United States: A New Year's (Awaiting) Resolution: How FASB's Change To "Materiality" Could Materially Change 2016

As we close the books on the first chapter of our 2016 year, many investors cling to their New Year's resolutions, hoping to make a material change that catalyzes a happy, healthy, and productive New Year. Yet it is a proposed change to "materiality" that the Financial Accounting Standards Board (FASB) hopes to implement that may undercut the efforts of these inspirited investors. The proposal would effectively transform the definition of "materiality," which defines the information companies have a duty to share with investors. This change to "materiality" could lead to material consequences in the world of financial reporting.

Under FASB's current rules, information is deemed material if omitting or misstating it could influence investment decisions made by users of financial statements—present and prospective shareholders or lenders. "In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity's financial report," FASB explains in its current Conceptual Framework. This "Conceptual Framework" is intended to serve as the bedrock upon which FASB can devise standards that are both sound and internally consistent.

Focusing on the need for consistency, FASB Chairman Russell G. Golden took issue with the fact that the current discussion of materiality in FASB's Conceptual Framework is inconsistent with the legal concept of materiality established by the U.S. Supreme Court. Golden claimed that this divergence engendered uncertainty about organizations' abilities to interpret what disclosures are material, as well as FASB's ability to identify and evaluate disclosure requirements in accounting standards. Yet, while the spirit of consistency would seemingly demand a mathematic definition, FASB's proposal champions an amorphous legal concept used by the Supreme Court in interpreting the antifraud provisions in the context of securities regulation. Borrowing the language espoused in TSC Industries, Inc. v. Northway, Inc., 426 US 438 (1976) and Basic Inc. v. Levinson, 485 US 224 (1988),  FASB now proposes 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."

Investors fear that this change will not only set the bar too high for what information is material, but will also inevitably delegate to lawyers what is inherently best left to auditors—disclosure decisions on accounting issues. FASB has been shocked by the searing stricture it has received in comments to this proposal, reading letters that FASB's changes "send an entirely wrong message to the corporate community — that less disclosure is better — when in fact, the opposite is true" and that "leaving materiality as a 'legal concept' is a significant flaw, which will appear to subordinate the judgment of the preparer and auditor to any attorney, regardless of their capacity or area of expertise."

Drawing from the disparagement evinced by investors' comments, the SEC Investor Advisory Committee (IAC) convened on January 21, 2016 to ensure it also had the opportunity to hurl its potent criticism at FASB in response to the proposal.  In a strongly worded comment letter, IAC urges FASB to reconsider its proposal to change the definition of "materiality." Indeed, this letter contends that the proposed changes are not clarifications, but rather represent "a significant and substantive alteration to the current definition. The approach taken in the proposal is explicitly designed to reduce disclosure and in doing so has the potential to adversely affect the quality of financial disclosure." IAC goes on further to contest that FASB failed to appreciate that reference to the legal definition of "materiality" would necessarily draw legal counsel into the decision-making: "beyond costs, the risk exists that, by replacing the current, differentiated professional accounting standard with a case-law driven legal standard, close questions of judgment will ultimately devolve to lawyers rather than accountants."

IAC's letter eloquently captures what is collectively becoming the New Year's resolution of the investor community as a whole—either convince FASB to maintain the current definition of "materiality" or withdraw its proposal and precede any future proposals with a more complete record evidencing both the concerns necessitating any changes to the definition of "materiality" and the implications of any such changes. Ultimately, while for 4,000 years we have embraced the Babylonians' belief that what we do to start the New Year will have a material effect on us throughout the rest of the year, it is FASB's proposal to redefine "materiality" and undermine a 30-year mainstay of corporate financial disclosure that may have the most consequential effect on 2016 and beyond and IAC is resolute "such a result is not in the best interest of investors, and is anathema to investor protection, capital formation, and the efficient functioning of the capital markets."

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Amanda Wilson
 
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