One of the increasingly evident downsides of the well-intended efforts by accounting standards setters to improve ‘transparency’ in financial reporting is disclosure overload. This is exemplified by the new accounting standards on revenue, financial instruments and leases, which each have extensive disclosure requirements. As a result, financial statements are now longer than ever and increasingly difficult for the average reader to understand. Furthermore, information overload risks key information being overlooked by users. Companies and IR professionals are therefore faced with the daunting challenge of sifting through details to identify information that is actually relevant to the users of financial statements.
In an effort to address this, the test often applied is whether something is ‘material’ to the financial statements. The concept of materiality flows throughout the International Financial Reporting Standards (IFRS) and effects what and how information is to be disclosed and presented. It also impacts accounting recognition and measurement decisions. While materiality is intended to be ‘entity specific’, stakeholders can have very different perspectives on what is ‘material’. In an effort to clarify the meaning of materiality for disclosure purposes, the International Accounting Standards Board (IASB) issued amendments to its existing definition of materiality in late 2018. The amendments will be effective January 1, 2020, with early adoption permitted.
In 2012, the IASB undertook a Disclosure Initiative, comprised of multiple projects, with the objective of improving the effectiveness of existing disclosure requirements. As part of the Disclosure Initiative, the IASB sought to clarify the meaning of ‘material’ to address concerns that companies were applying the concept of materiality in a way that was resulting in the disclosure of immaterial information. The existing definition of ‘material’ 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 (IAS 1).
Commentators have identified three main concerns with the existing definition:
- The use of the phrase ‘could influence’ can be interpreted broadly, meaning that pretty much any event could potentially influence some subset of users.
- The use of the terms ‘omissions’ and ‘misstatements’ focuses solely on what information cannot be excluded rather than also assessing why the inclusion of some information may not be useful.
- Lastly, the use of the term ‘users’ is too general and far-reaching.
New Definition of ‘Material’
The new definition of ‘material’ seeks to address these concerns as well as align the meaning across IFRS:
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.
The new definition includes three new aspects:
- ‘Could reasonably be expected to influence’ replaces ‘could influence’. This new aspect of the definition introduces a higher threshold than ‘could influence’, where anything and everything could be included, regardless of likely relevance. In considering whether information could reasonably be expected to influence decisions, an entity is required to take into account the characteristics of both its primary users and its own circumstances.
- ‘Obscuring information’ is added to the definition with the goal of addressing the second concern noted above, and is intended to prevent companies from obscuring material information with immaterial information. The amendments include examples of when material information is obscured:
a) Use of vague and unclear information to describe a material item;
b) Disclosure of a material item is scattered throughout the financial statements;
c) Dissimilar items, transactions, or other events are inappropriately aggregated;
d) Similar items, transactions or other events are inappropriately disaggregated; and
e) Material information is hidden by immaterial information, resulting in the inability to differentiate what is material
- ‘Primary users’ of financial statements is added to narrow down the broad definition of ‘users’. By focusing on primary users specifically, companies need not consider all possible users of its financial statements, thereby reducing the risk of disclosing immaterial information.
How can this be applied?
The new definition of materiality complements the IFRS Practice Statement 2: Making Materiality Judgments, which was released in 2017. The Practice Statement includes a four-step process to help companies with making sound judgements on materiality:
- Identify information that has the potential to be material considering requirements in IFRS and primary users’ needs.
- Assess whether the information identified is material based on quantitative and qualitative factors.
- Organize the information in a way that communicates the information clearly and concisely to primary users.
- Review the financial statements from a wide and comprehensive perspective.
In understanding the new definition of materiality and by following these steps, financial statement preparers and IR professionals can assess their disclosures to ensure that material information is communicated effectively with its key messages clearly conveyed to its primary users.
Charmaine Mak, CPA, CA is a Senior Manager, and Rob Brouwer, FCPA, CPA is Canadian Managing Partner, Clients and Markets, for KPMG LLP in Canada.