Compiling a financial report means treading a fine line between information overload and the omission of crucial facts. It’s all a question of materiality, writes Jane Fuller
This article was first published in the June 2017 UK edition of Accounting and Business magazine.
Nowhere is the tension between the demand for additional information and the demand for conciseness more visible than in the discussion of materiality. IFRS Standards define the concept as follows: ‘Information is material if omitting it or mis-stating it could influence decisions that users make on the basis of financial information about a specific reporting entity.’
This approach is in line with the view of investors, but investors also complain about clutter in company reports. This presents those who prepare the corporate accounts with two main problems: they must put themselves in someone else’s shoes and they must not respond simply by disclosing a torrent of increasingly irrelevant information.
Most published measures of materiality focus on a crude threshold, such as 5% of pre-tax profits. But standard setters on both sides of the Atlantic have rightly eschewed drawing a quantitative line. So management is forced to pay attention to qualitative criteria and to exercise judgment. And all measures must be related to their own company, rather than to sector or market generalities.
One example of a qualitative issue is stewardship, which is covered in the International Accounting Standards Board’s work on a new practice statement, Application of Materiality to Financial Statements. This acknowledges that investors have views on how a company should be managed, and might change their minds about buying, selling or holding shares or bonds on that basis.
Clearly this can lead to consideration of a multitude of sins. The US Securities and Exchange Commission’s Staff Accounting Bulletin No. 99 is eloquent on the subject of when small mis-statements might be material. It includes a number of points linked to management motivation: are management trying to hide a failure to meet earnings expectations? Are they close to a trigger point for bonuses? Might they be afraid of breaching a regulation or loan covenant?
Context clearly matters, and it is a forward-looking view that matters most. So a large writedown (material by any standards) in the value of an asset acquired years ago may not be as relevant to investors as a small change in the performance of a business on which the company’s future growth depends.
The increasing use of estimates in corporate financial statements does not make the task any easier, either for management or for the auditors scrutinising their judgments.
If in doubt about materiality, management will do better to include rather than exclude the information. No one will forgive them for saying that they thought about mentioning something that with hindsight looked like a red flag, but were more concerned about trimming the annual report. Indeed, no one will believe that was the real reason for the omission.
Jane Fuller is a fellow of CFA UK and serves on the Audit and Assurance Council of the Financial Reporting Council
"Standard setters have eschewed a quantitative line, so management has to pay attention to qualitative criteria and to exercise judgment"