For public companies, materiality has long been at the center of best-practice investor relations. Our experience has been that more open, transparent communications by companies typically leads to better relationships with investors, a level playing field and more accurate valuations. In the wake of the Financial Accounting Standards Board’s stunning proposal to change the definition of materiality, we invited a seasoned financial services executive to offer his perspective on what the FASB is proposing.
Armando Ramírez (MAcc, MBA) has held senior-level positions at large financial services companies in the U.S. During his 17-year tenure at National City Corporation he primarily worked in strategic planning, corporate development and executed over 50 acquisition transactions. Armando also served as CFO of a publicly traded regional bank in Puerto Rico.
The financial world is suddenly abuzz about one of the most basic accounting principles: Materiality.
The Financial Accounting Standards Board (FASB) recently published two exposure drafts that address the concept of materiality and how much information companies must disclosure in the notes to the financial statements. One of the justifications for the release of these drafts is the so-called “information overload” to which readers of financial statements are subjected, which supposedly makes the information too confusing and difficult to understand. Critics claim that some companies are disclosing too much information that is immaterial and irrelevant simply to avoid legal issues.
The first exposure draft deals with the concept of materiality itself. According to the FASB’s current definition, something is material if omitting it or misstating could influence decisions made by the users of financial information. Under the proposed change, the FASB would defer to the courts to define what is material. The courts have stated that something is material if “there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource as having significantly altered the total mix of information.” Does anyone see a real change here?
The second exposure draft addresses the amount of disclosures made in the notes to the financial statements. Preparers of financial statements would need to assess whether disclosures are material and would be encouraged to use their own discretion in making the decision. This is where the real problem lies.
Deciding what is material is very subjective, and promoting more discretion in determining what to disclose will result in less and lower-quality information. This is what investors are arguing, and I agree. When you look at the FASB’s definition of materiality versus the courts’ definition, it is hard to see the real change. The new definition is not going to reduce the amount of judgment involved in the process. But introducing more discretion in deciding what “immaterial” items to leave out from the notes could make the information less useful.
Are the proposed changes going to make a real difference? Most likely, yes – but in a negative way. Good CFOs and chief accountants are going to continue to report relevant and useful information based on a conservative interpretation of the accounting standards. However, companies that are trying to hide something will no doubt use the standards to leave out sensitive information that could have been useful to investors.
Sophisticated investors have the knowledge and resources to analyze companies they want to invest in. “Information overload” is not an issue for them. Individual, less sophisticated, investors do not have the same knowledge or resources to do adequate analysis, but they can and should rely on security analysts to help them make their investment decisions. So the concept of information overload is a poor argument to justify the changes.
As an investor, if I decide to invest in a company with fewer and lower quality disclosures, I would apply a higher discount rate to the cash flows expected from the investment. This is justified by the absence of good information, which introduces more risk into the investment decision. Again, this assumes that as an investor I decide to go forward with the decision. I may decide not to invest at all if I perceive the information to be incomplete, and will move on to other companies that provide a clearer picture. This was also the case when I was analyzing banks that my former employer was interested in acquiring. I would use a higher discount rate and more conservative assumptions to protect our shareholders. So one could argue that better information can lead to higher company values, and perhaps lower volatility.
I am not sure why the FASB has to change anything. I never perceived that there was anything tremendously wrong with the materiality standard. And there has been no serious debate about the financial statements having too many pages. As an investor, I would rather have more information than less information. I wouldn't be concerned about information overload. Let me, as an investor, decide if I want to read, or skip, a section of a 10K. I am more inclined to invest in a company that discloses everything, even if some might perceive that information as immaterial.
As an accountant, former head of corporate development, and former CFO, I want rules that set clear standards for what needs to be disclosed. CFOs don't want more discretion, but the standards require judgment and that will continue on.