The Concept of Materiality

Author(s): Leopold A. Bernstein

Source: The Accounting Review, Vol. 42, No. 1 (Jan., 1967), pp. 86-95
Published by: American Accounting Association
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 The Concept of Materiality
Leopold A. Bernstein
TEHE current debate on the state of
accounting theory and the practice
which is a reflection of it, or the lack
of it, is all too often conducted in terms of
sweeping generalizations. In order to make
further progress in accounting principles
and their application, we must isolate from
among the many problem areas revealed
by practice those whose definition and
resolution would make the greatest rela-
tive contribution to the furthering of bet-
ter accounting. Recently concluded re-
search clearly indicates that the concept of
materiality is such a problem area.
Treatment of Extraordinary Gains and
Losses
The theory, as well as the treatment and
presentation of extraordinary items of
gain and loss were the subject of a research
study recently completed by the author.
One aspect of this research involved a
comparison of a substantial segment of
practice with the provisions of Chapter 8
of A ccounting Research Bulletin No. 43, the
accounting profession's principal pro-
nouncement dealing with the treatment of
extraordinary gains and losses. This Bulle-
tin states, among other provisions, that
there should be a general presumption that
all items of profit and loss recognized
during a period should be included in the
determination of net income. The only pos-
sible exception represents items that are in
the aggregate material in relation to the
company's net income and clearly not
86
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identifiable with or result from usual or
typical operations. Such items may be ex-
cluded from a determination of net income,
and further, "they should be excluded when
their inclusion would impair the signifi-
cance of net income so that misleading
inferences might be drawn therefrom."'
The following summary of findings of
my research is pertinent to the present
discussion:
(1) Out of 324 presentations of extraor-
dinary items in the sample, 214 or 66%
were excluded from the determination of
net income. This does not support the
existence of a strong presumption for the
inclusion of all items of income and loss in
the determination of net income.
(2) In the main categories of extraordi-
nary items, practice is so diffused that the
size of an item in relation to net income
appears hardly to have any important
effect on whether an item is included in, or
excluded from, the determination of net
income. It can also be said that no per-
centage range emerges from our data as a
border zone between what, under the Bul-
letin, should be considered as material and
hence excludable from net income, or im-
I American Institute of Certified Public Accountants,
Accounting Research and Terminology Bulletins, Final
Edition, 1961; p. 63.
Leopold A. Bernstein is Assistant Profes-
sor of A ccountancy at the Bernard M.
Baruch School of Business and Public Ad-
ministration, City University of New York.
Bernstein: Materiality
material and hence includable therein.
Thus, viewing practice as a whole, there
emerges no pattern which would suggest
that there are any agreed-upon criteria
regarding the application of the concept of
materiality. And yet, the concept of ma-
teriality is one of the most critical of all
criteria enumerated in the Bulletin.
(3) Wherever enough examples were
available to lend some validity to conclu-
sions, the picture of practice at the level of
the individual major accounting firm ex-
amined confirms what we have learned
about practice as a whole, i.e., that, in
most cases, it does not appear to be guided
by any discernible standard of materiality.
(4) The study reveals that there is a
definite bias towards showing extraordi-
nary items with credit balances as special
items in the income statements (65%o of
total credits) and debit items in retained
earnings (77% of total debits.) Thus, it
appears that in the absence of materiality
guidelines, considerations other than those
intended played a dominant role.
The lack of definition of materiality
criteria can best be illustrated by the fol-
lowing examples taken from my study:
EXAMPLE 1: Archer Daniels Midland
Co., in its 1964 annual report included in
net income a profit on sale of depreciable
assets of $1.1 million or 26% of net income.
The item was not designated as extraordi-
nary or non-recurring. This should be con-
trasted with the treatment by Lily-Tulip
Corp. in its 1963 annual report of a net
realized gain on disposition of fixed assets
of $143 M. This item, representing 3% of
net income, was credited directly to re-
tained earnings.
EXAMPLE 2: Mueller Brass Co., in its
1964 annual report included in net income,
without any special designation, prior
years' investment credits of $184,000 rep-
resenting 41% of net income. This should
be contrasted with the treatment of such
prior-year investment credits by Tecumseh
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87
Products Co., in the amount of $156,000,
or about 1.3% of net income, which were
credited to the retained earnings account
in the company's 1964 annual report.
The concept of materiality has found its
way into many aspects of disclosure. Thus,
for example, we find it in Accounting Re-
search Bulletin No. 43, Chapter 10, where it
is applied to income tax allocation, in
Chapter 11 where it is applied to treatment
of renegotiation refunds, and in Chapter 15
where it is applied to the question of dis-
closure of unamortized discount. Material-
ity is, moreover, a central concept in Ac-
counting Principles Board Opinion No. 5
which deals with the accounting for leases.
Finally, the Accounting Principles Board
Opinion Exposure Draft entitled "Report-
ing the Results of Operations," dated
September 9, 1966, which, if adopted, will
make a significant contribution towards a
resolution of the problem areas revealed in
my aforementioned study, and towards the
implementation of its principal recom-
mendations, nevertheless retains the cri-
teria of materiality as an element of major
consideration.
The Meaning of "Materiality"
What do we mean by the term "materi-
ality?" The concept of materiality is part
of the wisdom of life. Its basic meaning is
that there is no need to be concerned with
what is not important or with what does
not matter. Man's work is burdensome
enough without the need to pay attention
to trivia.
In accounting, this concept of material-
ity assumes special significance. There are
two basic reasons for this:
(1) Most users of accounting informa-
tion do not comprehend it easily. Conse-
quently, the introduction of redundancy
into that information can make the task of
absorption and analysis even more diffi-
cult. Furthermore, the presentation of
significant data intermixed with insignifi-
88
cant data can also be misleading. Hence,
to make the information not misleading,
items which do not matter need no sepa-
rate disclosure.
(2) The process of auditing aims to
arrive at a satisfactory level of assurance
regarding the fairness of presentation of
financial statements at a point in time.
Never is this assurance complete, nor is it
economical or necessary to arrive at 100%
assurance. Consequently, the limited time
which the auditor can economically devote
to obtaining this assurance must be spent
on matters of importance and substance.
This means that the auditor must always
strive to avoid spending time on trivia or
what we otherwise know as items which
are not material. This is not always simple,
since it sometimes takes a great deal of
work to find out that an item is of no
consequence.
The concept of materiality thus perme-
ates the entire field of accounting and
auditing. That people, and especially
skilled professional people, should not
spend their time on things that do not
matter is common sense not requiring
much elaboration. Nevertheless, the fol-
lowing statement is found in the introduc-
tion to the Accounting Research Bulletins:
The committee contemplates that its opinions
will have application only to items material and
significant in the relative circumstances. It con-
siders that items of little or no consequence may
be dealt with as expediency may suggest. How-
ever, freedom to deal expediently with im-
material items should not extend to a group of
items whose cumulative effect in any one financial
statement may be material and significant.2
The Securities and Exchange Commis-
sion in its accounting regulations is also
concerned with materiality. Their concern
is that of a regulatory body trying to define
the limits within which required informa-
tion is to be furnished. Thus, they are
concerned with the possibility that the
reader of financial statements will be
swamped with unimportant information
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The Accounting Review, January 1967
which may be indiscriminately commin-
gled with significant information. More-
over, they do not want to burden the filing
company and its accountant with a re-
quirement to disclose information which is
not material. The SEC's requirement is
stated in Regulation S-X:
The term "material" when used to qualify a
requirement for the furnishing of information as
to any subject, limits the information required
to those matters as to which an average prudent
investor ought reasonably to be informed before
purchasing the security registered.'
The concept of materiality, when gen-
erally expressed, is simple to understand.
However. when it is made a central con-
cept in the application of accounting prin-
ciples, a lack of specific definition converts
it into a prime problem area. Nowhere is
the impact of an application of the concept
of materiality more important than in its
effect on reported net income. This view is
supported in the following statement taken
from a recent Canadian study:
An accounting error (or a total of accounting
errors) is material if the distortion affects or
should affect the decisions of an intelligent reader
of the financial statements. Since the prime con-
cern of most readers is the earning power of the
enterprise, the most obvious type of error affect-
ing the reader is one which distorts reported net
profit. In this study, therefore, materiality will be
considered as it relates to the total of known and
unknown errors distorting the net profit figure.4
One of the outstanding weaknesses of
the Bulletin on "Income and Earned Sur-
plus" (Chapter 8 of ARB No. 43) was that
the application of its most important pro-
visions hinged in large measure on a deter-
mination of what is material and what is
not. The proposed draft opinion of the
Accounting Principles Board which is
intended to supersede Chapter 8 of ARB
2 Ibid., p. 9.
3 U. S. Securities and Exchange Commission, Regula-
tion S-X Paragraph 1.02.
" The Canadian Institute of Chartered Accountants,
Afateriality in Auditing, Study Group on Audit Tech-
niques, October 1965, p. 3.
Bernstein: Materiality
No. 43 retains a most important role for
the concept of materiality, particularly in
the area of treatment of prior-year adjust-
ments and the segregation of extraordinary
items within the income statements.5 No
pronouncement can be stronger than the
most weakly defined concept used in for-
mulating it. Clearly, as in the case of other
pronouncements, much hinges on an inter-
pretation of what is material and what is
not. In practice and even in theory there
appears to be, however, no significant
agreement on how to judge the materiality
of an item.
Lack of Guides
But what is material? The Accounting
Research Bulletins offer no concrete guid-
ance in this respect. The interpretation
that is found in much of the literature on
the subject is that this lack of guidance is
due to the fact that the assessment of
materiality is purely a matter of judgment.
From this association of materiality
with professional judgment comes the
next step-the elevation of this simple,
common-sense concept to a position of
cardinal importance in accounting prac-
tice.
A well-known writer on the subject of
materiality has expressed this as follows:
The concept of materiality is among the most
important of the basic ideas by which an auditor
is guided in reporting on his examination of
financial statements and in the formulation and
application of his audit procedures . . .0
The questions that immediately come to
mind are these: Has the importance of
materiality been overrated? Is this simple
concept really of such great importance?
Does it rank as a basic idea in accounting?
The Needfor Criteria
The need for some guides on matters of
materiality is well illustrated in a just-
published and eminently practical work
which records the replies of the AICPA's
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89
Technical Services Department to member
inquiries.7 After receiving less than full
satisfaction on a question involving ma-
teriality, the inquirer wrote, "If material-
ity is to be measured by net income, at
which point does an item become or cease
to become material? . . . Please under-
stand that this letter . . . is intended to
help us establish some guidelines for use in
the future." In answer to the follow-up
inquiry the Technical Services Depart-
ment of the AICPA closed the correspon-
dence by saying in part that "it goes with-
out saying, the question of 'materiality' is
an elusive matter." In a similar response to
a request for guidance on materiality
questions, Carman G. Blough maintained
that the Committee on Accounting Proce-
dure did not consider it feasible to set
down any general criteria on the subject.8
As revealed by Carman Blough's reply, the
alternatives available to an accountant
faced with a decision on materiality are
quite varied. First, an item must be con-
sidered in relation to not one, but a num-
ber of years of income. But presently this is
an extremely flexible concept. There seems
to be no reason why an average of five
years is better than, say, eight years, or
ten, or even fifteen. Surely the results can
be substantially, different depending on the
number of years used. Actually, the in-
come figure to be used should be represen-
tative of a recent (say five-year) earnings
level if the current earnings figure differs
markedly from such a representative level.
It should be recognized also that to the
decision-maker the most recent years are
I American Institute of Certified Public Accountants,
Exposure Draft of Opinion of Accounting Principles
Board on Reporting on Results of Operations, Septem-
ber 9, 1966.
6 E. L. Hicks, Some Comments on Materiality, The
Arthur YoungJournal, April, 1958.
7 E. F. Ingalls, Practical Accounting and Auditing
Problems (American Institute of Certified Public Ac-
countants; 1966), Vol. I, pp. 289-293.
8 Some Suggested Criteria for Determining Material-
ity, Journal of Accountancy, April 1950, pp. 353-4.
 90
far more important than those of the more
distant past.
Once the percentage relationship of an
item to net income has been determined,
further variation is possible. Some consider
10% as material enough to justify the
exclusion of an item from income while
others go as high as 20-25%. Moreover,
Mr. Blough believes that the percentages
could vary between one kind of item and
another.
The above variations are only examples,
for the suggested considerations extend to
many more variables. Thus, one winter has
suggested that consideration be given to
the effect on the analytical measurements
employed by security analysts when judg-
ing whether an item is material or not.9
Here too, the focus on one type of relation-
ship may yield results that differ from
those which result from or focus on a
different type of relationship.
The Importance of Judgment
All this suggests the existence of a seri-
ous dilemma. In a profession where objec-
tivity is a consideration of cardinal impor-
tance, materiality seems to be its "Achilles'
Heel." If materiality is really such an
important concept, and it certainly does
play a dominant role in a number of pro-
nouncements, then how is the profession to
attain any semblance of consistent or
uniform treatment in this area? How are
new entrants to the profession to be
trained? What are they to be told about
the judgment processes leading up to
materiality decisions?
We are told that the determination of
materiality is a matter of judgment. What
kind of judgment? Professional judgment,
of course, is the answer. And here it ends.
We find no definition for the term "judg-
ment" let alone a description of the pro-
cess. Definition of these is completely
lacking in the sparse literature on the
subject.
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The Accounting Review, January 1967
In few areas of accounting practice is the
term "judgment" invoked so categorically
as in the area of materiality determina-
tion. We are told that we examine all the
surrounding circumstances, and then, as if
by inserting the information at one end of
a black box, we get the results at the other
end. This "black box" seems to be, more-
over, a highly personal device, since the
output can vary significantly on what are
apparently the same or very similar sets
of facts.
Judgment is, of course, a vital part of
any professional's work. In accounting it
plays an important role every step of the
way. But that does not mean that it is a
mysterious process, undefinable and inex-
plicable. We know that the processes that
feed professional judgment are varied and
complex, yet it does not follow that we
cannot make some progress in their anal-
ysis and description.
Let us first see why the analysis and
description of judgment processes are
important and necessary. There are three
main reasons:
(1) An undefined and all-embracing
process described as "judgment" does not
inspire the confidence of thinking men.
(2) The mere assertion that a vital pro-
fessional process depends on "judgment"
is of no help in educating and training en-
trants to the profession.
(3) Such an undefined approach is con-
ducive to the kind of practice most likely
to discredit the profession.
Let us examine these propositions more
closely:
Judgment lies at the heart of any intel-
ligent activity. It is, of course, not peculiar
to accounting. In management, where it
plays a vital role, it has, in recent years,
come increasingly under study. Encourag-
ing this study was the advent of the elec-
9 D. Rappaport, "Materiality," Tke Journal of Ac-
countancy,April 1,964.
 Bernstein: Materiality
tronic computer which has displayed a re-
markable capability for simulating our
thought processes. Yet, in order to pro-
gram a computer properly the thought
and judgment process of managers had to
be analyzed and understood. This led to
an increasing dissatisfaction with the all-
inclusive descriptionof the manager'swork
as constituting "the exerciseof judgment."
This dissatisfaction was described by a
leading student of decision theory in these
words: "When we ask how executives
make non-programmeddecisions, we are
told that they 'exercise judgment and
that this judgment depends, in some un-
defined way, upon experience, insight and
intuition. "10This, Professor Simon main-
tains, is like describinga sedative as some-
thing that possesses a dormitive faculty.
We can thus see that the processes of
judgment have come under increasing
scrutiny and have resulted in computer
applications and such specialized tech-
niques as operations research, linear pro-
gramming, Pert, and others comprising
the modern spectrum of management sci-
ence. Also, in the area of security anal-
ysis the judgment processes have come
undermore detailed and systematic study.
Nearer to the field under discussion, the
auditor, in recognition of advances in re-
lated fields, has abandoned the complete
reliance on a nondescript judgment pro-
cess and has embracedstatistical sampling
techniques as well as ratio, change, and
trend analyses-techniques which requirea
more thorough analysis and description
of his work and which lend themselves to
more objective evaluation.
It is clear that those most likely to sub-
ject accounting information to intelligent
use, having embarked on a painstaking
examination of their own judgment pro-
cesses, are least likely to accept the de-
scriptionof some of the most vital process-
es leading up to the preparationof finan-
cial statements as representingthe exercise
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91
of professionaljudgment when such judg-
ment is neither defined nor explained and,
moreover, when it can lead to substantial
variations in conclusionshaving as a basis
identical or similar facts.
One major reason for the interest in the
judgment processesof managersis that the
increasing complexity of managerial de-
cision-making as well as the shortage of
managerial talent have led to a study of
judgment processes for training purposes.
The same considerationsapply to the ac-
counting profession. It is not sufficient to
say that a determination of materiality
requires the exercise of professional judg-
ment.
The profession'sfuture progressrequires
that the criteriaand processesof judgment
in accounting matters be studied, ana-
lyzed, and described.Whilethis may not be
an easy task, it is an essential one. That
does not mean that all judgment processes
can be described, that there is a full sub-
stitute for experience, or that wisdom can
be taught. However, it does mean that the
processes leading up to professional con-
clusions should be describedwhereverpos-
sible.
Without some description of the pro-
cesses of professionaljudgment, we cannot
establish the essential norms which must
guide and circumscribeit. Right now the
undefinedconcept of professionaljudgment
in accounting, and especially as it relates
to materiality, can only result in a prolif-
eration of loose standards and practices.
Since, for example, the inclusion of an
item in income or its exclusion therefrom
does make a difference,the effect of loose
practice is such that it may undermine
confidence in the profession's work. That
is especially so when, as in the area of the
treatment and presentation of extraordi-
nary items, practice as a whole shows a sub-
stantial lack of uniformity.
10 Simon, H. A., The New Science of Management
Decision (Harper & Brothers; 1960), p. 11.
92
Need for a Reasonable Degree of Uniformity
But why is uniformity necessary? This
question must be answered because the
answer is by no means self evident. More-
over, the need for more uniformity is an
important reason why the processes of the
accountant's judgment cannot be allowed
to remain obscure. The debate around the
uniformity-diversity dichotomy has been
going on for many years among account-
ants. Unfortunately, often the positions
which are under attack are characterized
in too extreme a fashion. It is obvious that
no accountant who believes in a free so-
ciety would strive for dictation of his
discipline by a book of rigid rules. No
thoughtful and experienced accountant
can believe that such a system can really
work to the benefit of society. On the
other hand, no serious believer in "diver-
sity" can possibly mean by that, that judg-
ment and practice can be cut off from any
clearly defined central concepts and stand-
ards. Those who do believe that no con-
straints should be placed on professional
judgments are not concerned with the
profession's standing or future-they are
merely convinced about the unquestion-
able quality of their own judgment and
integrity.
But surely the substance of the entire
debate lies in between these extreme posi-
tions. Greater uniformity is necessary for
two major reasons:
(1) Because it facilitates comparability.
(2) Because it acts as a regulator of
quality
Comparison is a vital analytical tool. It is
important because no decision involving
the use of accounting information can be
made in a vacuum or by the consideration
of a single variable. Thus, investment de-
cisions are made by comparing one in-
vestment with others, a decision to lend
is made by contrasting one loan applica-
tion with another, and so on. It is not
relevant in this connection to say that
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The Accounting Review, January 1967
there are many factors which make com-
parisons among companies difficult. The
accountant must do his part in facilitating
the comparison process as much as he can.
The dilemma posed by considerations
of materiality in accounting is not a simple
one. Given vague or nonexistent guides for
the application of such an important con-
cept, the result must be a wide variety of
practice in an area where a reasonable de-
gree of uniformity and comparability is
essential. Without a common frame of
reference, uniformity of practice is impos-
sible. Adherence to a set of principles and
the methods of their application will give
the user a degree of assurance about the
uniform application of minimum stand-
ards to the accountant's work.
Freedom and Discipline
The professional accountant is natu-
rally disinclined to accept constraints on
the exercise of his judgment. He feels that
having first-hand knowledge of all the cir-
cumstances of a case, he is in the best
position to decide on what is material and
what is not. That is of course true; but at
the same time he may apply to this situa-
tion criteria which are different from those
applied by his fellow professional or cri-
teria which differ from those which the
reader assumes to have been applied. The
strong influences of management's view-
point, as well as the absence of any clear
standards, make this all the more likely.
The exercise of freedom of judgment is
an important "value" in our society. It is
first of all tied to the cherished concept of
personal freedom. Moreover, in the sphere
of economics, decentralization of decision
making has great advantages in that it
keeps down the magnitude of errors made
and their effect on society.
The exercise of freedom by a professional
man in arriving at a judgment in his field
is an important consideration. If possible,
it should not be abridged. Some would
Bernstein: Materiality
lead us to believe that this is the para-
mount "value" to be considered.' How-
ever, the public confidence in and under-
standing of the auditor's work, also, are
matters of prime importance. In fact,
without them auditing cannot serve as a
profession. It is a "value" which justifies
the profession's giving up of some of its
freedom of action. A choice must therefore
be made. Complete freedom of action and
choice that are not governed by any de-
fined criteria of materiality can be obtained
only at the cost of a serious lack of uni-
formity in practice.
XVhatis material and what is not cannot
be left to the undefined realm of "judg-
ment." Good judgment must receive guid-
ance from clearly formulated standards
and limits. The debate regarding which
criteria are applied is useless if the result-
ing practice can produce a great diversity
of results under similar conditions.
Materiality Guidelines
It is therefore recommended that we
establish definite standards which, given
similar circumstances, will help account-
ants to arrive at meaningfully similar
conclusions regarding questions of ma-
teriality. Such standards must be opera-
tive in areas where quantification is not
possible. The establishment of such border
zones has proved workable in the case of
accounting policy regarding stock divi-
dends. The SEC, in areas where a decision
was made necessary by the need for clear
directives, has also clearly designated the
borderline of materiality.'2
Such a suggested border zone is not
meant to be a monument to rigidity, but
rather an area of strong presumption from
which an accountant could undertake a
departure only for compelling reasons
known to him and disclosed by him. There
cannot be a presumption that circum-
stances are so complex that an account-
ant cannot disclose them. Communication
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93
of complex economic facts is a prime func-
tion of the accountant, and an area in
which he can give full reign to the exer-
cise of his judgment and skill.
A border zone has the advantage of
meeting the arguments of those who will
always point out that 10% is not so dif-
ferent from 10.1%. It brings the border or
cut-off point closer to the level of a con-
cept and removes it from the numbers
game. It still leaves plenty of room for the
exercise of judgment.
A widely known and accepted border
zone has other great advantages. It places
the burden of proof on those who deviate
from it. Moreover, it provides the profes-
sion and the users of financial statements
with a known and explicitly stated norm.
Professional accountants can use it as a
guide and as an assurance of some degree
of consistency of practice. Users of finan-
cial statements can rely on substantial
adherence to it and can expect to be altered
to any significant deviations from it.
WVhatshould the limits of such a border
zone be? The modal area of practice re-
vealed by the empirical study mentioned
at the beginning of this article suggests a
border zone of 10%-15% of net income
after taxes as the point of distinction be-
tween what is material and what is not.
As already indicated, by net income is
meant a figure which is typical of recently
experienced (five-year average) earning
power. Such a border zone could be a
starting point to progress and is prob-
ably one on which agreement within the
accounting profession could be reached.
It must, however, be recognized that
11 For example see, D. E. Browne, "Cost of Imposing
Uniform Accounting Practices," Financial Executive,
March 1966.
12 For example, Rule 1.02 of Regulation S-X in-
dicates that a significant subsidiary (for purposes of the
regulations) is one whose assets exceed 15% of the con-
solidated assets or whose sales and revenues exceed 15%
of the consolidated sales and revenues. (One can well
imagine the practice which would result from leaving
decisions in this area solely to "judgment.")
94
while the 10%o-15% border zone may
represent the thinking of many accoun-
tants, it does not necessarily coincide with
that of many serious users of the income
statement. In discussing materiality with
regard to the treatment of "nonrecurrent
items," Graham, Dodd, and Cottle state
that "small items should be accepted as
reported. For convenience we may define
'small' as affecting the net results by less
than 10% in the aggregate."'3
According to the 1957 Statement of the
American Accounting Association, "an
item should be regarded as material if
there is reason to believe that knowledge of
it would influence the decisions of an in-
formed investor."'4 Many security anal-
ysts would probably consider items that
affect net results by as little as 5% to be
significant, and hence, material. The com-
pound annual growth rate of earnings of
a great many corporations is around 5%;
hence, an influence on net earnings as
great as the annual change due to growth
factors must generally be deemed signif-
icant. The compound annual growth rate
of all manufacturing corporations will
vary greatly depending on the period
selected. A recent study shows that during
the postwar period, 1947-1964, it was at
the rate of 2%.1" Taking the longest pe-
riod covered by the study, i.e., 1935-1964,
we arrive at a 7% annual growth rate. This
latter period starts at or near a major
cyclical bottom and includes a major war.
Another study of compound annual growth
rates of earnings of 127 large and success-
ful companies shows that for the years
1947-1963 it was 6.9%.16 Thus, a change
considerably lower than 10%-15% can be
deemed significant in many instances.
While the experience of the individual
company can be expected to vary from an
average of the aggregates, we must, in
setting the border zone between what is
material and what is not, take the average
experience into account.
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The Accounting Review, January 1967
The following examples of compound
annual growth rates in earnings per share
for the years 1953-1964 for some well-
known and well-managed corporations
point out the importance of a 5% change
in earnings:
American Telephone & Telegraph Co..... 4.8%
American Tobacco Co .............. .... 5.3%
General Motors Corp.................. 6.6%
Gulf Oil Corp......................... 6.4%
Sears Roebuck & Co................... 7.3%
The border-zone of 10-15% between
what is presumed to be material and what
is presumed not to be material is at best
a broad guideline, but its establishment
would at least be a starting point. There
are many situations where items of a much
smaller percentage impact on net income
would require disclosure because of the
intrinsic significance of the item itself.
Cases involving conflicts of interest are
examples of such instances.
Regulation S-X of the Securities and
Exchange Commission provides an ex-
ample of such low materiality criteria in
the case of loans and advances to directors,
officers, and principal holders of equity
securities other than affiliates. In Rule
5-04 it is provided that an aggregate in-
debtedness to the filing corporation, by
such parties of $20,000 or 1% of total as-
sets, whichever is less, which is owed or
was owed during the period covered by
the profit and loss statements must, with
certain exceptions, be shown in a separate
schedule. It is quite obvious that the need
to disclose such relatively small amounts
is governed by considerations which stem
from the significance of the transactions
themselves.
" Graham, D. L. Dodd, and S. Cottle, Security
Analysis (McGraw-Hill; 1962), p. 112.
14American Accounting Association Committee on
Accounting Concepts and Standards, Accounting and
Reportingfor CorporateFinancial Statementsand Preced-
ing Statements and Supplements (American Accounting
Association; 1957), p. 8.
15 Sidney Cottle, "Corporate Earnings: A Record of
Contrast and Change,"Financial Analysts Journal,
November-December, 1965.
16Edmund A. Mennis, "Perspective on 1965 Corporate
Profits," Financial Analysts Journal, March-April, 1965.
Bernstein: Materiality
When the accountant assesses material-
ity he looks backward in order to assess
relationships, but he must also look for-
ward in order to assess the probabilities
of future and of cumulative effects. Thus,
not everything is subject to quantification
and some guiding qualitative judgment
criteria affecting materiality decisions
must be spelled out. Those should lower
rather than lift the border-zone percentage
range.
It is obvious that the problem of de-
ciding on specific materiality criteria is
very difficult and complex. This article
suggests that a start must be made in the
definition of the concept of materiality
and in the establishment of more objective
criteria of measurement. There may be
another way of tackling this problem. It is
to deemphasize the importance of "ma-
teriality" and, by extending the degree of
over-all disclosure in financial statements,
make the impact of its application less
critical. The accounting profession is, how-
ever, not moving away from according
great importance to the concept of ma-
teriality. To the contrary, a recent Special
Bulletin" issued by the Council of the
American Institute of Certified Public
Accountants, which represents a milestone
in efforts to strengthen the authority of
pronouncements issued by the Accounting
Principles Board, increases the importance
of what is "material." Thus, the Special
Bulletin states:
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95
5. If an accounting principle that differs ma-
terially in its effect from one accepted in an
Opinion of the Accounting Principles Board is
applied in financial statements, the reporting
member must decide whether the principle has
substantial authoritative support and is appli-
cable in the circumstances ....
6. Departures from Opinions of the Accounting
Principles Board which have a material effect
should be disclosed in reports ....
(italics supplied)
No one should doubt the importance of
the change that was instituted with the
publication of the "Special Bulletin."
Yet, most of its practical effect will de-
pend on the leeway left in its interpreta-
tion. As in other important areas such
leeway exists in large measure due to the
undefined nature of the concept of "ma-
teriality."
The preceding discussion is made with
full cognizance of the complexities facing
the practicing accountant. This is not an
attempt to underestimate the difficulty of
defining and describing the accountant's
judgment process. But a degree of defini-
tion is essential. Similarly essential is the
setting of a border zone between what is
material and what is not. Such a border
zone will certainly not be perfect nor will
it meet all situations equally well, but
without it the concept of materiality can-
not be useful to the profession or to the
users of financial statements.
17 Special Bulletin, Disclosure of Departures from
Opinions of Accounting Principles Board, October 1964.