Materiality (#183)
/In this podcast episode, we discuss whether to make adjustments to the financial statements based on materiality. Key points made are noted below.
How Materiality is Defined (Or Not)
Some potential adjustments to the financial statements are too small to bother with, because they are not material. A common view is that an error can be ignored if it represents less than 5% of net income, because such an error will not alter the investment decisions of someone relying on the financial statements.
However, materiality is not defined in the accounting standards, so that 5% threshold is just based on common usage.
The 5% threshold may not make sense in a number of cases. For example, a tiny upward adjustment in net income could trigger a major bonus payout. Or, a small increase in the reported earnings per share will satisfy analysts, and probably keep the stock price where it is, while a slight reduction could trigger a major sell-off of the stock. As a third example, a modest upward tweak to the numbers allows a company to remain compliant with its loan covenants, while no tweak will cause a loan to be called and the company to collapse. In short, even slight changes in the financial statements could have a major impact.
SEC Materiality Rules
The Securities and Exchange Commission (SEC) has created some rules in this area, which apply to publicly-held companies. The SEC states that you can begin with a percentage threshold, but you must also look at the impact of errors in aggregate. Also, if an error has been occurring for some time, aggregate it to see what the total impact is. A further examination is to see if an error has a significant impact on a subtotal in the financial statements. In all cases, the correction should be made to the financial statements.
According to the SEC, if an error has been going on for a long time, and the cumulative impact has only just become material, then do a prior year adjustment for the errors that occurred in prior years. This adjustment can be made in the next filing of financial statements made by the company, rather than replacing old filings.
It makes sense for a privately-held company to follow the SEC rules, both to create more accurate financial statements and to have the statements compliant if the decision is eventually made to take the company public.