Materiality in financial statements – I didn’t mean to do it!

As we discussed here, the IASB has issued for comment an exposure draft of a proposed practice statement Application of Materiality to Financial Statements, with comments to be received by February 26, 2016.

Here’s one aspect I didn’t touch on last time:

  • “Sometimes a deliberate decision is made by management not to apply a requirement in a Standard because management has concluded that the effect of not applying that requirement will not lead to a material difference in the financial statements…Unless management has intentionally misstated items to achieve a particular presentation or result, such practical expedients would not prevent the financial statements from complying with IFRS. However, if management intentionally misstates items to achieve a particular presentation or result it has done so presumably because it thinks that particular presentation or result could reasonably be expected to influence the decisions of the primary users of the financial statements and such misstatements are material.
  • For example there is a difference between:
  • (a) management deciding not to discount a liability to reflect the time value of money because there is no material difference between the discounted and non-discounted value, and
  • (b) management deliberately choosing to use an inappropriate discount rate to in order to reduce the amount of the liability.
  • A deliberate choice by management to use an inappropriate discount rate would be material because management is presumably doing so in order to ‘achieve a particular presentation of an entity’s financial position, financial performance or cash flows’.”

This will remind some readers of the SEC’s Staff Accounting Bulletin 99, originally issued in 1999 to emphasize that exclusively relying on certain quantitative benchmarks to assess materiality is inappropriate. As part of this, SAB 99 considered the issue of intentional misstatements, including the following:

  • “…the staff believes that a registrant and the auditors of its financial statements should not assume that even small intentional misstatements in financial statements, for example those pursuant to actions to “manage” earnings, are immaterial. While the intent of management does not render a misstatement material, it may provide significant evidence of materiality. The evidence may be particularly compelling where management has intentionally misstated items in the financial statements to “manage” reported earnings. In that instance, it presumably has done so believing that the resulting amounts and trends would be significant to users of the registrant’s financial statements. The staff believes that investors generally would regard as significant a management practice to over- or under-state earnings up to an amount just short of a percentage threshold in order to “manage” earnings. Investors presumably also would regard as significant an accounting practice that, in essence, rendered all earnings figures subject to a management-directed margin of misstatement.
  • The materiality of a misstatement may turn on where it appears in the financial statements. For example, a misstatement may involve a segment of the registrant’s operations. In that instance, in assessing materiality of a misstatement to the financial statements taken as a whole, registrants and their auditors should consider not only the size of the misstatement but also the significance of the segment information to the financial statements taken as a whole. A misstatement of the revenue and operating profit of a relatively small segment that is represented by management to be important to the future profitability of the entity  is more likely to be material to investors than a misstatement in a segment that management has not identified as especially important…”

The difference between the IASB’s and the SEC’s examples is rather interesting. The IASB’s discount rate illustration might seem rather abstract, given the overall lack of clarity over that aspect of the standards. The example says that choosing an inappropriate discount rate would “presumably” be done to achieve a particular effect, but doesn’t try to dig into how that might actually happen (although, of course, this part of the document intertwines with its other content on such matters). In contrast, the SEC honed in on how financial statements interact with management’s other representations to the market, identifying materiality in part as an empirical matter, observable based on actual human actions and reactions. This concept isn’t absent from the IASB’s paper – it notes for instance that “Information is material if it confirms trends that could reasonably be expected to reinforce decisions made by the primary users. For example, an entity’s earnings may have increased in line with expectations and this information may reinforce a decision to buy, hold or sell shares in the entity.” But even that doesn’t join the dots as explicitly as the SEC did fifteen years ago.

It’s not just in accounting that questions of intentionality can become philosophically knotty – people differ for instance on whether certain kinds of crime should be punished more severely if they’re motivated by “hatred” rather than just everyday criminality. Likewise, it’s not clear to me that deliberately misapplying a standard is always inherently more egregious than doing so out of ignorance or carelessness – to say it is seems arguably more like a moral position than a practical one. While understanding that the IASB wants to keep its practice statement relatively high-level and principle-based, it couldn’t hurt to expand a bit more on this aspect of things…

The opinions expressed are solely those of the author

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