Accountants confront the concept of materiality in two ways when applying the accounting standards to accounting information. First, each statement of financial accounting standards has the following disclaimer: "The provisions of this statement need not be applied to immaterial items."

Second, many accounting standards provide specific materiality "criteria." In SFAC 2, Qualitative Characteristics of Accounting Information, the FASB acknowledges giving materiality guidelines for specific situations. However, the Board recognizes that specific materiality guidelines are sometimes needed and will be given in future standards. The FASB qualifies that statement by adding that materiality judgments can properly be made only by those who have all the facts.

It is helpful for accountants to know the specific materiality guidelines given in the accounting standards and how they were developed. Knowledge of these guidelines should enable accountants to make consistent materiality decisions when standards do not give specific guidelines. It may be helpful to develop a model to assist accountants in making materiality judgments when no quantitative materiality guidelines are given.

The FASB Tries to Develop a Model

The FASB has studied the issue of materiality several times. Its most extensive public discussion appeared in a 1975 memorandum whose objective was to "establish materiality criteria." In 1980, the FASB removed the materiality topic from its agenda--uncompleted.

The FASB again studied materiality in SFAC 2. Again unable to devise criteria acceptable to the accounting community, the FASB decided not to promulgate the general materiality standard. Criteria that could consider all factors that enter into the judgment process of an experienced decision maker could not be identified.

Rules-of-Thumb

Without externally developed materiality criteria, accountants have relied on professional judgement or used internally generated rules-of- thumb. These rules have developed through years of practice. For example, one scale that has been proposed for profit-oriented enterprises is the least of--

* Five percent of normal pre-tax income where such income exceeds $2 million;

* Five to ten percent of normal pre-tax income where normal pre-tax income is less than $2 million or where there is not widespread public ownership; or

* One percent of gross revenue.

For non-profit organizations, 1/2% of normal gross revenues is often used as a rule-of-thumb. However, rules-of-thumb are not authoritative. Furthermore, previously used rules-of-thumb have shown little consistency among financial statement preparers. Because of this inconsistency, a model for making materiality decisions would be useful.

Methodology of Study

A prior study identified the accounting standards that contain either a quantitative materiality guideline or a qualitative materiality guideline. The former guidelines are specific materiality percentages. The study identified 16 standards that contained 39 quantitative materiality guidelines. The latter guidelines are judgment items that may be used as the basis for a materiality decision. Examples of judgment items include extraordinary items, accounting changes, and accounting errors. The latter guidelines were not considered in this study since they do not state a specific materiality guideline.

The quantitative guidelines were reviewed as a basis for answering the following questions:

* What rationale was used by the accounting standard-setting board in establishing the guideline--an empirical study, an arbitrary decision, or an inherent result of other guidelines?

* Is each percentage truly a "materiality" guideline or simply a substantive rule necessary to apply the standard?

* Are the percentages internally consistent? That is, can a model be derived from these examples that may be used to develop other materiality guidelines?

Findings

Rationale of Standard-Setting Board. Based on a review of the literature, quantitative guidelines were classified as arbitrary, empirical, or inherent. Guidelines were classified as arbitrary whenever the relevant literature specifically stated they were arbitrary. They were classified as empirical whenever a specific study was cited in the literature. A guideline is inherent if it is the logical extension of another quantitative materiality guideline. For example, Table 1 classifies each quantitative guideline identified in the earlier study.

The quantitative materiality guidelines were arbitrarily established by the standard-setting boards except the 10% disclosure guideline used for segment reporting in SFAS 14, and the oil and gas activities disclosure in SFAS 69. The two percentage guidelines were extensions of the SEC's segment disclosure rules that were adopted following a report titled, Financial Reporting by Diversified Companies, sponsored by the Financial Executives Research Foundation. The literature also specifically cited publications and suggestions of the AICPA, the IMA, and others as being the basis for the quantitative materiality guideline. Thus, these two guidelines were classified as empirical.

Some feel the 3% dilution standard was based on an empirical study. One author suggested the APB may have been influenced by research published in "various accounting literature." However, no specific study was cited, that supported the 3% criterion. Therefore, the 3% criterion was classified as arbitrary.

A third category of quantitative guidelines includes those that are inherent because of some other guideline. The only inherent guideline is the 90% dominant segment disclosure in SFAS 14. Once the 10% criterion is established, the 90% dominant segment disclosure is inherent since no other segment could be more than 10%.

Disclosure Guideline vs. Substantive Rule. As defined in SFAC 2, materiality is considered in terms of whether an overall assessment of the financial statements would be affected by the disclosure or nondisclosure of the matter in question. Thus, materiality is a disclosure issue. Therefore, only the guidelines that relate to a disclosure matter are truly materiality guidelines. A disclosure matter considers whether additional or alternative information should be included in the financial statements (e.g., primary and fully diluted EPS instead of simple EPS.)

Guidelines that do not relate to disclosure are not materiality measures. Rather, these guidelines constitute accounting rules, heuristics, rules-of-thumb, or they define accounting concepts. These guidelines usually determine when an accounting method should be used instead of another (e.g., equity method or cost method). Table 2 classifies each of the quantitative guidelines as either a disclosure measure or a substantive rule.

Consistency of Quantitative Guidelines. Based on previous studies, materiality guidelines have shown little evidence of consistency. However, Using the classification method of Tables 1 and 2, a consistency in the quantitative materiality guidelines emerges. Table 3 presents a flowchart that classifies the quantitative materiality guidelines into six categories.

Category 1 includes the guidelines related to footnote disclosure. The guidelines require that 10 to 20 items representing the detail of a gross amount on the financial statement be presented in the footnotes. Category 3 includes the guidelines for income statement disclosure. The guidelines indicate that an item between 3% to 10% is material on the income statement. This is consistent with the rule-of-thumb guidelines given previously. Category 2 includes the guidelines used in defining an accounting concept. The consistent guideline in this category is the definition of significant--ranging from 10 to 20%. Category 4 does not show a discernible pattern for determining when an accounting method should be used. Finally, categories 5 and 6 indicate the concept of control being established at 50% is used both in disclosure issues and in substantive rules.

No Universal Answer

Although a universal materiality criterion is neither feasible nor practical, materiality guidelines have been developed in selected cases. Materiality guidelines generally relate to whether a matter should be disclosed. These guidelines may be classified into categories such as footnote disclosure, income statement disclosure, and balance sheet disclosure. Other substantive rule guidelines have also been developed. These guidelines, often confused with materiality guidelines, are not used to determine whether disclosure of a matter is required but rather define an accounting concept or determine when a particular method should be applied. This study considers these alternative guidelines and provides a framework for classifying them. This framework should be useful as a starting point for those making materiality decisions for situations that are not covered by current standards.

From this framework, several observations can be made. The guidelines used in footnote disclosure and income statement disclosure are similar in amount, and most guidelines were established arbitrarily. The term "significant" generally refers to a substantive rule rather than to a materiality guideline. The term "control" appeared both in disclosure guidelines and in substantive rules.

TABLE 1

CLASSIFICATION OF QUANTITATIVE MATERIALITY GUIDELINES AS ARBITRARY, EMPIRICAL, OR INHERENT

Empirical

FAS 14: Segment Reporting Industry revenue 10% Industry operating profit or loss 10% Industry identifiable assets 10% Foreign operations 10% Geographic area 10%

FAS 30: Segment Reporting Major customers 10%

FAS 69: Oil and Gas Activities Significant activities--revenue 10% Significant activities--assets 10% Significant activities--profit/loss 10%

Inherent

FAS 14: Segment Reporting Disclosed Dominant Segment 90%

Arbitrary

ARB 43: Stock Dividends: Small 20-25% Large 20-25% Stock split 20- 25%

ARB 51: Investments in common stock Consolidation method |is greater than 50%

APB 15: Earnings per Share: Report dilution 3% Treasury method 20%

APB 16: Business Combinations Combinations-pooling unless companies are independent 10% Combinations-pooling method 90%

FAS 13: Leases Capital Lease 75% Capital Lease 90% Capital Lease-- Exception 25%

FAS 14: Segment Reporting Substantial portion of operation explained 75%

FAS 24: Segment Reporting Segment information for investee 50%

FAS 28: Leases Sale-Leaseback--Test for transfer of rights 10%

FAS 35: Defined Benefit Pension Plans: Disclosure of investments 10% Amortization of unrecognized gains and losses 10%

FAS 52: Foreign Currency Translation High inflationary economy 100%

FAS 57: Related Party Disclosures Principal owners 10% Related party transactions 50%

FAS 66: Sales of Real Estate Accrual method 10% Percentage of completion method 10% Installment method 10% Accrual method 90% Percentage of completion method 90% Accrual method 20% Significant receivable 15%

FAS 85: Earnings per Share Common stock method 66 2/3%

TABLE 2

CLASSIFICATION OF QUANTITATIVE MATERIALITY GUIDELINES AS DISCLOSURE OR SUBSTANTIVE

Substantive Guideline

ARB 43: Stock Dividends Small 20-25% Large 20-25% Stock Split 20-25%

ARB 51: Investments in Common Stock Consolidation method |is greater than 50%

APB 15: Earnings per Share Treasury method 20%

APB 16: Business Combinations Combinations--pooling unless companies are independent 10% Combinations--pooling method 10%

APB 18: Investments in Common Stock Equity method--significant influence 20-50% Cost method--no significant influence |is less than 20%

FAS 13: Leases Capital lease 75% Capital lease 90% Capital lease-- exception 25%

FAS 28: Leases Sale-leaseback--test for transfer of rights 10%

FAS 52: Foreign Currency Translation: Highly inflation economy 100%

FAS 57: Related Party Disclosures Principal owners 10%

FAS 66: Sales of Real Estate Accrual Method 10% Percentage of completion method 10% Installment method 10% Accrual method 90% Percentage of completion method 90% Accrual method 20% Significant receivable 15%

FAS 85: Earnings per Share Common stock method 66 2/3%

Disclosure Guideline

APB 15: Earnings per Share Report dilution 3%

FAS 14: Segment Reporting Industry revenue 10% Industry operating profit/loss 10% Industry identifiable assets 10% Substantial portion of operations explained 75% Disclosed dominant segment 90% Foreign operations 10% Geographic Area 10%

FAS 24: Segment Reporting Segment information for investee 50%

FAS 30: Segment Reporting Major customers 10%

FAS 35: Defined Benefit Pension Plans Disclosure of investments 5% Amortization of unrecognized gains and losses 10%

FAS 57: Related Party Disclosures Related party transactions 50%

FAS 69: Oil and Gas Activities Significant activities--revenue 10% Significant activities--assets 10% Significant activities--profit/loss 10%

TABULAR DATA OMITTED