I often work on litigation consulting engagements where the concept of materiality is front and center. A key question that I have encountered is, for a consolidated entity, whether or not materiality is to be assessed at the consolidated level or at the segment level from a financial reporting disclosure perspective.
Materiality
The guidance is clear that materiality is supposed to be assessed in the context of the “financial statements taken as a whole”, or at whatever level the issuer is reporting its financial statements. However, there are some items for consideration that can provide some color to this discussion and that can assist those involved with these types of decisions to understand the implications of making materiality decisions at a level lower than the consolidated level.
Auditor Considerations
When the external auditor opines, the auditor refers to the highest level of financial statements, typically the “consolidated” financial statements, presenting fairly, in all material respects, the financial position/results of operations/cash flows, etc. When the auditor plans and performs an audit, the auditor considers “materiality”, which, according to auditing standards, is also based on the “financial statements taken as a whole” concept.
Auditing Standard (AU) No. 312 titled “Audit Risk and Materiality in Conducting
an Audit” addresses materiality for particular items of lesser amounts than the materiality level determined for the financial statements taken as a whole. Paragraph 31 states:
When establishing the overall strategy for the audit, the auditor should consider whether, in the specific circumstances of the entity, misstatements of particular items of lesser amounts than the materiality level determined for the financial statements taken as a whole, if any, could, in the auditor’s judgment, reasonably be expected to influence economic decisions of users taken on the basis of the financial statements. Any such amounts determined represent lower materiality levels to be considered in relation to the particular items in the financial statements.
Paragraph 32 provides some items for consideration by the auditor. However, at the end of the audit, as I’ve explained previously, the auditor generally opines on the financial statements taken as a whole. This is important to remember.
Issuer Guidance
SFAS 131, Disclosures about Segments of an Enterprise and Related Information, discusses disclosure requirements for segments of a filer. Within par. 78, it states:
Paragraph 125 of Concepts Statement 2 states that “. . . magnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, will not generally be a sufficient basis for a materiality judgment.” That guidance applies to segment information. An understanding of the material segments of an enterprise is important for understanding the enterprise as a whole, and individual items of segment information are important for understanding the segments. Thus, an item of segment information that, if omitted, would change a user’s decision about that segment so significantly that it would change the user’s decision about the enterprise as a whole is material even though an item of a similar magnitude might not be considered material if it were omitted from the consolidated financial statements. Therefore, enterprises are encouraged to report information about segments that do not meet the quantitative thresholds if management believes that it is material. Those who are familiar with the particular circumstances of each enterprise must decide what constitutes material. (emphasis added)
It seems the FASB intentionally made the requirement to disclose something at the segment level a higher standard than the requirement to disclose something at the consolidated/enterprise level, for the reason that the focus should be on the “financial statements taken as a whole” and not at the level of a segment.
Interpretation
In the end, the question as to whether materiality is to be assessed at the consolidated level or at the segment level from a financial reporting disclosure perspective more clear. Decisions regarding materiality at a lower level than at the consolidated level, barring an exceptions (as described in SFAS 131), tend to get swallowed up in materiality at the reporting, or consolidated, level. Users of financial statements, including forensic accountants, should keep these concepts in mind.
Applicability
When a dispute or allegation comes forth that accuses an entity of not disclosing something that perhaps it should have, these concepts should be reviewed. SAB No. 99 also provides some color and should be consulted. I assist clients with these complex issues on a regular basis and often the answer is not black or white. The specific facts and circumstances should be understood, particularly the more macro factors (such as industry peer disclosures). In the end, professional judgment should be applied in a manner that is well-thought out, documented, and defensible.