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The Materiality Concept: Implications for Managers and Investors

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The Materiality Concept: Implications for Managers and Investors Finanz. polit. econ., ISSN: 2248-6046, Vol. 6, No. 1, enero-junio, 2014, pp. 159-168 Edición Especial - Economía Regional 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 “earnings management”. 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 accounting, 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 accountants’ 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 costs), funds providers (cost - 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, Dividend & 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 audit 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 external auditor’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.
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