MATERIALITY IN FINANCIAL REPORTING An Integrative Perspective This page intentionally left blank MATERIALITY IN FINANCIAL REPORTING An Integrative Perspective BY FRANCESCO BELLANDI United Kingdom À North America À Japan India À Malaysia À China Emerald Publishing Limited Howard House, Wagon Lane, Bingley BD16 1WA, UK First edition 2018 Copyright r 2018 Emerald Publishing Limited Reprints and permissions service Contact: [email protected] No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. Any opinions expressed in the chapters are those of the authors. Whilst Emerald makes every effort to ensure the quality and accuracy of its content, Emerald makes no representation implied or otherwise, as to the chapters’ suitability and application and disclaims any warranties, express or implied, to their use. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-1-78743-737-1 (Print) ISBN: 978-1-78743-736-4 (Online) ISBN: 978-1-78743-843-9 (Epub) ISOQAR certified Management System, awarded to Emerald for adherence to Environmental standard ISO 14001:2004. Certificate Number 1985 ISO 14001 To Anna, constant presence and support This page intentionally left blank Contents List of Figures xix About the Author xxv Preface xxvii Part I. Introduction and Background 1 Main Focus of Part I 2 1. Why Does Materiality Matter in Financial Statements? 2 2. Powerful and Dangerous 3 3. The Disclosure Framework 4 4. The Disclosure Initiative 5 5. The Disclosure Effectiveness Initiative 6 6. Objectives of the Book 7 Part II. Conceptual Bases of Materiality 9 Main Focus of Part II 10 1. Materiality in the Conceptual Frameworks 10 1.a. The Objective of Materiality 10 1.b. Level of Interaction in the Conceptual Frameworks 10 1.c. A Pervasive Concept or a Qualitative Characteristic? 11 1.d. Is Materiality a Constraint? 15 1.e. Interaction with Qualitative Characteristics of Accounting Information 16 1.f. Materiality versus Relevance 16 1.g. Entity Specificity 20 1.h. Materiality versus Reliability and Faithful Representation 22 1.i. Completing the Picture: Materiality versus Completeness 24 1.j. Materiality versus Understandability 25 vii 1.k. Does Prudence or Neutrality Affect Materiality? 27 1.l. The Link to Recognition in the Conceptual Frameworks 28 1.m. Cost/Benefit Constraint versus Materiality 30 1.n. Impracticability versus Materiality 30 1.o. Significance 31 2. Definitions of Materiality 33 2.a. Can a Definition of Materiality Be Given? 33 2.b. Summary of Definitions 39 2.c. US Supreme Court’s Definition 39 2.d. FASB (1985), CON 2 40 2.e. SEC Rules and Regulations 41 2.f. Common Law 43 2.g. IASB Framework 43 2.h. Common Conceptual Framework 43 2.i. The International Financial Reporting Standards 44 2.j. Auditing Standards 45 2.k. COSO Framework 45 2.l. AccountAbility 46 2.m. Integrated Reporting 46 2.n. WRI and WBCSD 46 3. Attributes of Materiality 47 3.a. Subject Matter 47 3.b. What Is an Item? 47 3.c. An Item versus Its Content 48 3.d. Omissions or Misstatements 49 3.e. Material Disclosures of An Item versus Its Required Disclosures 50 3.f. Materiality Test from Users’ Perspective 50 3.g. Materiality Test Contrasted with the Objective of General-Purpose Financial Statements 51 3.h. Materiality Test from the Standpoint of Objective Metrics 52 3.i. Addressees of Test 52 3.j. Reasonable Investor and Reasonable Person 52 3.k. Clusters versus Individuals 53 3.l. Primary versus Intended versus Other Users 53 3.m. Stakeholders versus Users 54 3.n. Assessor 55 3.o. Degree of Likelihood 55 3.p. Understanding Influence versus Influencing 57 3.q. Degree of Magnitude 59 3.r. Context 59 viii Contents 3.s. Degree of Specificity 60 3.t. Time Horizon 60 Solutions and Recommendations 61 Conclusion 67 Part III. Actors and Models of Materiality 69 Main Focus of Part III 70 1. Uses and Effects of Materiality 70 1.a. Is Materiality Exclusively a Legal Concept? 70 1.b. Are Legal and Accounting Definitions of Materiality Incompatible? 71 1.c. Practical Interactions of Legal and Accounting Concepts of Materiality 73 1.d. The Different Nature of an Accounting Concept of Materiality 74 1.e. The Quest for an Accounting Definition of Materiality 75 1.f. Materiality in Audit versus in Financial Statements 76 1.g. Other Uses of Materiality by Auditors 77 1.h. Materiality as a Managerial Concept 79 2. Who Decides about Materiality? 79 2.a. Who Allows Materiality? 79 2.b. Who Uses Materiality? 80 2.c. Who Decides Materiality? 80 2.d. Who Assesses Materiality? 81 3. Models of Materiality 82 3.a. Do We Need a Framework of Materiality? 82 3.b. A Positive versus a Negative Concept 82 3.c. A Discrete versus a Continuous Notion 83 3.d. Different Disclosure Regimes 85 3.e. Simulating User Decision Model 86 3.f. Probability/Magnitude Mapping 86 3.g. Severity of Deviancies 90 3.h. Range of Fluctuation 91 3.i. Opportunity Loss 91 3.j. Statistical Use of Information 91 3.k. Doctrine of Differential Disclosure 92 3.l. Expanded Dimensions of Materiality 95 3.m. The Flexibility Zone 97 3.n. Eyes of Management versus Eyes of Investors 98 3.o. The Ownership Triangle 100 3.p. Active versus Passive Role 101 3.q. The SenderÀReceiver Distortion 102 Contents ix 3.r. U-Materiality 103 3.s. Objective versus Subjective Determination 103 3.t. Materiality as a Planning Tool 104 3.u. Consensus Materiality 104 3.v. Adjustment Method 105 3.w. From Materiality to Materiality Determination Process 106 3.x. Qualitative Factors 106 3.y. Zero Materiality 107 Solutions and Recommendations 107 Conclusion 112 Part IV. Application of Materiality 113 Main Focus of Part IV 114 1. Materiality Applied to Recognition and Measurement 114 1.a. Does Materiality Apply to Recognition and Measurement? 114 1.b. Inapplicability by Analogy 115 1.c. De Minimis 115 1.d. Significant Accounting Policies 115 1.e. Accounting Policies with Immaterial Effects 117 1.f. Scope of a Change in Accounting Policies 117 1.g. Materiality in Disclosing Voluntary Changes in Accounting Policies 117 1.h. Materiality in Disclosing Involuntary Changes in Accounting Policies 118 1.i. The Case of Accounting Errors 119 2. Materiality Applied to Presentation and Disclosure 120 2.a. Does Materiality Apply to Presentation and Disclosure? 120 2.b. An Item versus Information of An Item 122 2.c. Required Disclosure of Immaterial Information 122 2.d. Allowed Disclosure of Immaterial Information 123 2.e. The Disclosure Overload Debate 124 2.f. Obscuring Material Information 125 2.g. Minimum Set of Required Disclosures 126 2.h. Classification 127 2.i. Interaction of Aggregation and Disaggregation of Information 128 2.j. Top-down Model of Disaggregation in the Financial Statements 129 2.k. Bottom-up Model of Aggregation in the Financial Statements 130 x Contents 2.l. Classes of Aggregation 132 2.m. Alternative Model of Aggregation in the Financial Statements 133 2.n. General Models of Disaggregation for Disclosure Purpose 134 2.o. Review Assessment 137 2.p. Quality of Disclosure 138 2.q. Material Items 138 2.r. Disclosure Objectives 139 2.s. Gains and Losses 140 2.t. Effect of Measurement Bases 140 2.u. Third Statement of Financial Position 141 2.v. Rounding 141 2.w. When Required Disclosure Is Not Enough 142 3. Materiality Applied to Management Commentary 143 3.a. Management Commentary versus the Notes 143 3.b. Views of Materiality in Management Commentary 144 3.c. Material Known Trends or Uncertainties in SEC’s MD&A 145 3.d. Material Changes 149 3.e. Critical Accounting Estimates in MD&A 149 3.f. Immaterial Information in MD&A 150 3.g. Segment Analysis 150 3.h. Layered Disclosure 151 4. Does Materiality Apply to Bookkeeping? 151 4.a. Bookkeeping versus Financial Statements: A Separate Perspective 151 4.b. Bookkeeping versus Financial Statements: An Integrated Perspective 152 4.c. The Direct Impact on Financial Statements of Bookkeeping Errors 153 4.d. The Indirect Impact on Financial Statements of Bookkeeping Errors 153 4.e. The Delicate Link to Intentional Immaterial Errors 154 4.f. Immaterial Misstatements versus Bookkeeping Errors 155 4.g. Can Immaterial Bookkeeping Errors Be Left Uncorrected? 155 4.h. Does Materiality Apply to Bookkeeping? 156 4.i. Reasonableness versus Materiality 156 4.j. Legal Implications 157 4.k. Should Accountants Care of Materiality at All? 158 5. Materiality in Auditing 159 5.a. Audit Definition of Materiality 159 Contents xi 5.b. Definition of Material Misstatement 160 5.c. The Risk of Material Misstatements and Assertions 161 5.d. Relationship between Audit Risk and Materiality 162 5.e. Iteration of Materiality and Inherent Risk 165 5.f. Second-Guessing Management’s Determination of Users’ Needs 166 5.g. Timing of Auditor’s Consideration of Materiality 166 5.h. Undetected, Identified, Uncorrected, and Corrected Misstatements 168 5.i. How Materiality Affects Auditors’ Responses to Misstatements 168 5.j. How Materiality Affects Auditors’ Responses to Fraud 169 5.k. How Materiality Affects Auditors’ Responses to Illegal Acts 170 5.l. Communications with the Management, Internal Auditors, and Audit Committee 171 6. Materiality Applied to Internal Control Over Financial Reporting 172 6.a. Internal Control over Financial Reporting versus Audit 172 6.b.