The Raw Nerve of Materiality

Published on May 24, 2016

FASB’s plan to use only the U.S. Supreme Court’s definition of materiality draws fire.

Last year, when the Financial Accounting Standards Board first proposed jettisoning existing accounting lingo in favor of a legal definition of the word “material,” the board members may have thought they were making a confusing issue clear, according to former FASB chairman Robert Herz. 

Instead, the board’s issuance of a proposed accounting standards update last September that would shed previous descriptions of materiality in favor of the U.S. Supreme Court definition “touched a raw nerve,” he observed in an interview with CFO earlier this year. 

While FASB has issued various concept statements and descriptions “of what could be” material financial information about a company — information that must be disclosed in the financial statements — “there was no specific standard regarding materiality,” said Herz, who was the board’s chairman in 2009, when FASB, under pressure from the Securities and Exchange Commission, put the issue on its agenda.     

But when the board unequivocally confirmed that it would follow only the Supreme Court standard, it upset some investors. They saw in it the threat of “a higher bar” on what information could be dubbed material, thus giving companies greater leeway in deciding what not to disclose to investors, according to Herz. Further, investors feared that “issuers [would] start to hide behind” the standard in a way that permeates other aspects of financial reporting, he noted.

Would he have upheld a legal standard for materiality if he were still chairing FASB? “My opinion is, with the benefit of hindsight, I probably wouldn’t have touched this raw nerve,” Herz said. “I think that they think they were just clarifying something, but I don’t know if it was such a burning need.” 

In its proposal, FASB stated that materiality “is a legal concept,” and that “it observes but does not promulgate definitions of materiality.” The U.S. Supreme Court’s definition of the term “generally states that 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.” 

Adopting that definition would free FASB of any responsibility to draw numeric guidelines between what’s material for a company to report and what’s not. Because it operates exclusively under the Supreme Court’s definition, “the Board cannot specify or advise specifying a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation,” FASB stated. 

Although FASB leaders do regard the proposal as a clarification rather than a major policy change, the raw nerve Herz alluded to seems to have grown increasingly inflamed. In early April, at a roundtable on materiality at the NYU Stern School of Business, the proposal drew fire from the accounting, legal, and investment professions, as well as a more moderate critique from the corporate side. 

Stanley Siegel, an emeritus professor at NYU Law School, blasted the notion of introducing legal definitions into the U.S. accounting system. “Materiality has meanings in several different contexts … it doesn’t follow that what’s material for a criminal case is material for accounting,” he contended. “We’re in a worrisome area when we attempt to apply one standard in another setting.”  

In fact, there is not one legal standard of materiality in the United States, but many. “If you wanted a legal standard, you’d have to talk about a standard under state law, under federal law, and under multiple different laws,” Siegel noted. 

For instance, materiality in a lawsuit that involves faulty corporate disclosure is defined under state law, which varies among the 50 states. But materiality concerning the violation of the federal securities laws is governed under a federal statute that’s interpreted by the federal courts. “The federal courts can interpret the statute one way, and the state courts another,” according to the law professor, who noted that the systems often divide that way. “The state courts are not bound by the U.S. Supreme Court.” 

To be sure, some senior finance executives have supported FASB’s broad efforts to simplify disclosure standards. But at least one expressed qualms about the legal definition of materiality. “Materiality as a legal concept is a little concerning,” said Jason Hays, Verizon’s corporate accounting policy manager. 

“From jurisdiction to jurisdiction there may be an issue about interpreting [the definition], and I think it leaves a lot for interpretation,” he added. 

A Notion of Materiality

Siegel had another objection to the proposal. “Do we really want to import into our accounting a notion of materiality that is so high that by violating it you’re implying that the law [governing accounting] is criminal?” he asked rhetorically. “Or are we ready to say: that standard of materiality [regarding financial disclosures] applies in one setting and other standards of materiality apply in another setting?”  

Then there’s the possibility that adopting a legal definition would bring large numbers of lawyers into accounting disputes. The law professor, who teaches accounting to lawyers, had a bit of fun with the legal profession’s math abilities. “These guys have enough difficulty figuring out that six and seven is really 13, and they’re willing to argue with me that it’s 15 or 11, depending on the circumstances. I’m just wondering if it’s there that we want to put things.” 

The law professor then proceeded to address what he referred to as the “elephant in room.” He said: “If you leave the issue of materiality up to lawyers, you get lawsuits. And the lawsuits do much more than hold people liable. They also change conduct. The kind of conduct that they change is that they sometimes make it expensive and difficult to disclose the kind of material information that you and I would like disclosed in the financial footnotes.” 

While crediting FASB with providing leadership in defining accounting disclosures, Pat Durbin, PwC’s U.S. standard setting leader, agreed with Siegel that accounting professionals should be able to apply a concept of materiality “without the need to constantly seek legal advice.” 

At the same time, Durbin noted that different views on a materiality standard need “to be bridged and aligned” among corporations, auditors, and investors because they are all operating within the same accounting context.

“Every accountant learns very early on that it’s very important to think about materiality in everything we do. It’s a learned practical concept that has been applied over time,” the accountant added. 

Even Marc Siegel, the one FASB member on hand at the roundtable seemed to be backing off from a purely legal definition of materiality. In working on the proposal, “I certainly wasn’t ceding the entire [accounting] profession to attorneys. That wasn’t what I was trying to do,” he declared.

He noted that materiality, while still a part of U.S. Generally Accepted Principles, is applied “around the world” in such countries as Japan and Canada. Still, FASB will have to revisit the issue to see if the phrase “ ‘legal concept’ makes any sense at all” in describing materiality, he said. 

“I do think it’s a living concept that has to move through time, jurisdiction, and markets,” he added. The board plans to hold discussions with various stakeholders on the issue and other disclosure proposals in the third quarter of this year.

(Source: AICPA - CPA Daily Letter - CFO.com - May 6, 2016)