Posted by & filed under Debt, Derivatives, Equity-Linked Transactions.

One of the interesting side benefits of using Google Analytics on this web site is that I can see the search terms people are using to find the site. When I see a common theme often enough, I write a post to address the search term directly. Today’s topic is derivatives and materiality.

When I think about materiality I do so from both a qualitative and quantitative perspective. In most cases, the quantitative approach is sufficient since there is generally not a lot of sensitivity around the ‘what’ it is. It’s mostly about ‘how much’ it is. So materiality becomes primarily a percentage of total assets, net assets (i.e., equity), revenue, net income/loss, or whatever the most appropriate measure is in the circumstances. The qualitative aspect is less relevant in these instances and usually enters when the item in question takes a reporting entity over a threshold…from profit to loss, for example.

Some issues, on the other hand, are material from a qualitative perspective without regard to the amount. Derivatives instruments fall into this category. People rarely understand them and even more rarely understand the accounting rules around them. For many of these people, that a reporting entity even has them is a material issue. That is enough to warrant recognition, even if the amount is otherwise immaterial to the financial statements. And, with recognition comes disclosure which accomplishes two objectives: 1) transparency…we, the reporting entity, think it is immaterial quantitatively, but we think you may find it important qualitatively, so here it is, and 2) CYA…derivatives have a way of becoming material quantitatively since they are by definition tied to an outside observable measurement or event that the reporting entity does not control. Both are good reasons to disclose.

I think embedded derivatives are a little tougher to handle. First of all, the entire concept of an embedded derivative is foreign to most users of financial statements…and to many accountants for that matter. Secondly, some provisions in contracts that rise to the level of ’embedded derivative’ are just plain silly. Take the case of an interest rate increase in a debt agreement due to an event of default. If the triggering event is beyond the company’s control, then the provision is likely an embedded derivative. The most common version of this I see is the failure to deliver audited financial statements on time, or at all. The issuance of the auditors’ opinion is not controlled by the company…so it’s an embedded derivative. Try explaining this one to even the most sophisticated investor. The universal response is, “You accountants have lost touch with reality”, or something a bit more crass.¬†From a qualitative perspective, disclosure of quantitatively immaterial embedded derivatives can actually be detrimental to the usefulness of financial statements.

In the end, these are your financial statements and you need to ask yourself that toughest of questions, “Does it matter to the user?” As accountants, we like to rely on math to answer that question. Derivatives, and embedded derivatives, are a special case where math is not enough.

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