The IASB has issued an exposure draft Definition of Material, with comments to be received by January 15, 2018, and (in final form) Practice Statement 2 Making Materiality Judgments.
The IASB hopes through the practice statement, as the news release puts it, to encourage “companies to apply judgment instead of using IFRS requirements as a checklist, so that financial statements focus on the information that is useful to investors.” The proposals in the exposure draft, once implemented, should help bolster this effort. We’ll cover the exposure draft here and return to the practice statement in the future.
The current definition in IAS 1 is as follows: “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.”
Here’s the proposed revised definition and supporting language:
- 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.
- Materiality depends on the nature or magnitude of information, or both. An entity assesses whether information, either individually or in combination with other information, is material in the context of its financial statements. Material information might be obscured if it is not communicated clearly—for example, if it is obscured by immaterial information. A misstatement of information is material if it could reasonably be expected to influence decisions made by the primary users.
- Assessing whether information could reasonably be expected to influence decisions of the primary users of general purpose financial statements requires consideration of the characteristics of those users judged in the entity’s circumstances.
- Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial statements are directed. Financial statements are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.
The two main points are unchanged – in general terms, that an item’s materiality depends on its capacity to influence decisions made on the basis of the statements, and that no single bright line test exists for making this determination. Beneath that broad similarity, the IASB’s proposal reflects a painstaking fine-tuning of nuance and implication. I’ll just bring out a few of the underlying considerations:
- The existing reference to information that “could…influence” the economic decisions of users may be regarded as too high a threshold, in that “almost anything ‘could’ influence the decisions of some users of the financial statements even if the possibility is remote.” The revised reference to what “could reasonably be expected” to carry such influence should place some real-world practicality around the determination (on the face of it, this change alone might make it easier to assess vast passages of potential disclosure as not being material).
- Similarly, the proposed reference to “primary users” rather than simply “users” should counter any possible concern about needing to consider all possible readers of the statements and how they might react to a particular item of information. The language in the fourth proposed paragraph above, about the characteristics of users, reflects the current language in the conceptual framework.
- The new reference to “obscuring” information chimes with the existing wording in IAS 1.30 that an entity “shall not reduce the understandability of its financial statements by obscuring material information with immaterial information.” Under the current definition, an issuer might argue (albeit not very scrupulously) that a key piece of narrative information is appropriately disclosed even if it’s buried in the middle of a large block of insignificant drivel. The revised version makes it clearer that financial statements might be considered materially misstated on such a basis.
Perhaps rather contradictorily, the basis for conclusions states that the “proposed amendments in this Exposure Draft will improve understanding of the definition of material” and yet that at the same time, the IASB “thinks that the proposed amendments are not substantive changes and would be unlikely to significantly affect how materiality judgments are made or to significantly affect entities’ financial statements.” The implication there seems to be that while the current language may cause some confusion or inefficiency on occasion, preparers usually end up getting to the right place. But perhaps that’s not correct – if “disclosure overload” is a problem, as we’re so often told, then perhaps the alleviation of that problem actually should be seen as a significant effect on financial statements. Of course though, that won’t be the fruit of these proposed changes alone, but rather of the multi-pronged effort encompassing the proposed practice statement, the previously-implemented amendments to IAS 1, the IASB’s frequent outreach on the topic, and (one hopes) of widespread cultural change taking root over time.
As I said, more to come on the practice statement…
The opinions expressed are solely those of the author