As company owners and managers consider what information warrants additional disclosure in their financial statements, there is little guidance available. Applying the concept of materiality requires judgment, and it’s often why the concept of materiality is thought of quantitatively. However, it is also important to consider the qualitative aspects.
Currently, the Financial Accounting Standards Board (FASB) does not define what information should be considered material when an organization prepares its financial statements. Instead, materiality is generally a legal concept, often defined through court decisions. The U.S. Supreme Court’s description of materiality is a “substantial likelihood” that omitting the information would be viewed by a reasonable investor or creditor as having “significantly altered” the total information available to make a decision.
Because of this lack of clear direction from the FASB, many financial statements have become a victim to “disclosure overload.” In a 2013 disclosure framework fieldwork study conducted by the FASB, some of the often-cited obstacles in the current system that may affect an entity’s incentive and ability to omit immaterial disclosures include:
- The requirement to communicate omissions of immaterial disclosures as errors to audit committees.
- Litigation concerns.
- Possible internal control changes required to support discretion in the preparation of information provided in disclosures.
- Possible U.S. Securities and Exchange Commission staff comment letters about omitted disclosures.
Also contributing to “disclosure overload” is the fact that the disclosure section of many Accounting Standards Codification topics include phrases such as “an entity shall at a minimum provide …,” which may make it difficult to justify omitting immaterial disclosures. It is also common for disclosures to be rolled over from year to year without a lot of thought regarding whether they are still necessary.
In September 2015, the FASB issued an exposure draft for a proposed accounting standards update related to the notes to financial statements and assessing whether disclosures are material (Proposed Accounting Standards Update No. 2015-310). Ultimately it is the FASB’s objective to improve the effectiveness of disclosures in the financial statements that are most important to the users of the financial statements.
The main provisions of the proposed update are summarized as follows:
- Materiality would be applied to quantitative and qualitative disclosures individually and in the aggregate in the context of the financial statements as a whole; therefore, some, all, or none of the requirements in a disclosure section may be material.
- Materiality would be identified as a legal concept.
- Omitting a disclosure of immaterial information would not be an accounting error.
It should be noted that the proposed update would not change any specific disclosure requirements but would instead allow management to omit certain disclosure requirements on the basis that they are immaterial to the users of the financial statements.
Eliminating immaterial disclosures will allow the users of financial statements to focus on the information that matters most. There are several common disclosures that are included in many entities’ financial statements which arguably don’t add much value to the financial statement users. One example is the disclosures related to income taxes, particularly for S corporations and partnerships.
Under current standards, an S corporation, a partnership, or a proprietorship is required to disclose why income tax expense is not recorded (accepted practice), a description of the tax years that remain subject to examination by major tax jurisdictions, and the nature and effect of any significant matters affecting the comparability of information for all periods presented. Often this one disclosure can add three paragraphs to an entity’s footnotes.
When considering these disclosure requirements from a materiality perspective, it could be argued that including one sentence in the footnotes that states that all tax attributes of the company are passed through to the stockholders (or members) and combined with their income on their individual tax returns would be sufficient. Others could argue that it is generally understood that S corporations, partnerships, and proprietorships are pass-through entities for tax purposes and that therefore the entire disclosure is immaterial.
Materiality is one of the gray areas in financial reporting. The FASB’s proposed changes to the materiality framework will allow management to use judgment in their decision-making process about what to disclose and not to disclose. Ultimately this will lead to the elimination of boilerplate information that obscures useful information and makes financial statements cluttered and less understandable. Comments regarding the FASB’s proposals to clarify materiality were due on December 8, 2015. Because this proposed update would permit but not require the omission of disclosures of immaterial information, it would be effective upon issuance.