Consultation and outreach performed by the International Accounting Standards Board (IASB®) identified a disclosure problem in general purpose financial statements prepared in accordance with International Financial Reporting Standards (IFRS®), such that:
- relevant information is not disclosed;
- irrelevant information is disclosed; and
- the communication of information that is provided can be ineffective.
The behaviour of preparers is highlighted as a cause of the problem, underlying which, is an inability of preparers to apply judgement in the preparation process. Preparers instead “use a checklist approach … because of time pressures, and because following a mechanical approach means that their judgement is less likely to be challenged by auditors, regulators and users of their financial statements.” (Discussion Paper DP/2017/1, Disclosure Initiative–Principles of Disclosure, paragraph 1.7).
Rarely does an entity include the exercise of judgement over the preparation of financial statements themselves as a significant judgement that warrants disclosure in accordance with IAS 1.122. That is perhaps indicative of the fact that preparers include every disclosure ‘mandated’ by the standards, regardless of how trivial the information is to their users’ understanding of the entity’s financial position and performance.
When an item has not been disclosed, my experience of the auditing profession and its regulation is that the initial reaction is that there is a departure from requirements, instead of prompting a discussion of whether the information is of use.
As a result, the IASB® is undertaking a disclosure initiative project, comprising several complementary parts. Two of the parts that are of relevance to this piece are the issuance, in September 2017, of IFRS® Practice Statement 2, Making Materiality Judgements (the Statement) and the amendments made to the definition of material in IAS 1 Presentation of Financial Statements and IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors in October 2018. Other pieces are still in development, including a Targeted Standards-level Review of Disclosures and a project to assist preparers in applying materiality in exercising judgement over disclosure of their accounting policies
While these are steps in the right direction of managing and improving financial reporting, the process of their application by entities will need to be adapted.
PREVIOUS DEFINITION OF MATERIAL
‘Material’ was defined in IAS 1 and IAS 8 as:
“Material 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.”
NEW DEFINITION OF MATERIAL
In October 2018, the IASB® amended the definition of ‘material’ included in IAS 1 and IAS 8 to:
“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.”
Some concepts included in the new definition have been highlighted already existed in IFRS: IFRS 7.B3 (in part) explains, for financial instrument disclosure,
“…It is necessary to strike a balance between overburdening financial statements with excessive detail that may not assist users of financial statements and obscuring important information as a result of too much aggregation. For example, an entity shall not obscure important information by including it among a large amount of insignificant detail. Similarly, an entity shall not disclose information that is so aggregated that it obscures important differences between individual transactions or associated risks.”
In making a comparison of the new with the old definition, a number of improvements are apparent, for example:
Obscuring – previously this requirement was included in the explanatory information at IAS 1.30A. Furthermore, the phrase “omitting or misstating” means the omission of immaterial information is allowed. Such omission is explicitly allowed by IAS 1.31 (in part): “…An entity need 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.” Moving the concept from the explanatory material and into the definition itself emphasizes the role of financial statements in communicating information by giving the obscuring of material information more prominence.
Reasonably be expected – taking into account the effect of information on the economic decisions of users was required in the previous definition, but the emphasis now is how the information could “reasonably be expected” to be influence users’ decisions. The likelihood of influence is now consistent with the omission of immaterial information.
Primary users – the intention here is to avoid interpreting users in the existing definition as being all possible users. Primary users are existing and potential investors, lenders and creditors. The characteristics of primary users included in the explanatory information following the definition in IAS 1 was lifted from the Conceptual Framework for Financial Reporting (the Conceptual Framework).
Changes were also made to the Conceptual Framework for consistency and to avoid confusion.
APPLICATION
The IASB® notes, however, that application of the new definition, which does not represent a substantive change, will not in itself give rise to any change in how materiality judgements are made or in financial reporting. The approach to changing behaviour is to provide guidance in the application of materiality, hence the issuance of the Statement.
The Statement has been available for voluntary application since September 14, 2017, with the objectives, amongst others, to assist preparers in changing their behaviour away from a rigid checklist approach and to allow the exercise of judgement in, for example, removing immaterial information from the financial statements. Such information may be determined to be immaterial and therefore removed, even though it is identified by a standard as “minimum required” information to be disclosed.
The Statement suggests that preparers use the following four steps:
Step 1 – identify information that primary users might need to understand to make decisions about providing resources to the entity. Decisions include buying, selling or holding equity or debt instruments, providing or settling credit and exercising rights. Therefore, the most relevant information is the return expected from an investment and its related credit risk. The starting point is the requirements of IFRS® standards plus the total of the information needs of each group of primary users, considered as a group. Useful information confirms past results or is predictive of future performance.
Step 2 – assess whether the information identified in Step 1 is material, by considering whether the primary users could reasonably be expected to be influenced by the information. The most efficient approach is to consider the magnitude of information first (quantitative factors) against the measures that are of most interest to primary users. For any other information that is below the quantitative measure, consider whether the nature of the information makes it material. Entity specific factors include related party transactions, non-standard features of a transaction or unexpected variations or trends. External factors are the industry or geographical location. For example, if an entity is not exposed to a risk that its competitors are exposed to, that fact could be considered material.
Step 3 – draft the financial statements
Step 4 – review the draft to consider whether information is material in the context of the financial statements as a whole and in light of its financial position, performance and cash flows. A preparer considers:
- Relationships between different pieces of information;
- Individually immaterial information that is collectively material;
- Whether the financial statements communicate information effectively, are understandable and organised to avoid obscuring information; and
- Whether the financial statements provide a fair presentation.
The results of the review are to add information that is necessary, disaggregate more information, remove (or aggregate) immaterial information and reorganise information that is retained.
The process described is very thorough. However, since the starting point for most entities is the existing financial statements together with the identification of the primary users, the questions that should be considered are:
- What additional information should be added;
- What information can (and should) be deleted; and
- Whether the organization and presentation of information can be improved.
The Statement does provide some colour as to how these judgements could be made.
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