Materiality is a GAAP (generally accepted accounting principles) principle. Material events or information are any events or facts that would affect the judgment of an informed investor. Material events should be publicly disclosed along with the corresponding financial statements. Also, if an accounting method or assumption is changed and the change has a material impact, the change must be disclosed along with the financial effects of the change.
As our example, let’s assume a public parent company owns a software company. The software company sells its software along with maintenance-and-upgrade contracts extending over a period of five years. So it has to make a judgment about when to recognize revenue from a sale. This quarter, unfortunately, it looks as if the parent company is going to miss its earnings per share estimate by one penny. If it does, Wall Street will not be happy.
So, the accountants in the parent company might think the following. Here is this software division. Suppose we change how its revenue is recognized? Suppose we recognize 75 percent up front instead of 50 percent? The logic might be that a sale in this business takes a lot of initial work, so they should recognize the cost and effort of making the sale as well as the cost of providing the product and delivering the service. Make the change—recognize the extra revenue—and suddenly earnings per share are nudged up to where Wall Street expects them to be.
The change is not illegal. An explanation might appear in a footnote to the financial statements, since any accounting change that is “material” to the bottom line should be footnoted in the notes to the financial statements.
(Excerpts from Financial Intelligence, Chapter 7 – Revenue)
Who decides what is material and what isn’t? You guessed it: the accountants. In fact, it could very well be that recognizing 75 percent up front (of sales revenues, rather than 50 percent) presents a more accurate picture of reality. But was the change in accounting method due to good financial analysis, or did it reflect the need to make the earnings forecast? Could there be a bias lurking in here? Remember, accounting is the art of using limited data to come as close as possible to an accurate description of how well a company is performing. Revenue on the income statement is an estimate, a best guess. This example shows how estimates can introduce bias.