November 21, 2017

Materiality Definition: FASB Presses “Rewind”

We’ve previously blogged about FASB’s controversial proposal to conform its approach to financial statement materiality to the judicial definition of “materiality” that applies in other contexts. While that proposal is supported by business groups, most investor advocates have panned it.

After two years of back & forth, FASB has decided to throw in the towel on the new proposal – but instead of leaving things stand, it opted to return to an earlier materiality standard. This Thomson Reuters article explains what FASB has done:

A unanimous FASB agreed to return to the definition of materiality from Concepts Statement (CON) No. 2, Qualitative Characteristics of Accounting Information, which defines materiality in the context of “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.” The FASB said the CON No. 2 definition is consistent with the definition used by the SEC, the PCAOB, and the AICPA.

The FASB’s new approach tracks a recommendation that it received this summer from the SEC’s Office of Investor Advocate – and also reflects an apparent consensus reached among participants at a roundtable meeting held by FASB last March.

More on “GAAP Means Nothing to Me”

Last month, I blogged about an investor survey that suggested that many institutional investors didn’t have a lot of use for GAAP.  Here are some insightful comments on the results of that survey from Maynard Cooper’s Bob Dow:

It was suggested that GAAP is not useful because cash flow is more important. But of course there are GAAP measures for cash flow on the cash flow statement. I have always found the cash flow from operations to be an important measure. If a mature company consistently has a negative cash flow from operations, that almost always spells big trouble.

We do expect start-ups to have a negative number until they become cash flow positive, but the measure can help to indicate how far we are from that milestone. The cash flow from operations is harder to manipulate than some other measures, except maybe straight EBITDA (unadjusted). But EBITDA is a less reliable measure of cash flow because it doesn’t take into account changes in working capital. You can go all the way to bankruptcy court with a positive EBITDA.

That’s a major problem with non-GAAP measures, they are susceptible to manipulation. As a Corp Fin Staffer once said, the most prominent non-GAAP measure is EBBS – everything but the bad stuff.

Of course most non-GAAP measures themselves are built on GAAP. To have a consistent and comparable measure for EBITDA, you have to have an agreed-upon set of ground rules for, e.g., revenue recognition. GAAP provides that set of rules. If everyone starts making up their own rules for revenue recognition, how could any of the measures be comparable?

My own experience suggests that Bob’s comments about EBITDA are right on the money – forgetting that the accounting concepts of depreciation & amortization represent the reality that assets wear out is a great way to end up in over your head.

Non-Voting Common Stock: Delaware Law Overview

As I recently blogged, multi-class capital structures continue to hang around – despite the opposition of many institutional investors.  This Hunton & Williams memo provides an overview of Delaware corporate law issues associated with non-voting common stock, and is a handy reference tool for companies considering such a capital structure.

John Jenkins