A definition of materiality offers preparers and users of financial statements guidance about what are unimportant (immaterial) misrepresentations and what are important (material) misrepresentations. The U.S. Supreme Court defines information as material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” This definition has served as the legal standard of materiality since 1976, although accounting standard setters and regulators historically relied on their own definitions of materiality.
In 2018, the Financial Accounting Standards Board (FASB) revised its definition of materiality when it amended Statement of Financial Accounting Concepts 8 (SFAC/CON 8). The associated press release stated that the new definition of materiality is aligned with the Supreme Court’s definition, and that the definitions of materiality currently being used by the Securities and Exchange Commission (SEC), Public Company Accounting Oversight Board (PCAOB), and American Institute of Certified Public Accountants (AICPA) are also aligned with U.S. Supreme Court’s legal definition.
Although these bodies claim that their definitions are aligned with the legal definition, they do not use precisely the same language. For example, definitions of materiality differ in using “could” versus “would” affect decisions by the “user,” “reasonable investor,” or “primary user.” The definitions also impose different “amounts” of uncertainty regarding what is considered a material misstatement. Most use a “substantial likelihood” test; the old FASB definition used a “could influence” test; and the current International Accounting Standards Board (IASB) and prior AICPA definitions use a “could reasonably be expected to influence” test. These differences suggest that the threshold for a material misstatement, and the uncertainty surrounding that threshold, are the important aspects of the definition of materiality.
The objective of our recent study is to understand the real effects of changes in these definitions of materiality, and to offer insight into the impact of any alternative definition or interpretation that might become relevant. To do so, we developed a game-theoretic model of a manager’s decision to misreport (materially or not), focusing on incentives to capture trading profits in the firm’s stock and to enhance the value of her future compensation.[1] The manager compares these incentives to the expected costs of material misreporting and makes the reporting decision. We then alter the definition of materiality (specifically, the threshold that determines what is material and the uncertainty surrounding the threshold) to evaluate the effects of changing definitions of materiality. The most important feature of equilibrium in our model is that no one can infer exactly how much misreporting, if any, the manager included in the financial statements. Thus, even after the distribution of financial statements, the manager retains an information advantage about the value of the firm relative to all other stock market participants.
We identify three important real effects and then apply our analysis to evaluate the impact of changes in the definitions of materiality. First, because the manager retains an information advantage in equilibrium, the bid-ask spread in the firm’s stock incorporates an information asymmetry cost which allows the manager to fund negative net present value (NPV) projects. That is, the definition of a material misstatement exacerbates a standard agency problem in finance in which the manager can, in expectation, divert bondholder wealth to stockholders. Second, the definition of materiality modulates the manager’s trade-off between current plus future compensation and the potential costs of being caught materially misreporting. As a result, the impact of the definition of materiality depends on the details of the manager’s compensation package. Specifically, it depends on the limits the firm places on the manager’s trading in the firm’s stock, and how tightly the manager’s current and future compensation are tied to the firm’s stock price.[2] Third, we show that the manager responds to increases in uncertainty about the threshold for a material misstatement by reducing the amount of misreporting she engages in which lowers her ability to finance negative NPV projects. Thus, our analysis shows that differences in definitions of materiality have significant real effects, and create different interactions between the definition and key aspects of corporate governance.
We use these results to compare actual and historical definitions of materiality. This allows us to examine differences in the impact of convergence to the legal definition of materiality, and then to consider the effects of an additional type of uncertainty: uncertainty associated with future changes in definitions or the application of the definitions. We interpret definitions of materiality that use “would affect” as employing probabilistically tighter thresholds relative to “could affect,” and those focused on less experienced users as also employing probabilistically tighter thresholds. We interpret “substantial likelihood” as associated with the least uncertainty over the materiality threshold, “could reasonably be expected” as associated with greater uncertainty, and “could be expected” as associated with the greatest uncertainty.
Former FASB Chairman Robert Herz and others argued that FASB’s adoption of the legal definition of materialitywould relax the threshold for materiality and permit greater leeway to decide not to disclose information to investors. Our reading is consistent with this view: focusing strictly on the definitions of materiality, aligned with the legal definition (including the new FASB and AICPA definitions), suggests that they have the least strict threshold and the least inherent uncertainty relative to IASB’s or prior definitions used by FASB and AICPA.
The results of our analysis suggest that the legal definition is associated with the most material misreporting, largest bids and asks, smallest bid/ask spreads, and the greatest opportunity to finance negative NPV projects. Our analysis also suggests definitions associated with looser thresholds and/or less uncertainty increase interactions with the firm’s corporate governance structures focused on the manager’s current and future compensation tied to the firm’s stock price and limitations on her ability to buy or sell the firm’s shares. Thus, the impact of the legal definition of materiality is more easily affected by these types of corporate governance choices. This indicates that the convergence to the legal definition of materiality permits greater misreporting and requires users of financial statements and the firm’s Board to pay greater attention to the form of compensation being earned by the manager to understand the interaction between the definition of materiality and the manager’s incentives to misreport.
Further, comment letters from accounting firms and state accounting organizations on the FASB proposal to change its definition of materiality focused on the impact of any future evolution in interpretation driven by future case law. If these concerns create sufficient uncertainty relative to changes in alternative definitions of materiality, our analysis suggests that they would lead to less material misreporting, smaller bids and asks, a smaller bid-ask spread, and less opportunity to finance negative NPV projects.
In recent speeches, SEC Chair Gensler has suggested that the SEC anticipates promulgating climate disclosure requirements, but Ryan (2021) observes that serious concerns regarding the materiality of Environmental, Social and Governance (ESG) disclosures are being raised. Since ESG disclosures affect firm value, our model can be applied to evaluate the effect of a specific materiality definition that might be applied to these disclosures. In particular, our work suggests that choosing definitions of materiality with less stringent thresholds or less uncertainty would lead to more material misreporting (i.e., greenwashing), larger bids and asks, smaller bid/ask spreads and greater opportunities for firms to finance negative NPV projects.
Finally, the New York Stock Exchange recently altered its rule concerning related party transactions that require independent directors to review and restore the prior transaction value and materiality thresholds to again align with SEC disclosure rules. The objective is to eliminate unintended consequences of the prior changes and reduce the significant compliance burden for small transactions that would not be material in other regulatory situations. Our model suggests that this relaxation of the definition of materiality will have similar effects to the alignment of the FASB definition of materiality with the legal definition.
Mark Bagnoli is Professor Emeritus and Olson Chair in Management at the Krannert School of Management at Purdue University.
Thomas Godwin is an Assistant Professor of Management, Accounting at the Krannert School of Management at Purdue University
Susan G. Watts is the Emanuel T. Weiler Professor Emerita in Management at the Krannert School of Management at Purdue University.
This post is adapted from their paper, “On the Real Effects of Changes in Definitions of Materiality” available on SSRN.
The views expressed in this post are those of the author(s) and do not represent the views of the Global Financial Markets Center or Duke Law.
[1] Specifically in our game, the manager takes the definition of materiality as given, privately learns the firm’s actual performance, and chooses what to report. Liquidity providers observe the report and choose prices at which they will buy and sell the firm’s shares. The manager observes these bids and asks, and decides whether to trade in her firm’s stock.
[2] For a fixed definition of materiality, misreporting is greater if the manager’s compensation is more tightly tied to the firm’s stock price or if she faces larger (smaller) caps on the number of the firm’s shares she can buy (sell).
