The Materiality Maze for Firms

Defining Materiality

Materiality matters – it is the cornerstone of financial, and increasingly non-financial, reporting – because it helps determine the importance of an information item for a variety of users. The global capital markets move on information that public companies have about their financing, investing or operating activities. Responsibility for the disclosure of material information rests with senior management and the board of directors.

However, there are multiple and conflicting definitions from the two major world standards boards —the Financial Accounting Standards Board (FASB), overseeing U.S. financial reporting practices, and the International Accounting Standards Board (IASB), addressing most other country contexts.

At the same time, there has been a growth of new, private-sector standard setters, which either challenge or complement the FASB and IASB definitions. These include, the International Integrated Reporting Council (IIRC), the Global Reporting Initiative (GRI) and Sustainability Accounting Standards Board (SASB), all of which have a global reach. I’ve outlined these in a chart below.

What is a Standard?

Regulatory bodies and standard setters ultimately have an impact on a manager’s moral judgment, creating the organizational context in which problems are or are not resolved. A standard is generally designed to apply to a person’s conduct and distinguishes the permissible from the impermissible. In doing so standards allow the individual to make judgments about the value of their own (or their firm’s) conduct. When a standard is applied to an increasing number of cases, more knowledge is gained concerning its meaning and it is slowly transformed into a collection of rules that can become a moral minimum presumptively requiring action only up to the boundary of permissible conduct. If this is the case, the incredibly high number of materiality judgments made by every firm, every day results in the application of the same deterrent force no matter how close or how far a given act is from permissible conduct.

These definitions of materiality call for a manager to make a judgment based on both the past and the future thus making determining material information subjective by company, country, or both. They also create a very real and practical problem for users of the information, as well as managers, faced with a decision to disclose –that information disclosed under one system is not readily available under another, giving rise to the impression that some users may be getting more and perhaps better information. For example, profits reported under one standard but not another can be different enough to change an acquisition decision.

Word Usage: Could vs. Would

In analyzing these definitions I’ve paid particular attention to the words used in these prevailing materiality standards. Words frame the mental models we use in decision-making and the way we frame an issue determines the moral consequences of it.

While not explained by any standard setter, the word “could” indicates something is possible whereas the word “would” means increased certainty, even a guarantee.

A manager operating under a “could” standard is likely to frame a situation in terms of a mere possibility that the information matters to an investment decision. Likewise, the consequences of the information are framed more broadly – could it impact a decision? Well, potentially, yes it could. One might be more hard-pressed to say it could not rather than it would not. Because it broadens the potential impact of the information, other information users could be affected. Given this, “could” language more likely leads to determining something is material whereas “would” language means it is less likely a manager perceives the information to be material due to the guarantee necessary.

Likewise, these words convey different degrees of probability. These definitions, through the use of “would” or “could”, have confused managers by essentially directing them to disclose both what one is certain will happen and what one believes may happen.

As a result, three common practices occur when disclosing material information, depending on the definition used, and include (1) issuing different information, (2) avoiding unfavorable information and (3) engaging in under-reporting. Each carries important ethical implications. Please contact me via my website if you’d like more information on these implications.

Various Definitions of Materiality

International Accounting Standards Board (IASB) The Securities & Exchange Act Financial Accounting Standards Board (FASB)
Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity. a substantial likelihood that the . . . omitted fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available. The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.
GRI

(G3, 2006), (G4, 2013, 2015), (GRI 101, 2016)

IIRC

(2015)

Sustainability Accounting Standards Board (SASB)
Materiality is the principle that determines which relevant topics are sufficiently important that it is essential to report on them. Relevant topics are those that can reasonably be considered important for reflecting the organization’s economic, environmental, and social impacts, or influencing the decisions of stakeholders. A matter is material if it could substantively affect the organization’s ability to create value over the short, medium or long term. a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.

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