by Joelle Moughanni, Technical Consultant, RSM - taken from RSM Reporting - Issue 27.
The International Accounting Standards Board (IASB) recently issued a Draft Practice Statement proposing (non-mandatory) guidance to help management use judgement when applying the concept of materiality in order to make financial reports, prepared in accordance with IFRS. more meaningful(1). As set out in the previous issue of this publication(2), inappropriate application of the concept of materiality is often pointed at as a key contributor to excessive disclosure of immaterial information that can obscure useful information and make financial statements cluttered and less understandable. It can also lead to useful information being left out.
Materiality plays a key role when preparing IFRS financial statements, as it impacts which information is considered relevant – in particular, from the users’ point of view – and should therefore be presented in the financial statements. However, the application of the concept of materiality requires significant judgement, which is inherently subjective.
There is a widely acknowledged uncertainty about how the concept of materiality should be applied, resulting in a somewhat overly cautious approach to disclosure, preparers being reluctant to ‘filter out’ information which is not relevant and auditors and regulators being reluctant to accept omissions. Also, the drafting of some Standards could be read to suggest the specific requirements of those Standards override the general statement in IAS 1 Presentation of Financial Statements that an entity need not provide information that is not material.
This article, in five simple Q&As, aims at reflecting on the factors that might be helpful in applying materiality to IFRS financial statements, in particular to the explanatory notes in such reports.
1. What is materiality and why is it difficult to apply the concept?
On average, financial reports are not as concise and/or as useful as they could be, for many reasons. For example: information is sometimes repeated within a report rather than incorporated by cross reference; regulatory and financial reporting requirements sometimes overlap; some IFRS Standards use prescriptive and inflexible language; preparers might think that auditors and regulators feel more reassured by including information than by filtering out immaterial information; the consequences of over disclosing are perceived as being better than under disclosing; the concept of materiality can be difficult to apply to information that supports the primary financial statements etc.
Something is material to a person if it influences the decisions they make. In the case of financial reporting, the issue is the influence that a particular piece of information would have on a decision being made, when included or omitted from the financial statements.
IFRS gives the following definition of materiality: ‘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.’
In other words, 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. Most importantly, materiality is an entity-specific aspect of relevance based on the nature and/or magnitude of the items to which the information relates in the context of an entity’s financial report.
The concept of materiality acts as a filter, helping management to ensure that financial statements include all material information (i.e. the financial information that could influence users’ investment decisions) and exclude information that is not material, in order to present material information in a clear and effective manner.
Whether information is material is a matter of judgement based on a range of factors and entity-specific circumstances. Currently, there is a lack of guidance to help management understand how to apply the concept of materiality when preparing financial statements, and in particular, in the notes.
Exercising that judgement requires that preparers of financial statements (preparers) understand the characteristics of the primary users of the financial statements (users) and the decisions they make, and the information that is relevant to particular types of activities of the business.
The different characteristics of materiality need to be considered when applying it: the pervasiveness of the concept in IFRS; the importance of management’s use of judgement; who the primary users of the financial statements are and what decisions they make based on those financial statements; the need for a quantitative and qualitative assessment when applying the concept; and the need to assess whether information is material both individually and collectively.
In plain language, applying materiality involves assessing the likelihood that including or excluding information, or changing how it is presented, will affect the decisions being made by the users, which sometimes proves not to be a straightforward task.
2. How do you identify who the primary users of the entity’s financial statements are, and the information those users need to find in the financial statements?
The definition of materiality focuses on the users of the financial statements, and the need for preparers to decide what information will be important to their users. General purpose financial reports are intended to help a broad range of users, including investors (existing and potential), lenders, creditors, employees, regulators, tax authorities, etc. It is essential that management know the main characteristics of their primary users, including whether those users include any groups with particular interests, and the types of decisions they are making. Users are assumed to be well informed, have a reasonable knowledge of business and economic activities and review and analyse the information diligently, although sometimes with the help of an adviser.
Management should also know what type of information their primary users want, and expect, to be included in the financial report. Meeting users’ needs requires management to identify the information that is likely to be relevant to those users and, from this information set, work out what is material to them (i.e. what to include or exclude), and to present the information in a meaningful way that emphasises those matters that are likely to be of most interest to the users.
Understanding what the primary user groups of a particular entity consider to be important is an essential element of applying materiality. The mix of users might reflect some different preferences, i.e. some information might be material to some primary users but not to others.
Investors, lenders and other creditors are likely to want information to help them make decisions related to providing resources to the entity. Those decisions include whether to buy, sell or hold equity and debt instruments, whether to provide or settle loans and other forms of credit, and voting as equity holders. Some shareholders could be more interested in corporate governance information, because their main decisions might relate to exercising their voting rights, rather than making buy, hold or sell decisions. Accordingly, some information such as director remuneration might be material to how they will vote on that matter but not material to an assessment of the value of the entity.
Hence, a business could have different types of primary users with a range of different interests. Management need to use their judgement as to whether the mix of current and potential investors and creditors means that they should provide more information to a particular type of primary user.
There are various ways to identify the types of decisions and information likely to be important to the primary users of an entity, including: analyst reports, listening to what key stakeholders have said is important to them, questions from shareholder meetings and investor calls, review of the information included in financial reports of others in the same industry, etc.
3. What factors should be considered in deciding whether information is material?
Whether information is material or not is a matter of judgement, and depends on a range of factors including entity-specific circumstances:
- Type of information (qualitative factors) and the amounts involved (quantitative factors) – Qualitative characteristics relate to the quality or nature of the matter being assessed, rather than the amounts involved. The nature of the activity or item informs preparers as to whether they should assign a higher or lower threshold in terms of the amounts involved. While information about individual ordinary/basic activities is likely to be of less interest to the users, those users are likely to be interested in knowing about remuneration of key personnel, related parties, one-off transactions and less usual matters, even if the amounts are smaller.
- Entity’s environment – Preparers need to be sensitive to how materiality is defined and applied in a particular jurisdiction (e.g. if an entity is filing its IFRS financial statements in the USA). Local enforcement and laws can help preparers identify information needs that are particularly important to the primary users in that jurisdiction. Some information will be of interest to some users even though the amounts involved are small.
- Unusual information – Entities need to have a system in place to ensure that they identify information that is unusual or sensitive and might therefore need to be disclosed. IAS 1 gives examples of circumstances that could warrant the separate disclosure of items of income and expense, because they are ‘unusual’, such as write downs or reversals of write downs, the effect of restructurings, disposals of items of property, plant and equipment or investments, discontinued operations, litigation settlements, reversals of provisions, etc.
- Trends – Entities also need to be aware of the trends affecting their business that could make smaller amounts more sensitive to their primary users. Focusing on information that is specific to the entity and its business can help filter out generic disclosures and reduce clutter. For example, the accounting policy information presented in the financial statements should focus on how the policies are relevant to the business and how management applies them.
- Hot topics – There might also be some hot topics that increase the materiality profile of particular issues, such as exposure to a particular sector or economy (e.g. the global financial crisis), and sometimes securities or banking regulators highlight such matters. In such cases, disclosing the fact that the entity does not have any exposure to a particular sector or risk could itself be material (i.e. a nil balance can be material by nature).
Management need to think about whether all the following could be material to their users: relationships (information about related parties, key management personnel, key suppliers or customers), circumstances of the entity (e.g. a major business combination during the year), nature of the entity (e.g. banks would be expected to include more disclosure around financial risks), trends in the industry or market, adequacy (i.e. whether more information is required to enable users to understand how judgements or estimates were made, or to understand a complex scenario).
Also, materiality assessments should not be made in isolation. For example, an item might not appear to be material now in terms of the amounts involved in the current period, but it could be clear that it will affect the long-term strategy of the entity or its ability to create value.
4. How can the amount of immaterial information in the financial statements be reduced, ensuring that material information is not obscured?
The fact that the IASB’s current definition of materiality focuses on omissions and misstatements has often been interpreted as implying that materiality is only about making sure that information is not omitted. In practice, many preparers tend to err on the side of caution and leave information in the financial statements because the consequences of omitting information are perceived as being greater than including it. Although Standards are an important source for identifying information that might need to be disclosed, there is no requirement to disclose every item specified in an IFRS.(3)
Materiality assessment also involves making sure that information that is important to the users is not obscured by immaterial information, thus undermining the usefulness of the financial statements.
However, it is also not appropriate to assume that only disclosing items specified in an IFRS is sufficient. One needs to step back and ensure that the information provides a faithful and balanced summary of a particular matter, such that information beyond the items specified by an IFRS might be necessary to give a more faithful and complete picture.
5. How is presentation (e.g. aggregation/disaggregation) of information influenced by materiality (and vice versa)?
The way information is presented is part of the materiality assessment, because presentation can affect the information’s usefulness and perception by the users. In other words, presentation matters if it can influence or affect the decisions taken by the primary users. It is not sufficient to argue that the information is included in the financial statements if it is difficult to find. Nor is it appropriate for information that should be considered together to provide a more complete picture of an aspect of the business to be presented as if it is not related. Part of the materiality decision therefore relates to identifying which matters should be given particular emphasis and which matters should be presented together, or at least related to each other by way of cross-reference.
Assessing disclosure requirements on a Standard by Standard basis can lead to a false sense that because the items are included in the financial statements, then the report is fair, balanced and understandable. Simply disclosing items specified in IFRS could lead to important information being omitted, and including all specified items could obscure material information. The most common examples include use of the disclosure requirements as a checklist, and describing accounting policies in financial statements using words directly from IFRS, or copying note disclosures from illustrative financial statements without making the information entity‑specific (i.e. boilerplate disclosures).
On the contrary, preparers should consider whether there is any information that could be removed, or summarised further, to reduce clutter or to make sure the information known to be important to the primary users is more accessible. They should also consider whether there are any gaps in the information that need to be remedied, whether the report is structured in a way that gives appropriate emphasis to the matters they know were important to the entity during the period, etc. Financial statements are meant to be a means of communication, and should not be viewed as a mere compliance exercise. Management needs to take a step back and consider whether they are providing the right level of information in the financial statements and whether it is useful.
(1) See RSM’s comment letter on the Draft Practice Statement in this issue. Since improving the quality and quantity of disclosures requires joint efforts by auditors, regulators, companies and standard-setters, the IASB has consulted with the International Auditing and Assurance Standards Board (IAASB) and the International Organization of Securities Commissions (IOSCO) during the development of the Draft Practice Statement.
(2) See the role of materiality in “An overview of the IASB’s Disclosure Initiative in ten questions-and-answers”
(3) Although it has always been the case that if the information is not material it needs not be disclosed, the IASB amended IAS 1 Presentation of Financial Statements in 2014 to remove any doubt. The amended IAS 1 now clearly states that an entity needs not provide a specific disclosure required by an IFRS if the information resulting from that disclosure is not material. This is the case even if the IFRS contains a list of specific requirements or describes them as minimum requirements.