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The preparation of financial statements requires an entity to make materiality judgements to determine what and how financial information should be presented and disclosed in the financial statements. In one of our articles in the Accounting 101 series, we have highlighted that materiality is one of the considerations in the preparation of the financial statements. You can refer to Accounting 101: Considerations for the presentation of financial statements for a refresher.
The process of making materiality judgements requires an entity to assess and understand what information is material to the users of the financial statements. How do we know if a piece of information is material? IAS 1 Presentation of Financial Statements states that information is material if omitting, misstating or obscuring it in the financial statements could reasonably be expected to influence decisions that the primary users of the financial statements make on the basis of those financial statements. Based on this definition of materiality, an entity will need to strike a balance between disclosing too much information (including immaterial information) which could obscure material information or disclosing too little information which means omitting material information from the financial statements.
Because of the complexity surrounding the process of making judgements on materiality, the International Accounting Standards Board (“IASB”) has issued a non-authoritative guidance – Practice Statement 2, Making Materiality Judgements to guide preparers on this area. Let us now discuss the 10 key takeaways on the Practice Statement 2.
#1: Materiality – whose perspective?
Often when entities consider materiality for the preparation of the financial statements, they mistakenly considered them from the perspective of the entity itself. Some also consider materiality from the perspective of the regulators simply because entities do not want the regulators to penalise or question them for not disclosing enough information in the financial statements. Practice Statement 2 emphasises that in making materiality judgements, entities should consider it from the perspective of the primary users of the financial statements. Who are these primary users? We have covered this in Accounting 101: Objectives and users of the general purpose financial statements. Unfortunately, in reality, there is no crystal ball to help entities to determine what information is material from the primary users’ perspective. Hence, lots of judgements are still required in this area.
#2: Application of materiality for recognition and measurement
The application of materiality is not only applicable to the presentation and disclosure of information in the financial statements. Materiality should also be considered when making a decision about the recognition and measurement of an item. In the IFRS world, the requirements in the IFRS standards, which include the recognition and measurement, are only applicable when the effect of applying them is material. Entities should continue to monitor and reassess whether the items where the IFRS requirements are not applied because of materiality, continue to be immaterial in the future periods. Nevertheless, it is inappropriate to use the materiality ground to achieve a particular presentation of the statement of financial position, financial performance or cash flows.
#3: Reassessment of materiality judgement
‘I had assessed materiality in the past. Can I still rely on that assessment?’. This is also one of the common questions entities always asked regarding materiality especially as entities apply lots of judgement in deciding whether the information is material in the preparation of the financial statements. However, take note that materiality judgement needs to be re-assessed from one reporting period to another because the entity’s circumstances change over time. A piece of information or transaction may not be material in the past, but it could be material in the future periods. So, concluding materiality based on the circumstances in the past reporting period may not be appropriate.
#4: Interaction between the requirements in the standards and laws and regulations
Entities need to comply with the requirements in IFRS standards in order to state their compliance with the IFRS. This also includes materiality requirements as emphasised in IAS 1 and the Practice Statement 2. Accordingly, an entity cannot provide less information as required in the standards even if the local laws and regulations permit otherwise if that information is material. In another situation, local laws and regulations may require entities to provide certain information in the financial statements although such information may not be material from the IFRS perspective. In such a situation, providing such information in the financial statements to comply with local laws and regulations is permitted or allowable provided that such information does not obscure material information as required by the standards.
#5: The four-step materiality process
Practice Statement 2 introduces the four-step materiality process to describe how an entity could assess whether the information is material for recognition, measurement and presentation or disclosure under the IFRS framework. They are:
- Step 1: Identify information that has the potential to be material.
- Step 2: Assess whether the information identified in Step 1 is material.
- Step 3: Organise the information within the draft financial statements
- Step 4: Review the draft financial statements to determine whether all material information has been considered.
#6: Threshold of materiality
How do we consider whether the information is material? Is there any specific threshold being set in the Practice Statement 2? These are the common questions people normally asked, particularly for simplicity and standardisation, should there be any threshold being set. Practice Statement 2 does not set any threshold to determine whether the information is material or not. Practice Statement 2 also made reference to requirements in the standards that the assessment of materiality is not solely based on quantitative factors. Instead, an item could be material based on the item’s nature, size or both – nature and size (i.e., quantitative and qualitative factors). This requires judgement based on the entity’s facts and circumstances. Although the Practice Statement 2 appreciates that assessing materiality from the quantitative perspective could be an efficient approach, Practice Statement 2 also emphasises that there are certain situations where the qualitative factors are more important than the quantitative factor. Accordingly, the more significant the qualitative factors, the lower the quantitative thresholds will be.
#7: Materiality of the prior-period information
Interestingly, the Practice Statement 2 also covers a topic on prior-period information. Prior-period information is needed to form a complete set of financial statements. We have also covered this topic in Accounting 101: Considerations for the presentation of financial statements. In assessing whether the prior-period information is material to the current-period financial statements, entities may do the following with regard to the prior-period information:
- Providing more prior-period information in the current-period financial statements as compared to information provided in the prior-period financial statements. The amount of prior-period information provided in the past has no bearing on the prior-period information that should be provided in the current period. Accordingly, prior-period information that was not previously included would be required or included if they are necessary for the primary users to understand the current-period financial statements.
- Providing less prior-period information than was provided in the prior-period financial statements. Entities are not required to automatically reproduce in the current-period financial statements all the information provided in the prior-period financial statements. Accordingly, entities may summarise the prior-period information in the current-period financial statements if they are necessary for the primary users to understand the current-period financial statements.
#8: Material cumulative errors
Immaterial errors do not need to be corrected to be in compliance with IFRS if they are not done to achieve a particular presentation. These immaterial errors may accumulate over the number of reporting periods and become material. It is important to note that cumulative errors that have become material to the current-period financial statements must be corrected. Factors to consider whether a cumulative error has become material to the current-period financial statements are:
- The entity’s circumstances have changed that leads to different materiality assessment for the current period; or
- Further accumulation of current-period error onto the cumulative error has occurred.
#9: Materiality consideration for interim reporting
If you are wondering whether materiality judgement is also applicable to interim reporting, the answer is yes. Materiality judgement applies to both annual and interim reporting. Entities may also apply the 4-step materiality process when preparing their interim reports. In making materiality judgements, Practice Statement 2 encourages entities to focus on the period covered by the report to:
- Assess whether the information in the interim financial report is material in relation to the interim period financial data.
- Applies materiality factors on the basis of both current interim period data and data for the current financial year to date when there is more than one interim period.
- Consider whether to provide in the interim report information that is expected to be material to the annual financial statements.
Information that is expected to be material to the annual financial statements may need not be provided in the interim report if the information is not material to the interim report. Besides, information that is material to the interim report may not need to be disclosed in the annual financial statements if the information is not material to those statements.
#10: Material information about covenants
Materiality judgement also plays a role in determining whether information about loan covenants needs to be disclosed in the financial statements. The 4-step materiality process can be applied to help entities to determine whether information on loan covenants needs to be disclosed in the financial statements. When a loan covenant exists, entities to consider:
- the consequences of a breach occurring, particularly on the impact a covenant breach would have on the entity’s financial position, financial performance and cash flows; and
- the likelihood of a covenant breach occurring. The more likely the covenant breach would be occurring, the more likely the information on loan covenants is material.
The 10 key takeaways above summarised the principles and guidance included in Practice Statement 2. Making materiality judgements remains the crucial area in the preparation of the financial statements. For more related articles, do visit the Financial Accounting section.