Materiality in Financial Reporting

Part I introduces the background of why materiality matters in financial statements. One of the main reasons for determining whether a fact is material is to check whether its misstatement overtakes the watershed which makes financial statements not comply with the relative financial reporting framework.

This part also introduces one of the themes of the book: the interaction of the views of the different subjects involved in materiality assessment, i.e., users, preparers, auditors, regulators, and the related conflicts of interest. Materiality plays a different role in this depending on who is looking at it.

The part also comprises an overview of the main projects underlying the current debate about materiality, that is, the International Accounting Standards Board’s Disclosure Initiative, the Financial Accounting Standards Board’s Disclosure Framework and the SEC’s Disclosure Effectiveness Initiative, including a list of their main steps and documents issued to date.

Part II contrasts the views of materiality in the Conceptual Frameworks of the IASB, FASB, IPSAS, and other framework such as the Integrated Reporting. In particular, it analyzes at what level and how differently that concept interacts with the qualitative characteristics of financial information in each of those frameworks. It looks at its pervasiveness and entity specificity, the interlock with the concept of relevance, reliability and faithful representation, completeness, understandability, neutrality, and drills down to the link to recognition.

This part then compares the definitions of materiality in different standards and contexts, to then draw a taxonomy of materiality and its attributes, such as the subject matter, thecontext of assessment, the addressees, the assessor, and the materiality test. A large part of the analysis involves the comparison between legal definitions of materiality and characterizations in the accounting, financial, and larger management contexts.

Part III reviews the uses and effects of materiality as an accounting, legal, audit, and managerial concept. After mentioning several uses of materiality as a legal concept and explaining the FASB’s proposed direction to avoid an accounting definition, it goes in depth to the differences in the respective definitions, applications, practical interactions, and different nature of the legal and accounting views. It then draws on the differences between audit and accounting uses of materiality.

It counterbalances the interests and positions of the various stakeholders involved, such as investors, preparers, standard-setters, auditors, regulators, financial analysts, and other users of the financial statements. It shows that those who regulate, use, decide, and assess materiality are different subjects.

Finally, the part capitalizes on the author’s vast experience in industry to theorize a plethora of alternative and complementary models of materiality with their pros and cons.

Part IV provides readers with the extant requirements for the application of materiality to recognition, measurement, presentation, and disclosure in the financial statements. This part also includes a detailed critical review of the recent Practice Statement on materiality, the FASB’s proposed ASU on the notes and the amendments to the Conceptual Framework proposed by the IASB and the FASB.

The part expands to issues that are typical of Management Commentary, including the SEC guidance on materiality in Management Discussion and Analysis.

It informs about the complexities and subtle differences between financial statements and bookkeeping and the different standards of reasonableness versus materiality.

A section moves from materiality to material misstatements and covers the application of materiality in auditing.

Another section goes in depth on internal control over financial reporting, showing the linkages between materiality and risk appetite and risk tolerance and the related application guidance.

Part V analyzes the details of how to assess materiality. It first tackles qualitative versus quantitative criteria and the role of professional judgment. It then analyzes the selection of quantitative threshold, to expand to the choice of benchmarks. It contrasts the whole financial statements with subaggregates, line items, and components.

Specific sections contrast IASB, FASB, SEC, and other guidance on materiality applied to comparative information, interim reporting, and segment reporting.

The section on estimates mingles complex guidance coming from accounting, auditing, and internal control over financial reporting to explain how the management can improve its assessment of materiality concerning estimates.

After explaining the techniques to move from individual to cumulative misstatements, the part tackles verification ex post, and finally summarizes the intricacies of whether immaterial misstatements are permissible and their consequences.

Part VI illustrates different approaches concerning the processes and methods that an entity can establish to determine materiality. Given the highly subjective nature of materiality assessments, proper processes, systems, and methodologies are at the forefront of the recent and future developments in this area.

The part divides the processes analyzed into four groups: (1) those that derive from accounting approaches, including the recent IASB’s four-step approach; (2) audit-derived models, generally elaborated from techniques to detect material misstatements; (3) risk-based approaches employed in risk management or in internal control over financial reporting; and (4) approaches derived from larger models involving financial, management, environmental, and corporate responsibility factors.

Finally, two sections deal with the disclosure of materiality determination, one concerning the process employed by an entity, and the second concerning general model disclosures of material matters.

Part VII highlights certain accounting pronouncements that call for a specific application of materiality to certain financial statement items.

After reviewing the general debate of whether the same concept of materiality should apply evenly to financial statements or it should be standard-, entity-, or topic-specific, it considers the use of a specific unit of account for materiality considerations in revenue recognition, the object of materiality in related-party transactions, and specific items or circumstances that trigger materiality judgments,

The part includes a checklist of accounting pronouncements relating to specific materiality decisions. It also lists where, according to the IASB, each specific standard indicates the need for a specific attention of users to materiality.

The last part of the book wraps up the whole content in showing how an experienced professional can handle discussions with management to uncover inappropriate schemes, manipulation tactics, if not frauds.

It first reports the predominant idea that today’s issue about materiality is simply behavioral or concerns implementation issues. It then moves to the observation of illegitimate use of materiality in the real world to manipulate financial results.

It then goes through an illustration of SEC staff’s comments on materiality in the review of Form 20-F of foreign private issuers reporting under IFRS.

Finally, the part spells out typical materiality abuses by management, which can be found in practice. Each occurrence of this long list is linked to the respective part of the book that treats the theoretical bases of why a certain reasoning is a fallacy, and the specific pronouncements that such a behavior would contravene.