A counterproposal to FASB: Make materiality transparent
January 2016 User View by Sanford Lewis, Attorney and Council, Investor Environmental Health Network, United States
IN late 2015 the Financial Accounting Standards Board (FASB), US equivalent of the International Accounting Standards Board (IASB), received comments on proposed changes to the accounting rules that govern corporate disclosure in financial statements. The proposed changes on definitions of “materiality” were written as if they would be minor technical reforms designed to reduce the inclusion of marginally useful information in corporate filings. Yet in my opinion they were misdirected – sending precisely the wrong message to the corporate community, that less disclosure is better.
Jonas Kron, Vice President of Trillium Asset Management, has noted that one of the defining features of the past 15 years is being flooded with information, thanks to the Internet. One response is to say we need less information, another response says we need better information, a third that we need better tools to manage and understand the information. He argues the third is more in line with a market system and an economy that wants innovation. As data management tools have made the sifting of large volumes of information increasingly feasible, the interest of shareholders is in more disclosure not less, to allow application of those sophisticated tools.
The inclusion of data in corporate reports is determined under accounting and SEC rules by whether the information is “material” to investors. In a general sense, determination of materiality is based on whether the information would influence the judgment of a “reasonable person/investor.”
There is no single template for a “reasonable investor”. The determination of materiality is better determined with reference to the array of relevant audiences reading the financial statements, as well as factors used to judge materiality – relevant time horizons, types of risks considered or excluded based on uncertainty, magnitude of risk to the firm, etc. Failure to clarify these factors causes confusion in materiality assessment and perhaps contributes to the misperception of current disclosures as including “excess.”
You can read the details of the FASB technical proposals in commentary, for example at the Huffington Post. Current SEC Chair Mary Jo White has long spoken about her agenda for potentially streamlining or simplifying disclosures to shareholders; the FASB proposal seems one outcome of that agenda. In essence, the FASB proposal would give more leeway to companies and auditors to leave out information. The tone of the proposal conveys a message – when in doubt, leave it out.
If FASB’s proposed changes are adopted, it would have the effect of reducing disclosures that a company views as “at the margins” of materiality. Disclosure of bad news in particular is typically only disclosed where auditors, accountants or lawyers assert a legal or accounting necessity. Creating more discretion without requiring transparency in the materiality determination process, the result will be generating less disclosure.
Materality is in the eye of the beholder. The determination of materiality may be based, for instance, on a company’s assumption that short term investors are driving the company’s stock price, and therefore the only information that is deemed material is information relevant to quarterly returns, or more generously, a 3-5 year timeline. Alternatively, companies less concerned about meeting the quarterly earnings estimates of analysts and who are focused on delivering returns over a 3-5 year time frame are likely to consider a different set of information as material.
What are the array of investment scenarios and considerations that merit treatment as material? Does the firm consider investors that may hold shares in the company for the next 15 years? Does it consider investors that are using environmental, social and governance (ESG) matters as a proxy for management quality? Does it consider the investors who are making buy and sell decisions based on long-term considerations such as climate change?
Materiality determinations made without transparency encourage manipulation of disclosures by delayed quantification, narrowed time horizons, and narrow interpretation of the “reasonable investor” to whom the data is of interest.
Disclosure must meet the needs of a very diverse array of users with different risk tolerances, time horizons, strategies, perspectives and concerns (see graphic below). The determination is made by a gatekeeper with a strong interest in non-disclosure. Harvard`s Robert Eccles and Tim Youmans (see “Materiality in Corporate Governance: The Statement of Significant Audiences and Materiality”) have suggested that registrants be required to file a “Statement of Significant Audiences and Materiality” which would help in some instances to explain how materiality determinations are made. It recognizes that a board must make judgments, tough judgments, since it cannot claim that all audiences are significant.
In comments submitted to the FASB, the Investor Environmental Health Network – a coalition of investors concerned with environmental and toxicity risks, urged that the FASB reject the proposed changes in materiality rules, and instead require transparency regarding the process companies use to determine what they regard as material disclosures. This leaves substantial discretion to company management, which is appropriate. Each reporting company should include in its filing a description clarifying how it determines materiality:
- identify the groups or categories of investors to whom materiality assessments are directed,
- relevant time frames,
- rationales and
- issues of known or potential interest to significant subgroups of its investors.
In addition, recognizing that financial disclosures are also a key source of information to other constituencies, FASB rules should allow reporting companies, in their discretion, to identify other audiences of investors or stakeholders to whom disclosures have also been addressed.
Meeting the needs of diverse users:
The author can be reached at: email@example.com. This article is derived from his comments to the FASB, which can be downloaded here.