By: George M. Wilson, SEC Institute
Materiality is one of the most challenging judgments we have to make in our period-end reporting. Few areas in our financial reporting world are as subjective and difficult to interpret. An issue that makes materiality judgments even more complex is that if, in a later period, someone (the SEC for example!), wants to evaluate or second guess our judgment, it is always with 20-20 hindsight.
We need to be thoughtful and complete in our analysis and documentation for every materiality judgment we make.
Where is the official guidance we should cite in our white paper to document materiality decisions?
From a US GAAP perspective you may remember that as part of its Conceptual Framework project the FASB was considering making some changes to the definition of materiality in the GAAP literature. At the Board’s November 8, 2017 meeting they decided not to make changes and instead use the existing definition from old, now superseded, Concept Statement 2:
Materiality is a pervasive concept that relates to the qualitative characteristics, especially relevance and reliability. Materiality and relevance are both defined in terms of what influences or makes a difference to a decision maker, but the two terms can be distinguished. A decision not to disclose certain information may be made, say, because investors have no need for that kind of information (it is not relevant) or because the amounts involved are too small to make a difference (they are not material). Magnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, will not generally be a sufficient basis for a materiality judgment. The Board’s present position is that no general standards of materiality can be formulated to take into account all the considerations that enter into an experienced human judgment. Quantitative materiality criteria may be given by the Board in specific standards in the future, as in the past, as appropriate.
So, the Board’s new Concept Statement 8 will have a definition close to the words above.
As a next reference point, Regulation S-X, Rule 1.02(o) provides this definition of material:
(o) Material. The term material, when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters about which an average prudent investor ought reasonably to be informed.
Obviously, this is not a simple definition to interpret and apply. It emphasizes the need for thoughtful, careful judgment when evaluating materiality. The SEC issued SAB 99, codified as SAB Topic 1-M, to provide more guidance as we make materiality judgments. SAB 99 quotes a Supreme Court Decision that held that a fact is material if there is:
a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available
This SAB also clearly articulates that materiality is not simply a quantitative concept:
“In the context of a misstatement of a financial statement item, while the “total mix” includes the size in numerical or percentage terms of the misstatement, it also includes the factual context in which the user of financial statements would view the financial statement item. The shorthand in the accounting and auditing literature for this analysis is that financial management and the auditor must consider both “quantitative” and “qualitative” factors in assessing an item’s materiality”
Not surprisingly, the CorpFin Staff writes comments about materiality. As you can see in this comment, the Staff will actually ask for your SAB 99 white paper:
We have the following comments on your use of incorrect translation rates for reporting U.S. Dollar value of goodwill held by foreign subsidiaries:
Please tell us the date you determined this error, clarify how this error arose, and identify the periods affected by this error;
Please clarify impact, if any, the correction of this error had on your reported $(287,524) foreign currency translation adjustment for the three months ended December 30, 2016;
Provide us with your sufficiently detailed SAB 99 materiality analysis to support how you determined that effected accounts were not quantitatively or qualitatively material to any of the affected periods; and
Tell us how the errors impacted the previous conclusions regarding disclosure controls and procedures and internal control over financial reporting.
The auditors’ materiality determinations were unreasonable in that they were based on a quantitative analysis and failed to consider whether the revenues at issue were qualitatively material.
When we make difficult decisions the 20-20 hindsight factor is always in our minds. The best way to deal with this hindsight factor is to make a thoughtful judgment using all the facts available to us in the moment, and then to document all our considerations. We need to clearly and completely articulate all the relevant facts and information, enumerate quantitative issues, describe qualitative issues, and come to an overall conclusion that is consistent with all the above guidance.
As always, your thoughts and comments are welcome!