Materiality in accounting

The concept of materiality pervades the whole process of accounting. Preparers, auditors and professional users may all understand in broad terms what is meant by materiality but this has not stopped the debate on how to apply it. The Institute of Chartered Accountants in England and Wales (ICAEW) issued a guidance statement on "The interpretation of 'material' in relation to accounts". It is instructive to quote from the first paragraph of that guidance:

Material depends on the circumstances and it is a matter of professional judgement as to what would influence a user of the financial statements. If materiality is properly applied, financial statements should provide users with all the available information that would influence their decision making. Is this what users are provided with? The answer is perhaps not in all cases. The recent proposed acquisition of the US telecommunications operator MCI by British Telecom is a good example of shareholders not getting the full picture.

Recently, BT announced that it would re-negotiate its acquisition of MCI after a 'surprise' discovery of losses. Indeed reading the text of BT's Reports and Accounts over the last few years the announcement of losses at MCI would be a surprise. But are we to believe that BT's management knew nothing of MCI's internal forecasts of future losses even though it had held a 20% interest since September 1994? The truth is hidden in BT's notes to the accounts which show that MCI was anything but a star performer in the period from 1994 to 1997. In addition, disclosures in the US have been more forthcoming on MCI's prospects. BT's management ought to have known something about MCI's prospects and yet this was not communicated to shareholders, despite it being a material issue (as the fuss over its eventual disclosure clearly demonstrates). Surely this is a failure of BT's management to apply the materiality concept.

In this article we outline existing guidance on materiality and, by looking at how accounting standards have developed, speculate on the future of this important concept. The two regulatory regimes have brought different approaches to accounting standards and by looking at the shifts in emphasis, we gain some idea of how accountants have been expected to interpret important concepts such as materiality. We also take a brief look at some interesting international developments in materiality.

Materiality in practice

As noted above, materiality is fundamental to the work of preparers and auditors when putting together financial statements. Preparers and auditors should be concerned to ensure that all material transactions are correctly recorded and that the financial statements reflect the true position and performance of the company in all material respects.

From the auditor's perspective he will make an assessment of materiality based on previous experience of the client organisation and the business in which it operates. The auditor may define a threshold for materiality on a base such as turnover or total assets.

Thresholds of between 0.5% and 5% of the base are typical and every transaction above that threshold will be selected for checking.

When it comes to considering the materiality of disclosure requirements and deciding on the form of the audit report, the profit figure becomes a further important base to apply. Again, a percentage guide can be applied but essentially the final assessment will be based on the auditor's judgement of materiality, as the ICAEW guidance explains.

Materiality under the ASC

How then have accounting regulators interpreted materiality and sought to apply it in standards? The Accounting Standards Committee's (ASC's) principal attempt to define materiality came in SSAP 3, Earnings Per Share. When deciding whether to disclose the dilution to earnings per share (eps) caused by irrecoverable tax on dividends, paragraph 16 states, "Dilution amounting to 5 per cent or more of the basic earnings per share is regarded as material for this purpose." This gives us a clear and unambiguous statement that, at least in the case of eps, the materiality threshold is 5%.

The ASC took a second bite at materiality with its last standard, SSAP 25, Segmental Reporting. Paragraph 9 requires each segment that is significant to be separately reported. Significant is defined as 10% or more of turnover, profit or loss, or total net assets. This gives us a definition of significant, which is closely related to the concept of materiality, of 10% or more.

The setting of a percentage is typical of the approach the ASC took to accounting standards, not just with regard to materiality. Other examples include:

• SSAP 1, Accounting for Associated Companies. An investment is presumed to be an associate if 20% or more of the equity is held (paragraph 14).
• SSAP 21, Accounting for Leases and Hire Purchase Contracts. A finance lease is one where the present value of the minimum lease payments amounts to "substantially all (normally 90 per cent or more) of the fair value of the leased asset" (paragraph 15).
• SSAP 23, Accounting for Acquisitions and Mergers. Paragraph 11 of the standard defines a merger such that 90% of the equity is secured, no more than 20% of equity was held before the offer and not less than 90% of the consideration for equity was itself equity.

Statement of principles

With the demise of the ASC and the creation of the Accounting Standards Board (ASB) (on 1 August 1990) we were promised a whole new approach to accounting standards that would be based on a theoretically coherent framework.

The ASB published, as an exposure draft, its Statement of Principles for Financial Reporting in November 1995. Materiality appears in Chapter 2, The Qualitative Characteristics of Financial Information. Qualitative characteristics are defined in that document as, "the characteristics that make the information provided in financial statements useful to users for assessing the financial position, performance and financial adaptability of an enterprise".

The chapter is mainly concerned with what it calls the primary qualitative characteristics:

• relevance,
• reliability,
• comparability and
• understandability.

However, it defines a "threshold quality", which is simply another term for materiality and goes on to say: "Information is material if it could influence users' decisions taken on the basis of the financial statements".

"... materiality ...depends on the size and nature of the item in question judged in the particular circumstances of the case." This is not dissimilar from the guidance published by the ICAEW.

As the theoretical framework, the Statement of Principles should lie behind everything accountants do. Certainly we would expect the Statement of Principles to be the cornerstone of accounting standards. Is this what we observe? Or has the ASB sought to reduce the scope for professional discretion, as it has often been accused of doing, by imposing a rigid definition of materiality? In answering these questions we consider one key way in which the ASB's FRSs differ from the ASC's SSAPs.

The percentage rule under the ASB

As we saw, the ASC made wide use of the percentage rule to define how a transaction should be treated and whether or not it should be disclosed (i.e., whether it was material or not). For the accountants looking to apply their creativity this approach often proved to be too good an opportunity to miss. A percentage is clear and unambiguous; it is like a hurdle - meet the percentage rule and you get to define the transaction in the way you want. The consequence of this is evident in the transactions some businesses enter into.

We see leases structured so that the payments do not exceed the 90% threshold that means they are finance leases and hence brought onto the balance sheet (SSAP 21). Similarly, we saw acquisitions structured in clever ways such as vendor placings and vendor rights issues that enabled the combination to be recorded as a merger (SSAP 23). (Essentially in vendor rights and vendor placings the acquiring company issues equity shares to the target company shareholders but has arranged for a bank to buy the shares so that the target shareholders receive cash.) This ensures the transaction meets the merger requirement of SSAP 23 that the consideration for equity must be at least 90% equity, whilst also buying out the target shareholders with cash.

The evidence suggests that the simple percentage rule was not worked. Whilst it might appear a straightforward and appealing way to define something, its simplicity and rigidity leave it open to abuse.

In response the ASB appears to have avoided the hard and fast percentage rules. Typically the ASB has defined transactions in words in such a way that it is no longer possible to apply the letter without the spirit of the rules. We see this in the new standards on group transactions (FRS 2, Accounting for Subsidiary Undertakings, FRS 6, Acquisitions and Mergers, and FRS 9, Associates and Joint Ventures), that apply criteria that are hard to meet but which no longer use percentages. For example the 90% rule on equity consideration (described above) becomes "an immaterial proportion". Table 1 gives some examples of the way in which the ASB is moving away from percentage rules.

This new approach, where transactions are defined in words rather than simple percentages, is fostering a whole new accounting terminology. Table 2 shows just a few of the new phrases that we are beginning to see come into FRS's.

Do we observe a similar shift away from percentages when it comes to the ASB's application of materiality? An obvious opportunity for defining materiality was with FRS 8, Related Party Disclosures, a standard primarily concerned with materiality. Paragraph 20 provides a definition of materiality in the context of related parties. It is written in similar language to the Statement of Principles and seems wholly consistent with the ASB's overall approach to new standards.

A second opportunity for defining materiality came with the revision of SSAP 3 which, as we saw above, was the first standard to define the concept in percentage terms. In May 1996 the ASB went to press on earnings per share by publishing a discussion paper on the subject. This paper invited respondents to comment on whether they thought the SSAP 3 definition of materiality of 5% should be removed. In June 1997 we got the answer. FRED 16, Earnings Per Share, if adopted as a full standard, will require all dilutions to be disclosed - not just those exceeding 5%. In the case of dilution of eps, materiality will no longer be an issue.

International developments

Given the trend for harmonisation of accounting, it is useful to look at what other standard setters are saying about materiality. The International Accounting Standards Committee (IASC) has not explicitly published any guidance on materiality although IAS 1, Preparation and Presentation of Financial Statements, touches on the subject. It requires material items to be presented separately in the financial statements. The only attempt to put a percentage on materiality comes with IAS 14, Segment Reporting, (revised September 1997), which, like its UK equivalent (SSAP 25), adopts a 10% definition of a material segment.

One standard setter that has tried to get to grips with materiality is the Australian Accounting Standards Board. It issued, in 1995, Accounting Standard AASB 1031, Materiality. The standard starts with the familiar definition of materiality that says an item is material if its omission or misstatement would adversely affect users' decision making. The standard then goes on, somewhat bravely, to try and put a "quantitative threshold" on materiality. Although the thresholds are given as guidance only, we have already seen how these can be misinterpreted (deliberately or otherwise) as definitive rules. Essentially, the standard says 10% or more is presumed to be material while 5% or less is presumed not material. This can be compared with the ASC's definitions of materiality of 5% (SSAP 3) and 10% (SSAP 25).

Conclusion

So what does all this mean for our understanding of how materiality should be applied? We saw that the ASC's attempts to define by percentage resulted in an industry of creative accounting seeking to exploit the rules. We can at this stage only speculate, but will the Australian Accounting Standards Board's percentage definition of materiality face the same fate?

The ASB, on the other hand, seems keen to avoid the pitfalls of the percentage rule by defining transactions at great length but without resorting to numbers of any kind. Its definition of materiality in the draft Statement of Principles follows this approach. Although the ASB has been accused of reducing professional discretion, this move away from fixed percentages, while reducing the scope for abuse, does require the preparer to have a far greater understanding of accounting issues.

Coming back to our example of BT and MCI, what should users have reasonably expected and what can they expect in future? The performance of MCI would have come as less of surprise to BT shareholders if BT had been more explicit in its disclosures. Materiality needs to extend to the way information is presented - it is not good enough to leave important disclosures in obscure notes. If financial statements are to show a true and fair view then the spirit of materiality must be applied (not just the letter) in the same way that the ASB is encouraging this in other areas of accounting.

Many commentators argue that financial reporting needs more explicit guidance on the application of materiality and how it must extend to the way transactions are presented, not just to the fact of their presentation. The Australians have tried to issue guidance on materiality, but experience shows it is better to avoid the percentage rule and it appears that the ASB is well aware of this. We must wait and see if the ASB is going to take a structured look at materiality, although we have seen no hint of this to date.