Revista Finanzas y Política Económica ISSN: 2248-6046 [email protected] Universidad Católica de Colombia Colombia

Hussein Juma’h, Ahmad The Materiality Concept: Implications for Managers and Investors Revista Finanzas y Política Económica, vol. 6, núm. 1, enero-junio, 2014, pp. 159-168 Universidad Católica de Colombia Bogotá D.C., Colombia

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Ahmad Hussein Juma’h* Universidad Interamericana The Materiality Concept: de Puerto Rico, San Juan, Puerto Rico Implications for Managers Recibido: Concepto de evaluación: and Investors Aprobado:

ABSTRACT “”. Imply the content description and analysis of FASB the absence of materiality guidelines in the US GAAP. Materiality, importance Todos los derechos reservados. apply materiality on decision making. Keywords: Accounts Manipulation, Earnings Management, Materiality, and Financial Statements. JEL: M00, M4

El concepto de materialidad: implicaciones para gerentes e inversionistas

RESUMEN Se discuten las implicaciones de la materialidad de la información importancia relativa en los Principios de Contabilidad Generalmente Aceptados “importancia” fueron usados para determinar la inclusión de materialidad en las *Ph. D., CPA, Professor of finance and , DBA (Finance) coordinator, Metro Campus, Inter- American University of Puerto Rico. de “manejos de ganancias” y, segundo, los PCGA de EE. UU. no cuentan con Mail: Inter-American University of Puerto Rico, Apartado Apartado Palabras clave: manipulación de cuentas, manejo de ingresos, materia- 191293, San Juan, Puerto Rico 00919-1293. Mail: [email protected]

159 O conceito de materialidade: implicações para os gerentes e investidores

RESUMO sobre “gestão de ganhos”. Implica a descrição e a análise do conteúdo da Codi- de Contabilidade Geralmente Aceitos (em inglês, GAAP) dos Estados Unidos principais conclusões indicam que, primeiramente, os fatores determinantes - nidas para aplicar a materialidade na tomada de decisões. Palavras-chave: Manipulação de contas, gestão de ganhos, materiali-

160 Finanz. polit. econ., ISSN 2248-6046, Vol. 6, No. 1, enero - junio, 2014, pp. 159 - 168 Edición Especial - Economía Regional The MaTerialiTy ConCepT: iMpliCaTions for Managers and invesTors

INTRODUCTION Second, perceptions, and motives for earnings mana- gement are discussed. Third, the aspects of auditing and regulatory enforcement controls are presented. the investors’ perceptions on the evaluation of Fourth, the relation between US GAAP and materiality companies’ released information. The corporate’ are included. - ACCOUNTS MANIPULATION AND Chen et al., 2005, Noronha et al., 2008). The EARNINGS MANAGEMENT ’ practices, in particular estimation of of managers to make accounting choices or to statements, are important to add an additional design transactions affecting the possibilities of element to explain the relationship between the transferring wealth between the company and the society (political ), funds providers ( - of capital) or managers (compensation plans). In from the wealth transfer. In the third, managers The concept of materiality is referred to the Breton, 2003). magnitude of an omission or misstatement of ac- boundaries. Earnings manipulation activities ex- Statement No. 2, 1980). ceeded from legitimate/legal activities to fraud Accountants frequently use estimations to or violating GAAP, with the intention to mislead some stakeholders about underlying economics and performance of a company. The terms of ac- counts manipulation and earnings management are differentiated based on the law’s boundaries considerations are important for accountants’ es- (Noronha et al., 2008). timations. The application of materiality concept varies between accountants. Materiality applica- to the accounting guides: earnings management is the presentation of accounting numbers within as the process of intentionally exploiting the GAAP - smooth (maximize or minimize) reported income ding to the managements’ interests, and to achieve (Stolowy and Breton, 2003; Moore, 1973; Noronha et al., 2008). management activities are seen as a continuum of In linking the materiality implications on accoun- tants’ decision making that involves earnings manage- reporting process from legitimate activities (Bara- ments and the fairness of companies’ information, the lexis, 2004; Koumanakos et al., 2005; Guang et al., remaining of the article is organized as follows: the fo- et al., 2008).In the following table, llowing section presents the differentiations between examples of earnings management and earnings accounts manipulation and earnings management. manipulation/fraud are presented. 161 Ahmad Hussein Juma’h

Earning management versus Earning Manipulation/Fraud

Earnings management Earnings manipulation/Fraud Estimations Innovations & Managing accounts Managing accounts & adopting Accounts & events Records’ increasing internal for company’s for manager’s accounting manipulation interest interest methods Managing Not disclosing R&D, new products, Depreciation, & Altering company’s announcements economic events on patents, etc. accruals estimations repurchase signals records dates time Source: Adopted from Baralexis, 2004; Koumanakos et al., 2005; Guang et al.et al., 2008.

PERCEPTIONS AND MOTIVES OF gement actions as unethical compared to CPAs in EARNINGS MANAGEMENT organizations with low values. In industry, CPAs view Accounting academics have different perception values compared to CPAs in public accounting and of earnings management than do practitioners academia (Elias, 2004, Levitt, 1998). and regulators. The managerial incentives created There is no clear consensus in the accounting by compensation contracts, regulatory motivates, profession regarding their ethical acceptability of capital market motivates etc. lead to earning ma- earning management. The debate on ethical accep- nagement (Elias, 2004; Healy, 1985; Gaver et al., 1995; Noronha et al., 2008; Healy and Wahlen, after the revelation of their negative consequences 1998; Reverte, 2008). Revealing relevant information is crucial for and Skinner, 2000). CEO wealth sensitivity is positively associated (Fischer and Rozenweig, 1995; Sevin and Schroeder, with abnormal accrual usage and the relation is 2005). How to perceive events as earnings mana- gement or earnings manipulation are important Performance expectation is important in conduc- issues for investors (Chen et al., 2005). The share ting an because people try to validate their perceptions of reality no matter if they perceive an with earnings variability. Managers can reduce the event incorrectly. Performance evaluation depends cost of capital and increase share prices by reducing on the perceptual process and the performance earnings variability (Kanagaretnam et al., 2004). expectations. The cases of earnings manipulation increa- se over years and refocus the attention on the ENFORCEMENT POWERS It is noted that unethical earnings management Reforms set forth in Sarbanes Oxley (SOX) and the behavior can be attributed to the failure of cor- NYSE, AMEX, and NASDAQ are designed to prevent the reoccurrence of corporate collapses at compa- to the development of earnings management and nies such as Enron Corp., WorldCom Inc., Ahold, and manipulation behaviors. Global Crossing Ltd (Kanagaretnam et al., 2004). The corporate ethical values are important The considerable amount of regulatory determinants of earnings management perception. attention given to corporate governance issues CPAs employed in organizations with high ethical in recent years suggests that stronger gover- values were more likely to view earnings mana- nance mechanisms would reduce opportunistic 162 Finanz. polit. econ., ISSN 2248-6046, Vol. 6, No. 1, enero - junio, 2014, pp. 159 - 168 Edición Especial - Economía Regional The MaTerialiTy ConCepT: iMpliCaTions for Managers and invesTors management behavior, thus improving the quality ability to engage in earnings would be diminished believe that this in turn will help to maintain and et al. and Qi, 2005). The corporate scandals after the case of MATERIALITY IMPLICATIONS ON Enron raised concerns about audit quality even EARNINGS’ MANAGEMENT and associated with higher audit quality. Audit decision making, in particular decisions requiring quality research has focused primarily on differences estimations. The information considered immate- rial by accountants is not reported to investors, (Chen et al., 2005). The adequacy of auditors’ works to manage The stakeholders are aware of all public information control force against earnings management has (mandatory or non-mandatory information), and recently received much attention (Johl et al., 2007). investors give attention to the released no-manda- The control forces are related to the effect of audit committee independence on the outside auditor The concept of materiality is simple but it is choice, and on ’s effectiveness and central in applying GAAP. FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Earnings management is related to the size Information of the board of directors. This supports the view that larger boards appear to be ineffective in their The magnitude of an omission or missta- oversight duties relative to the smaller boards. The tement of accounting information that, relation between measures of earnings management in the light of surrounding circumstances, makes it probable that the judgment quality of its outside audit is assumed consistent and of a reasonable person relying on the information would have been changed or influenced by the omission or missta- the earnings manipulative behavior. They found that tement. (Para. 132) earnings management is pervasive in the quarterly earnings numbers. For example, there are more zeros and fewer nines in the second digit of the ear- nings number in each of the four quarters. Also, the earnings management in the fourth quarter, while materiality. The economic factors are considered to still prominent, but is less as compared to each of determine the materiality of any issue. A rough cri- et al. The ability to manage earnings under the an adapted guideline of materiality by some CPAs integral approach to interim reporting, however, as income trend or income growth has been used. Auditors usually use three quantitative measure- ments, namely percentage effect on , percentage effect on total sales or total , only the fourth quarter is audited, if the auditor and percentage effect on total (Thompson, 1993; Thompson et al. 163 Ahmad Hussein Juma’h

FASB ACCOUNTING STANDARD of all relevant considerations. Materiality concerns CODIFICATION™ is a substantial likelihood that a reasonable person 250 Accounting Foundation (FAF) and the Changes and Error Corrections > 10 Overall > S99 American Accounting Association (AAA) enable us SEC Materials. to identify keywords related to materiality concept in accounting practices. To identify the materiality - - delines or bases for the materiality determination. some of these words derivations such as material, responsibility of each registrant. However, absent concerns about trends or other qualitative consi- on the year 2010, only 95 indicate some implica- derations, the staff generally will not insist on the reporting of income or loss applicable to common stock if the amount differs from net income or loss 1990). The following table summarizes the count 225 and the percentage of each keyword. > 10 Overall > S99 SEC Materials. Keyword Importance Materiality Total loans … except that in the determination of sig- Count 58 21 95 Percentage 310 Receivables > 10 Overall > S99 SEC Materials. - that include materiality concept without guidelines or materiality of the discussed issues. establish a materiality criteria for omission, and the arbitrary exclusion of summarized information for the determination as to whether those continuing - 323 Investments— Method and 205 Presentation of Joint Ventures > 10 Overall > S99 SEC Materials. Financial Statements > 20 Discontinued Operations > 55 Implementation Guidance and Illustrations. Code 944 explains the bases for the materiality of under these items are fundamental policies which insurance with respect to inclusion as a note to cannot be changed without prior shareholder ap- proval, the importance of adopting a clear policy with regard to such investments is apparent. The prospectus of a registered investment company implications. should also fully disclose the company’s policy with - percent of total liabilities. State in a note to the vices - Investment Companies > 320 Investments - Debt and Equity Securities > S99 SEC Materials. participating insurance expressed as percentages - of (1) insurance in force and (2) premium income; propriately be used as a substitute for a full analysis and the method by which earnings and 164 Finanz. polit. econ., ISSN 2248-6046, Vol. 6, No. 1, enero - junio, 2014, pp. 159 - 168 Edición Especial - Economía Regional The MaTerialiTy ConCepT: iMpliCaTions for Managers and invesTors

944 The internal factors and external factors Financial Services-Insurance > 210 > S99 SEC Materials. views and perceptions. Examples of external fac- - tors include political, economic, and cultural issues to in determining whether those assets with respect to a decision making. are readily convertible to cash. The internal factors are those under the individual’s control and external factors are con- shall consider those estimated conversion costs to cerned to the situation and the individual may be force to act. This determination of the internal 815 Derivatives and Hedging and external factors depend on three factors: > 10 Overall > 15 Scope and Scope Exceptions. 1) distinctiveness where the individual act differently under different situations, 2) consensus is referred to the behavior of all individuals is the same way in the CONCLUSIONS same situation, and 3) consistency referred to Accountants frequently use estimations to report the behavior of an individual is the same over time for similar situations. for their companies. The materiality concept is Rigorous regulations cannot completely re- essential for any estimation in all decision making. move earnings management from the market, but it The existence of information asymmetry between can probably reduce it and provide explicit evidence management and shareholders is a necessary con- for detecting and penalizing earnings management dition for earnings management. This is because behaviors. The lack of a systematic framework of accounting standards brings many opportunities performance and prospects in an environment for earnings management (Noronha, et al., 2008). in which they have less information than mana- Governance practices, especially independent gement. In such an environment, management boards and committees, effective management - compensation, and powerful shareholders are nings. Also, management’s discretionary ability important in constraining management from ma- to manage earnings increases as the information naging earnings and in ensuring a higher quality of asymmetry between management and sharehol- ders increases. Based on agency theory, issues associated accounting, generally accepted accounting princi- with the separation between ownership and ples, and the environment are the main factors that control will lead managers (agents) to act in an opportunistic manner by increasing their personal wealth at the expense of the owners (principal) In a turbulent political status, accountants may become more cautious than in a stable poli- tical status. Accountants in a boom economy may When managers are concentrated on the perceive events in different way as in a recession company’s goals and motivated toward achieving economy. People in different cultures see things those goals, it is highly expected that the company differently. Therefore, accountants depend on so- achieve its goal. However if managers are working mehow on their culture and the environment in to achieve their own objectives and do not work which they work. to maximize companies wealth, the company is The complexity and the time required versus the time available to solve any issue are important 165 Ahmad Hussein Juma’h

factors. Also, individuals involved and or related In estimating the performance of companies’ to the decision influence accountants in their units, the absence of clear materiality judgment works. Personal attitudes, motivations, interests, perhaps enables accountants to decide differently education, experience, and expectations are the on same materiality situation. The perception of - countants, auditors, managers, and investors in perception and expectations of accountants and considering the materiality of the relevance of an auditor in their decision making. Accountants may event or a transaction. consider an event as immaterial because most Auditors normally conduct most of their investors consider the same event as immaterial. works judging others’ work. Therefore, auditors’ Earnings management has been studied in perception on the adequacy of accounting data is a variety of contexts, for example compensation important. People in general selectively interpret contract, debt covenants, seasoned equity and what they see based on their interest, experience initial public offerings. Some accounting research and attitudes. In the same way auditors perceive has examined the relationship of different cor- an event based on their interest, experience, edu- cation. How auditors believe about an event may misstatements, fraud and earnings management such event. (Dechow, et al. Also, how other auditors perceive such an There is a scarcity to study the techniques used to manipulate companies’ accounts (Stolowy auditors in evaluating a company’s data. Auditors and Breton, 2003). Also, there is a need to study may judge an event based on a single instance. earning management in relation to corporate For example if they found a material error in a control contests (Ben-Amar and Missonier-Piera, transaction then they may decide to reevaluate the 2008) and it is important to realize more research complete data. The type of organization and the with respect to application of materiality and its relation to earnings managements and accoun- the materiality of an event. and conditions.

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