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Materiality in financial reporting

Materiality in financial reporting

Materiality in financial reporting

Given all the changes to financial reporting standards which people are currently dealing with, these seemingly minor tweaks to existing standards seem to have slipped by unnoticed, writes Michael Kavanagh, Director, Department of Professional Practice at KPMG.

The International Accounting Standards Board (IASB) recently refined its definition of that fundamental concept in financial reporting – materiality. These revisions to the financial reporting standards add to the 2017 practice statement issued by the IASB and concludes their deliberations on this important topic.  The IASB has stated that the amendments to the standards are not expected to “change existing requirements substantially”. However, this article explores whether that is actually the case and suggests that the changes are more significant than people may think.

Why is materiality important in financial reporting?

In my view, materiality is the most important concept in financial reporting. Its application impacts on decisions such as how an entity should recognise, measure and disclose specific transactions and information in the financial statements; whether misstatements require correction; and whether assets and liabilities or items of income or expense should be separately presented. Indeed, most definitions of the fundamental concepts of “true and fair” or “present fairly” revolve around financial information being materially correct. Where information that is required by a financial reporting standard is omitted or misstated and such information is deemed material, those financial statements cannot then be said to achieve a fair presentation or give a true and fair view.

Materiality is the most important concept in financial reporting... indeed, most definitions of the fundamental concepts of “true and fair” or “present fairly” revolve around financial information being materially correct.

So what has changed?

The refined definition of material is as follows: “Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity.” The main changes are embodied in the references to “obscuring”, “could reasonably be expected to” and “primary users”.

The definition is also now aligned across the various IFRS Standards and the Conceptual Framework. Furthermore, the amendments provide a definition and explanatory paragraphs in one place (IAS 1) and remove the definition of material omissions or misstatements from IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

 While some have felt that the IASB is merely playing with words and the IASB itself doesn’t feel that the changes are significant, some of the altered emphasis could lead to changes in practice. Let’s explore this a little further.

First, the amendment replaces the term “could influence” with “could reasonably be expected to influence”. This, in my opinion, can only be read as increasing the materiality threshold and encouraging entities not to disclose immaterial information in their financial statements.

Second, the concept of “obscuring” information has been added to the requirements against “omitting” and “misstating” information. This can only be seen as an effort to alleviate stakeholder concerns that the previous definition encouraged entities to disclose immaterial information in their financial statements, which could inadvertently obscure information relevant to users.

And third, the previous definition of material was also seen to be lacking in explaining why it is unhelpful to include immaterial information. To prevent this, the characteristics of users have also been expanded on, as it is now explained that they are the “primary users of general purpose financial statements”. Previously, the characteristics of users were not explained, which some people felt required an entity to consider all possible users when deciding on what information to disclose.

It is worth recalling who the IASB has deemed to be the primary users of general purpose financial statements. In short, they are current and potential providers of finance to the entity (i.e. present and potential investors, lenders and other creditors who use the financial statements to make decisions about buying, selling or holding equity or debt instruments, providing or settling loans or other forms of credit, or exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources).

Up to 2010, the definition of users of financial reports was much wider than that and explicitly included suppliers, customers, government and the public. The practical result was that the materiality threshold was much lower at that time, given that information could be deemed to affect the decision-making of a wider user group.

Practice statement: making materiality judgements

The changes outlined above build on the 2017 practice statement, Making Materiality Judgements, issued by the IASB. As well as offering comprehensive guidance on various principles, the statement outlined a four-step process for entities to follow when making materiality judgements. 

Step 1

The entity identifies information that has the potential to be material. In doing so, it considers the IFRS requirements applicable to its transactions, other events and conditions, and its primary users’ common information needs.

Step 2

The entity then assesses whether the information identified in step one is material. In making this assessment, the entity needs to consider quantitative (size) and qualitative (nature) factors. The practice statement notes that the presence of a qualitative factor lowers the thresholds for the quantitative assessment (i.e. the more significant the qualitative factors, the lower those quantitative thresholds will be).

Step 3

The entity organises the information within the draft financial statements in a manner that supports clear and concise communication and the statement provides guidance on this.

Step 4

In this, the most important step, the entity steps back to assess the information provided in the draft financial statements as a whole. It needs to consider whether the information is material, both individually and in combination with other information. This final assessment may lead to the introduction of additional information or the removal of information that is now considered immaterial; aggregating, disaggregating or reorganising information; or even beginning the process again from step two.

Evolution of the materiality concept

The current iteration of the materiality concept is part of an ever-evolving process in which I have had the dubious honour of being centrally involved. As the then Head of IAASA’s Financial Reporting Supervision Unit, I was responsible for the production of a paper in 2010 entitled IAASA’s Observations on Materiality in Financial Reporting. That paper outlined IAASA’s interaction with issuers at that time as well as specific recommendations as to how companies should be dealing with, and applying, the concept of materiality in their financial reports.

Resulting from this IAASA paper, I was asked to chair a group on materiality established by the European Securities and Markets Authority (ESMA). The main output from that group was the hosting of a roundtable with key European stakeholders, the issuance of an ESMA consultation paper entitled Considerations of Materiality in Financial Reporting followed by a feedback statement which provided an overview of the key messages from the responses received.

I subsequently engaged with the IASB, which ultimately led to the issue of the IASB practice statement, Making Materiality Judgements, in 2017. The present revision to the standards is the conclusion of this journey and both the practice statement and revised standards will have effect in over 120 countries globally. The amendments to the standards, once endorsed by the European Union (EU), will be effective for annual reporting periods beginning on or after 1 January 2020, but earlier application is permitted.

Conclusion

The application of the concept of materiality is of critical importance in the context of the preparation of financial statements. It needs to be clearly understood so that preparers can apply it appropriately and users are provided with useful information in the financial statements. The revised definition and accompanying practice statement should go some way to meeting this objective.

This article originally appeared in the February 2019 edition of Accountancy Ireland and is reproduced here with their kind permission.