Punitive damages are a penalty or fine levied against a company to punish the company and deter further wrongdoing, without adversely affecting the company's ability to continue in business. To determine the appropriate punitive damage amount, Bruce L. Ross & Company uses the accounting concept of materiality. Materiality is a concept that has been utilized by the accounting profession for many years. Materiality is defined as "the magnitude of an omission or misstatement of accounting information that . . . makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement." 1 One use of materiality is to determine what amount of money is required to necessitate a change in the financial statements of a company. As an example, if an auditor finds an immaterial error in the company's books, no change to the financial statements is required, because the financials are still fairly stated even though they include the error. If, on the other hand, the error is material, then it is brought to management's attention so a proper adjustment can be made to the company's financial statement. We conclude that an appropriate punitive damage amount is the minimum level of materiality, i.e., the minimum amount necessary to have the penalty brought to the attention of company management, and ultimately the shareholders or owners. Since we choose the minimum amount of materiality, there is no long-term adverse effect on the company as a whole.
Most commonly, materiality judgments are based on Total Revenue, Total Assets, Net Worth and Income Before Taxes. 2 We apply guideline factors to determine a minimum material amount for each of these areas. Although the minimum level of materiality is typically derived from the most recent financial information available, we perform the analysis for several years to look for trends and to avoid an anomalous result.
The definitive base for calculating punitive damages is the larger of Total Revenues or Total Assets. The guideline factors are then applied to the definitive base to determine what amount is material. As a confirming check, the guideline factors are also applied to the remaining bases.
Up to this point the analysis has been totally objective, relying on calculations and guidelines contained in the accounting literature. The next step is subjective. We first look at the material amount calculated from the definitive base and compare it to the material amounts calculated using the other bases. We then conservatively adjust the material amount from the definitive base to reflect any changes, trends or unusual occurrences revealed from a complete review of the financial statements and the materiality calculations from the non-definitive bases (Net Worth, Income Before Taxes and Total Revenue or Total Assets). The final punitive damage amount is then determined.
- Financial Accounting Standards Board Statement of Financial Accounting Concepts Number 2.
- Auditing Standards and Procedures Manual 1990.