Misapplication of "Materiality" May Distort Financial Reporting
"Materiality" refers to where something in a financial statement may influence the users of such financial reporting to the extent that it causes them to make mistaken judgments. In other words, when the omission of information or inclusion of incorrect information is enough to affect the financial statement user’s decisions, that omission or inclusion is "material". When accountants apply the principle of materiality to the auditing of financial statements, they must give overall consideration to the key elements of transactions, since, under certain circumstances, modest financial amounts may have a big impact on financial statements.
In practice, the basis for judging the level of materiality is one or more key factors, which typically includes total assets, net assets, operating income, and current period net earnings, with the criteria being a fixed or variable percentage of the above figures. When the standard for acceptability is loosened, audit risk rises proportionately. If the audit evidence indicates that the sum of the possible mistakes is greater than the standard set for materiality, the accountant will ask the company being audited to make appropriate adjustments. Otherwise, it will be necessary to issue a qualified or adverse opinion in the audit report.
In accounting, where the type of transaction is the same, materiality standards are often used to decide between different accounting treatments or information disclosures. Materiality does provide an objective basis for making such decisions. On the other hand, it also gives those who would hope to avoid using one particular accounting treatment an additional way to manipulate financial statements, by choosing between equity and cost methods, for example. In the following paragraphs, I will enumerate some of the accounting principles that relate to materiality and its influence on financial statements.
Materiality - Application of accounting principles
Choosing between equity method and cost method
Long-term equity investments may be accounted for by either the equity method or the cost method. (This has to do with Taiwan's Statement of Financial Accounting Standards No. 34 "Financial Instruments: Recognition and Measurement", which took effect at the beginning of 2006: In general one can differentiate between "financial assets available for sale", "financial assets held for trading purposes", and "financial assets carried at cost".) When business conditions at an invested company are unfavorable, and that company has not gone public, the investing company, in order to avoid the necessity of recognizing a big investment loss under the equity method, may struggle to get its shareholding down to 19%, or resort to overlapping shareholding with companies that are, in essence, related parties. Although to outward appearances its influence over the invested company is much less, in practical terms its influence has not decreased. At such times, simply taking the shareholding percentage to choose the accounting treatment will produce a direct impact on the financial statements.
Materiality - Information disclosure
Using clever arrangements to hide the real nature of related party transactions
Taiwan's SFAS No. 6 "Disclosures of Related Party Information" enumerated 7 circumstances under which a party would meet the definition of a related party. For the most part, these use the degree of influence, or potential influence, to differentiate between related and unrelated parties. Related parties would include, for example, those where equity method is used to value investment in the other party, or a party holds an important position such as director, supervisor, general manager or deputy general manager, and for the sake of skirting disclosure requirements, companies will bend over backwards to keep their transaction counterparts from meeting the conditions laid out in the accounting standards.
Using organizational planning to avoid revealing division-level information
Enterprises operating in a diversified environment can and do put products with similar production and sales processes together in a single department or division. But under SFAS No. 20 "Disclosure of Segment Financial Information", whenever the income or assets of a corporate segment reach 10% of an enterprise's total income or assets, financial information on the segment must be disclosed. High tech companies in particular worry that if they disclosed such information and their competitors did not, the resulting information asymmetry would mean the loss of a significant advantage. As a result, companies may use organizational arrangements as a way to avoid disclosure. This means, in other words, that a 10% threshold is applied across the corporation.
Taking together the simple examples given above, we can understand that materiality standards are aimed at the expressing the economic substance of transactions or disclosing financial statement-related information. However, in order to avoid the misuse of materiality, it is not enough for accountants to make materiality judgments with dollar amounts or percentages as the only considerations. They should also consider the economic substance of transactions, and allow that the same materiality standard may not be applicable to another company. Differences in the overall financial statements, or the amount or classification of a particular accounting item, may require accountants to make professional judgments on materiality based on the substance of transactions. Only then can they keep the materiality principle from becoming a mere shield used by enterprises to avoid their share of the tax burden.