Tuesday, December 8, 2015

A Counter-Proposal to FASB: Make Materiality Transparent

Sanford Lewis

Today is the deadline  for submitting comments to the Financial Accounting Standards Board on a proposed set of changes to the accounting rules that govern corporate disclosure in financial statements. While the proposed changes on definitions of "materiality" are written as if they are minor  technical reforms designed to reduce the inclusion of marginally useful information in corporate filings, in reality they are a misdirected set of proposals that send precisely the wrong message to the corporate community - that less disclosure is better. 

The author submitted a counter-proposal on behalf of the Investor Environmental Health Network, for  FASB to require transparency regarding the factors that go into a reporting company’s materiality determinations.

As Jonas Kron, Vice President of the investment firm,  Trillium Asset Management, noted in recent email correspondence:
One of the defining features of the past 15 years or so is being flooded with information.The internet and increasing computing power has led to this. One response would be to say we need less information, another response would be we need better information,  a third would be that we need better tools to manage and understand the information.   I would suggest that the third is more in line with a market system and an economy that wants innovation.  The third approach is consistent with the underlying philosophy of a regulated market; the first two are trying to put the genie back in the box, to roll back time, to give us a 20th Century economy where power was more consolidated in the hands of the few. 
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, which is based on whether the information would influence the judgment of a “reasonable person” or a “reasonable investor.”  

Since there is no single template for a “reasonable investor,” in reality 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 proposals in our letter and elsewhere (here and here)  but suffice it to say that the FASB proposal would replace a current accounting rule defining materiality with one that gives lots more leeway to companies and auditors to leave out information.The tone of the proposals conveys a message - when in doubt, leave it out.  

If the FASB’s proposed changes are adopted, it would have the effect of reducing disclosures that a company  views as "at the margins" of materiality.  Since those criteria for determining materiality are unarticulated, and 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 means 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, and therefore for instance, considering the extent to which a company is committed to fossil fuels?

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. And, the determination is made by a gatekeeper with a strong interest in non-disclosure.  A Harvard Business School working paper, Materiality in Corporate Governance: The Statement of Significant Audiences and Materiality by Robert G. Eccles Tim Youmans suggests  that registrants be required to file a “Statement of Significant Audiences and Materiality,” (“The Statement”) which would help in some instances to explain how materiality determinations are made. The authors noted:  
When issuing “The Statement” the board must make judgments, tough judgments, since it cannot claim that all audiences are significant. Saying “We will create value for our shareholders by meeting the needs of all of our stakeholders” is not a Statement, it is puffery. It is greenwashing. A corporation, no matter how large, has limited resources and has to set priorities in terms of how they are allocated. For example, a corporation may choose to lay off employees or cut back on its R&D expenses in order to meet its quarterly earnings target. Implicitly, this is making short‐term shareholders a more significant audience than employees or than long‐term shareholders who would benefit from this research. Or the firm can have a different view, such as cutting dividends before “downsizing.” Short‐term shareholders may not like this decision, but long‐term investors (e.g., pension funds) might applaud it.  
The Statement should also be clear about the time frames in which the corporation evaluates the impact of its decisions on its significant audiences. A 10‐year horizon is very different than a one‐year horizon. 
Our recommendation is that  FASB 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.

Based on letter to FASB submitted by the author on behalf of the Investor Environmental Health Network 


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