1 Unit
CPD technical article
Adam Deller explains the need for judgment in assessing materiality in an entity's financial statements
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This article was first published in the November/December 2017 international edition of Accounting and Business magazine.
In September, the International Accounting Standards Board (IASB) issued a practice statement on making materiality judgments. The statement is intended as guidance that helps preparers rather than a standard that has to be applied to demonstrate compliance with IFRS Standards.
The IASB has also released an exposure draft that proposes minor amendments to the definition of ‘material’. The definition of material information, currently included in the Conceptual Framework for Financial Reporting, is as follows: information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity.
The exposure draft proposes the following minor amendment: information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of a specific reporting entity’s general purpose financial statements make on the basis of those financial statements.
One of the key elements to this change is the introduction of the term ‘primary users’ rather than the existing definition’s ‘users’.
In the practice statement, the IASB explains who it means by primary users: existing and potential investors, lenders and other creditors – in other words, users who cannot require entities to provide information directly to them and so must rely on financial statements for much of their information.
Information needs
The financial statements cannot conceivably provide all the information that primary users need, and an entity should aim to meet the common information needs of its primary users. Thus, in applying its materiality judgments, an exemplar entity called Grimtown FC (see box on the next page) would not need to consider the specific information needs of a single investor (Example 1 in the box), and could rightly conclude that a particular item of information is immaterial for its primary users as a group. It would therefore not need to furnish this information in its financial statements.
When assessing whether information is material to the financial statements, an entity’s decision should not be affected by that information being available from other sources (see Example 2 in the box). The public availability of information does not relieve an entity of the obligation to provide material information in its financial statements.
An entity may also consider the requirements of local laws and regulations in its materiality judgments. It can provide more information than required by IFRS Standards, as long as that does not obscure items deemed material by IFRS Standards. An entity may not provide less information than required under IFRS Standards, even if local regulation allows it.
The IASB’s practice statement also presents the following four steps that an entity may follow in making materiality judgments when preparing financial statements. We will look at each step using the Grimtown FC examples cited.
Step 1: Identify
Identify information that could be material. The entity should also consider the common information needs of its primary users. In our example, Grimtown will have identified a set of potentially material information.
Step 2: Assess
Assess whether the information identified in step 1 is in fact material. This assessment involves quantitative and qualitative considerations.
Quantitative factors include the size of the impact on the transaction or event, as well as the size of any unrecognised items, such as contingent assets or liabilities. There could also be factors that do not have a significant size impact on the financial statements, but might have an impact on similar entities in the industry (see Example 3).
Qualitative factors are those that make information more likely to influence the decisions of the primary users. These can include transactions with related parties, uncommon transactions or unexpected variations in trends.
While there is no hierarchy among materiality factors, it may be efficient to consider an item from a quantitative perspective before assessing the presence of qualitative factors.
In highlighting these issues, the IASB is reinforcing the idea that judgment is required in the assessment of materiality. Items such as Example 5 also reassert the IASB’s position that IFRS Standards requirements need only be applied if their effect is material in the complete set of financial statements. The output of step 2 is a preliminary set of material information.
Step 3: Organise
Organise the information identified as material in a way that communicates clearly and concisely to primary users. The output of step 3 is the draft financial statements.
Step 4: Review
Review the draft financial statements to determine if all material information has been identified. An entity needs to assess whether information is material both individually and in combination with other information in the context of its financial statements as a whole. This review gives the entity the opportunity to step back and consider the information from a wider perspective and in aggregate. The output of step 4 is the final financial statements.
In producing this practice statement and an exposure draft on the definition of materiality, the IASB has attempted to clarify the need for judgment in conjunction with the specific requirements of individual IFRS Standards. It reinforces the current focus of the IASB to look at disclosures within the financial statements as much as looking at specific accounting standards.
Comments on the exposure draft on the definition of materiality must be submitted by January 2018.
Adam Deller is a financial reporting specialist and lecturer
1 Unit
CPD technical article
"The IASB is reinforcing the idea that judgment is required in the assessment of materiality"