Materiality is a crucial concept in financial reporting. A requirement in IFRS (including disclosure) need not be applied if the effect of not applying it is immaterial (see paragraph 8 of IFRS Practice Statement 2 Making Materiality Judgements). Under IFRS, ‘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.’ IAS 1 goes on to say that materiality depends on the nature or magnitude of information, or both and that an entity assesses whether information, either individually or in combination with other information, is material in the context of its financial statements taken as a whole (IAS 1.7).
In October 2018 the IASB issued amendments to IAS 1 and IAS 8 (effective from 1 January 2020) which added the concept of obscuring information to the definition of materiality. The amended IAS 1 explains that information is obscured if it is disclosed using vague or unclear language or it is ‘lost’ in immaterial information so that a reader is unable to determine which information is material and which isn’t (IAS 1.7).
Materiality is entity specific and IFRS do not give any quantitative thresholds. IASB issued a non-binding IFRS Practice Statement 2 Making Materiality Judgements which is worth reading when considering materiality concept.
Materiality: quantitative considerations
The starting point for quantitative materiality consideration is usually a specific percentage of net income or other major financial aggregate. 5% of net income from continuing operations or 2-3% of operating income (or other measure of operating profitability) are common starting points for many entities and their auditors, but these thresholds can vary significantly. Even if an audit firm has a predetermined threshold in its auditing methodology, it can be altered for entity-specific reasons, especially when entity incurs losses or it is near break-even point. Undoubtedly, it is very useful for an entity to have its own quantitative threshold as a starting point in assessing materiality. If possible, this should be aligned with materiality assessment of the auditors of the entity. Different levels of materiality can be determined for items impacting P/L, balance sheet reclassifications or aggregations and for disclosure.
IAS 1 requires individual and collective assessment of materiality of items. Therefore, immaterial item may become material when taken together with other individually immaterial items. It is therefore important to keep track of any uncorrected misstatements identified during a period in order to be able to assess their collective materiality. On the other hand, material misstatement cannot be offset by other material misstatements (e.g. overstated revenue and expenses).
The cumulative impact of immaterial misstatements from previous years may become material at some point. E.g. a failure to recognise a liability and expense of $100/year for the last 10 years results in an understatement of liabilities by $1,000. While $100 may not be material in any given year, understatement of liabilities by $1,000 at the reporting date may be a material omission. If this is the case, entities cannot recognise $1,000 of liability and expenses in current period as this would materially misstate current results. In such a case, entities need to make a retrospective correction of error even though this error was not material in any previous year.
Materiality: qualitative considerations
An item cannot be considered as immaterial only because it is below a predetermined quantitative threshold.
When a misstatement is made intentionally in order to achieve a particular presentation or result, the misstatement is considered to be material irrespective of the amount. It is so because such a misstatement would not have been made if the entity would not expect it to influence decisions made by users of financial statements. This is not to be confused with simplifications adopted by an entity, as these are not intended to achieve a particular presentation or result.
Examples of other qualitative factors that should be taken into account when assessing materiality include:
- whether misstatements enable the entity to meet financial forecasts (either its own or the market consensus),
- whether misstatements enable the entity to comply with regulatory requirements, debt covenants or other contractual requirements,
- whether misstatements change net loss into net income or vice versa,
- whether misstatements affect key ratios or other disclosures in financial statements that users put particular focus on,
- whether misstatements increase management bonuses,
- whether misstatements distort segment reporting, disclosure of transactions with related parties or other specific matters.
Materiality in interim financial statements
Things get more challenging when applying a quantitative determination of materiality in interim financial statements. IAS 34 is clear that materiality in interim financial statements should be assessed with reference to interim results and not forecast full year results (IAS 34.IN9, IAS 34.23 and IAS 34.25). Therefore, in financial statements for e.g. first quarter, the quantitative threshold for materiality is only a quarter of that determined for annual financial statements.
Is there any way to stick to the annual levels of materiality in interim financial statements and still be in line with IFRS? Not really, as IAS 34 is crystal clear in this respect. Interestingly, US GAAP are much more merciful and allow applying the annual materiality levels also in interim financial statements with additional disclosure required for items material for interim period only (ASC 270-10-45-16 and ASC 250-10-45-27).