Acuity Advisors

Financial statement disclosures: A closer look at materiality

Shakespeare thinking.

The concept of “materiality” helps management identify what’s important enough to a company’s financial well-being to warrant additional disclosures in the financial statements. Unfortunately, the FASB doesn’t currently define what information should be considered “material” under Generally Accepted Accounting Principles.

Investors don’t generally view materiality in terms of rule-of-thumb percentages. Instead, they see it as a qualitative, legal concept. The U.S. Supreme Court’s description of materiality is a “substantial likelihood” that omitting the information would be viewed by a reasonable investor or creditor as having “significantly altered” the total information available to make a decision.

Proposals attempt clarity

In late 2015, the FASB released two related proposals to guide businesses on when to include information in a footnote disclosure and when to omit it. Under the proposals, businesses would be required to assess whether investors will find the information useful and whether the information fits the legal concept of materiality.

Concerns mount

Many businesses are concerned that the Supreme Court’s definition of materiality could evolve over time — and potentially morph into something that’s overly prescriptive or otherwise undesirable from a financial reporting perspective. So, the FASB is considering omitting any specific references to the Court’s definition.

To further complicate matters, if the FASB adopts these proposals, its definition of materiality could differ somewhat from the definition set forth by the International Accounting Standards Board.

Materiality is a gray area

The proposed changes to the materiality framework are designed to help facilitate management’s decision-making process. They aim to eliminate unhelpful, boilerplate information in the footnotes that makes it harder for investors to get at important facts.

During a March 2016 meeting, the FASB reviewed comments letters on its proposals. Now the project is back in the re-deliberation phase. Contact us for the latest information about this fundamental financial reporting concept.

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Demystifying the percentage-of-completion method

Businessman depressed

Long-term projects usually require a different approach to recognizing revenues called the “percentage-of-completion” method. It’s used by homebuilders, developers, creative agencies, engineering firms and many other types of companies. Here’s how it works.

Dueling methods

Contracts that last for more than one calendar year can be reported two ways:

The completed contract method. It records revenues and expenses upon completion of the contract terms.
The percentage-of-completion method. It ties revenue recognition to the incurrence of job costs.

GAAP generally prescribes the latter method, as long as you can make estimates that are “sufficiently dependable.” Most companies with long-term contracts also must use this method for federal income tax purposes. (An exception is permitted for companies with less than $10 million in annual revenues.)

Project status

Companies typically compare the actual costs incurred to expected total costs to estimate percentage complete. Alternatively, some may opt to estimate the percentage complete with an annual completion factor. To support this technique, the IRS requires detailed documentation.

Balance sheet effect

The percentage-of-completion method can also impact your balance sheet. Suppose you’re working on a $1 million, two-year project. You incur half of the expected costs in Year 1 ($400,000) and bill the customer $450,000. From a cash perspective, it seems like you’re $50,000 ahead because you’ve collected more than the costs you’ve incurred. But, you’ve actually underbilled based on the percentage of costs incurred.

So, at the end of Year 1, you’d report $500,000 in revenues, $400,000 in costs, and an asset for costs in excess of billings of $50,000. If you had billed the customer $550,000, however, you’d report a $50,000 liability for billings in excess of costs.

Confounding factors

This method necessitates subjective estimates about expected costs. It’s further complicated by job cost allocation policies, change orders, changes in estimates, and differences between book and tax accounting methods. Contact us for help training your staff on how this method works — or we can perform the analysis for you.

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Unexpected retirement plan disqualification can trigger serious tax problems

It’s not unusual for the IRS to conduct audits of qualified employee benefit plans, including 401(k)s. Plan sponsors are expected to stay in compliance with numerous, frequently changing federal laws and regulations.

For example, have you identified all employees eligible for your 401(k) plan and given them the opportunity to make deferral elections? Are employee contributions limited to the amounts allowed under tax law for the calendar year? Does your 401(k) plan pass nondiscrimination tests? Traditional 401(k) plans must be regularly tested to ensure that the contributions don’t discriminate in favor of highly compensated employees.

If the IRS uncovers compliance errors and the plan sponsor doesn’t fix them, the plan could be disqualified.

What happens if qualified status is lost?

Tax law and administrative details that may seem trivial or irrelevant may actually be critical to maintaining a plan’s qualified status. If a plan loses its tax-exempt status, each participant is taxed on the value of his or her vested benefits as of the disqualification date. That can result in large (and completely unexpected) tax liabilities for participants.

In addition, contributions and earnings that occur after the disqualification date aren’t tax-free. They must be included in participants’ taxable incomes. The employer’s tax deductions for plan contributions are also at risk. There are also penalties and fees that can be devastating to a business.

Finally, withdrawals made after the disqualification date cannot be rolled over into other tax-favored retirement plans or accounts (such as IRAs).

Voluntary corrections

The good news is that 401(k) plan errors can often be voluntarily corrected. We can help determine if changes should be made to your company’s qualified plan to achieve and maintain compliance. Contact us for more information.

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