Materiality from a different point of view.

• Author: Colman, Vincent P.
• Position: Financial reporting

The number of financial statement restatements has grown substantially in the last several years. There are many factors that have contributed to this growth.

The business environment is certainly far more complex today than it was in the past. Transaction structures have changed; more sophisticated risk management products have evolved and companies have expanded globally. Additionally, the economy--once based on "bricks and mortar"--is now focused on services, information, technology and intangible assets. As complexity in the business environment has increased, the level of complexity in financial reporting has also grown. The greater complexity in financial reporting creates challenges in "getting it right the first time."

The level of restatements is also being driven by a legal/regulatory view of financial statement materiality, which has significantly lowered the threshold at which corrective action in the form of restatement is required. Although the capital markets appear to be digesting many of these restatements without significant upset, this muted market reaction may also be a signal that restatements are being processed for immaterial items--items that do not significantly alter an investor's view of the total mix of information.

This may not be in the best interests of investors or the markets. If left unchecked, the level of restatements has the potential to seriously erode the confidence in our system of financial reporting and, ultimately, drive a decline in the competitiveness of the U.S. capital markets.

The time is right to take a fresh look at materiality; all capital market stakeholders should come together and make the investment in developing improved and understandable principles to guide materiality determinations.

A Fresh Look

The U.S. Supreme Court has stated that an item is generally considered to be material if there is a substantial likelihood that a reasonable investor would view it as significantly altering the "total mix" of available information. The question of whether or not a financial statement error or omission is material is not a new one. It is, however, a complicated one and an important one.

The restatement process is costly, with some of the costs readily quantifiable and others, not. Some of the less visible--but no less important--costs include the opportunity cost of diverting attention away from growing the business or focusing on operational improvements. Other "intangible" costs of...