After the release of the SFAC No. 8, your definition of materiality has been brought into question. In the past, your rule for determining materiality was based solely on quantitative data, where an event was only material if its impact was more than a given percentage of the income statement amounts. Using a quantitative measure is effective because it keeps the process objective; however there are also times when the quantitative difference doesn’t adequately demonstrate the true effect of an action. For this reason, “materiality is an entity-specific aspect of relevance based on the nature [quality] or magnitude [quantity] or both items,” as stated in Q:11 of the SFAC No. 8. For The Framework Company each of the following closing entries must be judged on a case-by-case level on the parameters of whether it could influence decisions that our users make.
1)In this entry, the company is paying a fine of a foreign subsidiary. The amount is less than 3% of net income, making it quantitatively immaterial. The description of the case lists that after the fine is paid, business will go back to normal with only slight changes. However, this is qualitatively material because it shows that the company did something unlawful which makes users question the company’s integrity and ethical standards.
2)This entry shows an investment in an expansion of the company. The impact on the company amounts to only 4.3% of its total assets (it was predetermined that the bar for materiality is 5%) so it is not quantitatively material. However, in terms of this action affecting a user’s decision about the company, this entry is definitely material. It represents an expansion of the company which users can either see as promising for future growth or frightening because it’s a risky investment.
3)Generally a loss, no matter the size isn’t seen as material due to the fact that it tends to be a one-time thing, compared to an expense that occurs regularly. However, in this case the amount of the loss proves to be material both quantitatively and qualitatively. Its impact on net income is above the 3% predetermined materiality threshold, making it quantitatively material. Also, it was determined that more of these losses may be coming in the near future for this line and that it’s becoming more delinquent. These two qualitative aspects are very impactful for a user’s decision regarding the company because they show serious problems with one of the company’s most profitable line and puts huge question marks on the quality of the product.
4)In this entry, the management made the decision to self regulate based on a court case of a similar company. The amount of additional expense accounts for 4% of the net income, making it a quantitatively material. The main reason this decision is also qualitative is due to the fact that the additional $200,000 in expenses needs to be explained to the user to show that The Framework Company is being responsible and cautious by policing themselves.
5)The ruling in a litigation case is that The Framework Company owes credit customers 325,000 in damages, which is 6.5% of net income. The company plans to appeal the case and believes they have a good defense in that appeal. A large portion of their customer base was involved in this case, meaning if the ruling is overturned some of their customers could take their business elsewhere. That makes this entry both quantitative and qualitatively material.
6)This 200,000 dollar loan that didn’t show up in the financial statements would only increase the assets by 0.08%, making it quantitatively immaterial. This event is a one-time occurrence for the company, because the chance of a payment being “mishandled” should be small. Since it is a small portion of the balance sheet and is something that won’t frequently happen, this entry is quantitatively and qualitatively immaterial.
Based on The Framework Company’s current accounting standards, this set of post-closing entries is quantitatively material because the sum of all the changes is greater than 3% of their net income and equal to 5% of assets. Even if the sum of the changes didn’t surpass the preset threshold, it would still be smart to report these entries based on the idea of conservatism. The accountants are responsible for the information released, so if they leave something out that a user would deem important, they are liable. So, when in doubt, it’s best to release the information.
The SFAC No. 8 mentions a number of times that cases of materiality, such as this one, cannot be decided by a general set of standards. The concept of materiality is too difficult to restrain. Under our current system, the expansion branch (entry 2) would be considered immaterial due to is size relative to our total assets. However, this entry really is material because it means so much to the future of the company and that’s what financial report users are looking for. The only standard that can be set when dealing with materiality is does this entry “influence decisions that users make on the basis of the financial information” (SFAC No. 8, Q:11).