by Cydney Posner
FASB has issued two exposure drafts as part of its disclosure framework project, which is intended to facilitate clearer communication of GAAP information required in notes to financial statements. The two proposals are intended to “clarify the concept of materiality.”
The exposure draft containing amendments to FASB Concepts Statement No. 8, Conceptual Framework for Financial Reporting, is intended to clarify the concept of materiality primarily by modifying the current definition to add a statement that materiality is a legal concept. The amendments would also include a brief summary of SCOTUS’s definition of “materiality,” based on TSC Industries v. Northway and Basic v. Levinson, in the securities law context: generally, “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. Consequently, [FASB] cannot specify or advise specifying a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.”
The proposed Accounting Standards Update (ASU), Notes to Financial Statements (Topic 235): Assessing Whether Disclosures Are Material, is “intended to promote the appropriate use of discretion by organizations when deciding which disclosures should be considered material in their particular circumstances.” A key objective is to improve the effectiveness of financial statement notes by assisting companies to omit immaterial information and focus communication on material, relevant information. The amendments would apply only in the context of disclosure requirements, not to other substantive aspects of the Accounting Standards Codification (ASC). The ASU would apply to all types of organizations, including both public and private companies. The amendments would be effective upon issuance; companies could choose to apply the proposed amendments prospectively or retrospectively.
More specifically, the ASU proposes to amend Topic 235, Notes to Financial Statements, to make the following changes:
“1. Materiality would be applied to quantitative and qualitative disclosures individually and in the aggregate in the context of the financial statements as a whole; therefore, some, all, or none of the requirements in a disclosure Section may be material.
2. Materiality would be identified as a legal concept.
3. Omitting a disclosure of immaterial information would not be an accounting error.”
The impetus for providing the new guidance was that FASB’s current discussion of materiality in its Conceptual Framework was not consistent with the legal concept of materiality (as interpreted by SCOTUS discussed above), resulting in “uncertainty about organizations’ abilities to interpret what disclosures are material… and the Board’s ability to identify and evaluate disclosure requirements in accounting standards.”
In addition, a FASB field study conducted in 2013 revealed that an explanation of how to appropriately consider materiality could help companies to reduce or eliminate irrelevant disclosures. According to the ASU, often-cited obstacles that might inhibit a company from omitting immaterial disclosures included the following, especially the first point below:
“1. The requirement to communicate omissions of immaterial disclosures as errors to audit committees
2. Litigation concerns
3. Possible internal control changes required to support discretion in the preparation of information provided in disclosures
4. Possible [SEC] staff comment letters about omitted disclosures.”
Some stakeholders indicated that it was easier and less time-consuming in many cases just to provide an immaterial disclosure than to defend to the auditor a decision to omit it or to communicate the omission to the audit committee. To address that concern, the amendments provide that, omitting an immaterial disclosure would not constitute an error.
The study also found that “consideration of materiality usually focuses almost entirely on the magnitude of monetary amounts even though qualitative factors are important in determining materiality, especially in the context of disclosures.” In some cases, some stakeholders questioned whether qualitative disclosures were eligible to be assessed on the basis of materiality. Accordingly, the amendments would clarify that the materiality of both quantitative and qualitative disclosures can be assessed. Some also viewed “all disclosures in a Topic to be required if a Topic relates to a material element in their entity’s financial statements.” To address that issue, the amendments “state that materiality should be applied to disclosures individually and in the aggregate. Therefore, preparers (as well as auditors and regulators) should be evaluating whether the disclosure is material, not the Topic itself.”
There were also indications from stakeholders that the way in which disclosure requirements were drafted often did not promote the use of discretion. Accordingly, while the proposed amendments would not change the substance of any specific disclosure requirements, they would state, in each disclosure section of the ASC, that an entity must provide required disclosures if they are material and refer to Topic 235 for discussion of the appropriate exercise of discretion. In addition, restrictive language — phrases such as “an entity shall at a minimum provide”– that may make it difficult to justify omissions of immaterial information would be replaced with “less prescriptive language.”
The ASU suggests that costs that would be incurred in connection with the amendments would include “implementation of new control procedures and additional effort to both initially and subsequently support the decisions made when a disclosure is omitted. Preparer and auditor participants in the 2013 field study noted that those costs may be moderate.” Those costs would likely decline after initial implementation.