is important that materiality judgments are aligned with investor needs. In particular, there should be additional focus on the role of qualitative factors in evaluating materiality from the investor's perspective.

Materiality is a highly subjective matter, and well-reasoned professional judgment is required to evaluate whether a particular error is material. Materiality analyses should weigh quantitative and qualitative factors in light of the relevant facts and circumstances from the perspective of the intended user.

The analysis should not focus on whether an item is "quantitatively material" or, separately, whether it is "qualitatively material." An item is either material or it is not--after considering all relevant facts and circumstances. Qualitative factors may render a small item as material. The U.S. Securities and Exchange Commission (SEC) staff made this clear in Staff Accounting Bulletin No. 99. But SAB 99 is oriented toward considering qualitative factors in just one direction (i.e., whether qualitative factors might indicate that a small item is material). It does not specifically address whether the analysis works both ways.

The model should work both ways, and the concepts in SAB 99 should be adapted and expanded. Qualitative factors, particularly when viewed from the investor's perspective, may very well indicate that an error that is relatively large in magnitude is, nonetheless, immaterial.

For instance, an unintentional error that does not mask a change in earnings or other trends, that does not affect a high-profile business segment and that does not hide a failure to meet analyst expectations, might be properly considered immaterial even if the quantitative magnitude of the error is large.

The consideration of materiality should be expanded beyond traditional financial statement metrics to evaluate how an error impacts the fundamental value drivers of the business. Two errors of equal quantitative magnitude may have very different effects on investor behavior.

For instance, the failure to identify and disclose the impairment of a key intangible asset relating to a developing technology or product may have far greater consequences from an investor's perspective than an error with the same historical financial statement impact relating to a technical misapplication of derivative instrument accounting standards.

Similarly, even large errors in classification (in the statement of cash flows) simply may not be material from an investor's perspective, particularly when the misclassified item was transparently disclosed. When considering the materiality of errors from the perspective of an investor, the analysis should generally take into account whether the error significantly diminishes the predictive value of the financial statements for purposes of assessing the expected future discounted cash flows of the enterprise.

Materiality analyses should, among other things, generally consider whether the error raises questions about the integrity of senior management; the impact of the error on key performance indicators; market price reaction to the announcement of the error; and whether investors are still relying on the incorrect information.

When there is no indication of significant bad conduct on the part of senior management, it may not make economic sense to expend huge amounts of time, effort and resources to correct prior-period reports that investors are no longer using or for an error which did not have a market impact when it was disclosed. Investors should, however, generally be provided transparent disclosure so they will understand an error occurred and they will have the information they need to evaluate the impact of the error on the period in which it originated and the period in which it is corrected.

The nature of the affected accounting period (interim vs. annual) is another element that generally should be considered when assessing materiality. Investors understand and accept that the level of precision inherent in interim financial statements is less than that for annual financial statements. This is recognized in the lower levels of detailed disclosure and external assurance that investors receive in interim periods.

There should generally be a low tolerance for permitting errors to remain uncorrected when they are identified before the related financial statements are first issued. However, when evaluating errors identified on a post hoc basis, the materiality analysis should recognize the reduced expectations of precision in interim periods.

When an error is discovered after the financial statements have been issued, the materiality analysis should generally look at the error from two different perspectives: as an originating error and as an out-of-period correction. Originating errors generally should be evaluated for materiality against the annual and interim period (quarter) in which the errors arose. However, if an error was not material to the annual or interim period in which it arose, the effects of correcting the error as an out-of-period item should generally be evaluated against the expected financial results for the full fiscal year (with transparent disclosure). The U.S. accounting literature supports this type of model.

The judgments around materiality are complex. There is no black box into which we may pour a set of facts and circumstances, turn a crank and receive a conclusion, and we should not seek to construct one. But the time is right to reevaluate the existing framework to ensure that it is aligned with the needs of investors. So, let us begin.

Vincent P. Colman is U.S. National Office Professional Practice Leader and John A. May is a U.S. National SEC Services Partner, both for PricewaterhouseCoopers LLP.
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Title Annotation:financial reporting
Author:May, John A.
Publication:Financial Executive
Date:Jun 1, 2007
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