How should the concept of materiality be applied?
On 28 October last year, the IASB published a draft Practice Statement on the application of materiality to financial statements. The public consultation on the draft is open until 26 February 2016.
Keywords: Mazars, Thailand, IFRS, Materiality, GAAP, IASB, ESMA, QC11, IAS1
2 February 2016
The document is the result of numerous appeals to the IASB to address this subject, including one from ESMA. The European market authority carried out its own public consultation in 2011, as national enforcers had noted differences in practice between companies, auditors, users of financial statements and market regulators.
The Practice Statement falls within the context of the IASB’s broader Disclosure Initiative. The Board notes that amendments to the Practice Statement may be necessary following completion of the Disclosure Initiative, as relevant issues may be addressed in that project.
The current document is not a draft standard. The term ‘Practice Statement’ has been used to emphasise the pervasiveness of materiality (see point 1, below) and in particular to avoid conflicts with legal requirements on materiality that may exist in some jurisdictions.
IFRS do not generally prohibit entities from providing further information in addition to that required under IFRS in order to meet stricter local legal requirements. If a jurisdiction does not have existing legal requirements, it may decide to adopt the Practice Statement into its national framework.
Readers may remember that the IASB’s guidance on management commentaries was also published in the form of a Practice Statement, in 2010.
The IASB’s objectives for the Practice Statement are as follows:
- To provide guidance on:
- the characteristics of materiality;
- how to apply this concept when presenting information in the financial statements and the notes;
- how to assess whether omissions and misstatements are material to the financial statements.
- To illustrate the types of factors that should be taken into account when assessing whether information is material.
Definition of materiality under IFRS
Materiality is defined in the current Conceptual Framework (QC11) and in IAS 1 – Presentation of Financial Statements (IAS 1.7) as follows:
“Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.”
Thus, the exposure draft explains that applying the concept of materiality should:
- Ensure that material information is presented separately in the primary financial statements and/or in the notes to the financial statements;
- Act as a filter to ensure that the financial statements are an understandable and effective summary of the information that the entity holds in its internal records.
The key aspects of materiality are then explained in the four substantive chapters of the document, which we will address below:
- General characteristics of materiality
- Presentation and disclosure in the financial statements
- Recognition and measurement
- Omissions and misstatements.
1. General characteristics of materiality
The exposure draft identifies five general characteristics of materiality.
First of all, the concept of materiality is pervasive, as it applies to the complete set of primary financial statements, as well as the notes to the financial statements. This was noted in the December 2014 amendments to IAS 1.
Use of judgement
The second characteristic is that the assessment of materiality requires judgement. When applying judgement, management should consider the entity’s specific circumstances and environment, while also bearing in mind how the information will be used by the users of financial statements. The situation should be re-assessed at each year-end.
Users should be taken into account
The exposure draft devotes quite a lot of space to the third aspect of materiality, which relates to the users of financial statements and the decisions they will make.
As stated in IAS 1, the users of financial statements “are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence”. Thus, the users to be taken into account are deemed to be typical and rational users, representative of a broad range of users. Management is not required to meet the specific needs of a particular user that would have little or no relevance to other users.
In order to determine what information is material to the users of financial statements, it is first necessary to identify their needs. The IASB notes that these considerations are already taken into account when developing standards, particularly in the requirements for presentation and disclosure. Thus, the requirements set out in IFRS provide an appropriate basis for management to carry out this assessment. Entities may also take into account questions raised by users on the publication of financial statements, the practices of other entities in the same market segment, and market responses to information issued by the entity.
Finally, the exposure draft reminds readers that, as stated in the Conceptual Framework, information is useful if it has predictive value and/or confirmatory value.
Moreover, if information is material, then the cost of providing it should not be a factor in the decision on whether to provide the information.
Qualitative and quantitative assessment
The fourth characteristic of materiality is that it should be assessed both qualitatively and quantitatively. Quantitative thresholds used by the entity may be useful tools, but they are not sufficient. The assessment should take into account both the size and the nature of an item, event or circumstance, the uncertainties and contingencies to which the entity is exposed, and the sensitivity of particular assumptions. The IASB also notes that it cannot set quantitative thresholds, as it cannot predict what will be material in a particular situation. When assessing whether information is material, entities should thus consider other disclosure requirements (in particular, information required by the market regulator), their business plan and the economic environment.
It should be noted that the AMF’s Guide to the Relevance, Consistency and Readability of Financial Statements recommends a similar approach.
Individual and collective assessment
The final characteristic is that materiality should be assessed both individually and collectively. This section notes that even if information is not material in isolation, it may be material when aggregated with other immaterial information.
An example of this is multiple acquisitions of relatively small businesses, which become material when taken collectively. This could be in terms of revenue, profits, debt levels or the structure of the group.
Key points to remember
The assessment of materiality:
- Applies to the complete set of financial statements, including the notes;
- Requires judgement;
- Should consider the users of the financial statements and their needs;
- Involves both quantitative and qualitative factors; and
- Should be carried out on both an individual and a collective basis.
2. Presentation and disclosure in the financial statements
The assessment of materiality needs to be carried out within the context of the objectives of financial statements, which are to provide information on the entity’s financial position, financial performance and cash flows that is useful to a broad range of users in making economic decisions.
Thus, the assessment of materiality allows management to determine not only whether or not information should be included in the annual or interim financial statements (even if this information is specifically required by an IFRS), but also where it should be presented, and if it needs to be presented separately.
After carrying out this assessment, the entity should review its conclusions by looking at the complete set of financial statements, to see whether any changes are needed in order to make the information clearer or more prominent.
When deciding whether to present the information in the primary financial statements or the notes, management should consider the objectives of the various financial statements. The main objective of the notes is to supplement and explain the information contained in the primary financial statements. However, another objective of the notes is to present information that is necessary to meet the general objectives of financial statements, but that is not included in the primary financial statements (e.g. contingent liabilities).
The notes may also present information that is not required under IFRS but that may influence decisions made by the users of financial statements.
As regards immaterial information, the exposure draft restates the fact that entities are not prohibited from publishing such information; however, they should ensure that material information is not lost in a sea of immaterial information. However, in some cases it may be relevant to state that a particular item is not material. Here, the IASB borrows a favourite example from the AMF: it may be useful to state that the entity does not hold securities of issuers that are in dire economic straits.
Regarding aggregation, the exposure draft quotes a few paragraphs of IAS 1, drawing attention to the following principles:
- A line item that is not sufficiently material to warrant separate presentation in the financial statements does not need to be presented separately even if required under IFRS; however, it may warrant separate presentation in the notes;
- Items presented in the primary financial statements only require disaggregation in the notes if information about their components is material.
As well as considering the nature of the components and their amounts (relative to the individual line item, the sub-totals and total), the entity should also take into account the extent to which the components are similar when deciding whether they should disaggregate them.
For example, if a line item in the statement of financial position comprises a large number of similar contracts, none of which are individually material, this line item would not require disaggregation in the notes. In contrast, if one of a number of exchange losses is material, as it occurred within the context of an atypical transaction, the entity may need to present a specific disclosure on this exchange loss.
The exposure draft states that disclosures in the notes should be reviewed at each year-end, to check whether information provided previously is still relevant. In some cases a summarised version may suffice, while in others the information could be removed altogether.
The IASB notes that users of financial statements also use other information sources. However, the exposure draft emphasises that the existence of other sources does not relieve the entity of its obligation to present material information required by IFRS in its financial statements.
Key points to remember
Entities should base their assessment of materiality on the objectives of the financial statements as a whole and those of each statement. This will enable them to determine:
- Whether or not information should be included (irrespective of whether it is required under IFRS);
- Whether it should be presented in the primary financial statements and/or the notes;
- The appropriate level of aggregation for various items of information, in both the primary financial statements and the notes.
The complete set of financial statements should be reviewed at the end of the process to check that information is presented and disclosed appropriately. Disclosures in the notes should be reviewed at each year-end.
3. Recognition and measurement
This short chapter reminds readers that materiality is not only relevant to presentation and disclosure, but also to the recognition and measurement of items presented in the financial statements.
The exposure draft includes a reminder of the principle set out in IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors, which stipulates that financial statements that include deliberate errors, even if they are immaterial, are not compliant with IFRS. However, an entity may still use practical expedients.
One such expedient would be a relatively low quantitative threshold, below which items would be recognised as expenses rather than capitalised as assets. However, such practices should be reviewed regularly to check that their overall impact is still immaterial.
Key points to remember
Entities are permitted to use practical expedients for recognition and measurement as long as their overall impact is not material.
4. Omissions and misstatements
The exposure draft uses the broad term “misstatements” to include:
- omissions, i.e. exclusion of relevant data or information;
- errors, arising from a failure to use, or misuse of, reliable information that was available or that could reasonably have been obtained and taken into account (including arithmetical mistakes, mistakes in applying accounting policies, oversights, misinterpretations of facts, or fraud);
- other misstatements, such as ambiguous descriptions of information, or obscuring material information.
Management should assess whether or not misstatements are material, as follows:
- initially on an individual basis, then collectively. If a misstatement is material individually, it may not be offset by other misstatements;
- with relation to the individual line item(s), sub-totals and totals in the financial statements;
- taking into account the precision of the measure (e.g. cash flows compared with Level 3 fair value estimates).
If possible, current period misstatements and prior period errors should be corrected, even if they are immaterial, as required by IAS 8. If the misstatements and errors are deliberate and are intended to mislead the users of financial statements, they are considered to be material even if they only relate to small amounts. In this situation, the financial statements do not comply with IFRS.
Key points to remember
A misstatement is material when it is deliberately intended to influence the decisions made by the users of the financial statements.
Misstatements (as opposed to practical expedients – see point 3) should be corrected if possible, whether or not they are material.
The points covered in this ‘Practice Statement’ do indeed simply restate current practice: in other words, there is nothing really new. However, this draft document is still useful, in that it combines points from different standards into a single document, and provides illustrative examples.
The consultation responses and subsequent practice will show whether it is possible for all the stakeholders in the financial reporting chain to agree on what information is ‘material’, and thus move away from the checklist approach which has been criticised from all sides.