Materiality in IFRS Standards and Financial Reporting

Materiality is a fundamental concept in financial reporting under IFRS Standards. If an item is deemed immaterial, IFRSs do not apply to it. An information is considered material if its omission, misstatement or obscurity could reasonably be expected to influence decisions made by the primary users of financial statements (IAS 1.7).

Materiality is relevant to decisions related to the selection and application of accounting policies, as well as the disclosure and aggregation of information in financial statements. IAS 8.8 provides entities with relief from applying IFRS requirements when the outcome of following them is immaterial. Further, IAS 1.31 states that entities don’t have to provide a specific disclosure as mandated by IFRS if the outcome of that disclosure is immaterial. This holds true even if the IFRS outlines specific requirements or labels them as minimum requirements. Furthermore, IAS 1.30 states that if an item is not individually material, it should be grouped with other items. Yet, an item that doesn’t merit individual presentation in the primary financial statements might still deserve a separate disclosure in the notes.

The notion of materiality is specific to individual entities and IFRSs don’t provide any quantitative benchmarks, as highlighted in the Conceptual Framework (CF 2.11). However, the IASB has released a non-binding IFRS Practice Statement 2 Making Materiality Judgements, which offers insights into the concept of materiality.

Quantitative considerations

To determine materiality, entities and auditors adopt the approach of applying a percentage to a selected benchmark like profit before tax, operating income, EBITDA, or net assets. Typical bases for such calculations include 5% of profit before tax or 2-3% of operating income or EBITDA. However, these benchmarks will differ between sectors. For example, materiality levels employed by financial institutions sometimes equate to 1% of assets or equity.

The UK International Standard on Auditing 701 mandates auditors to disclose overall and performance materiality (refer to ISA 320.10-11 for definitions) in their audit reports, accompanied by a rationale for the significant judgements made in the process (ISA UK 701.16-1). Such disclosures offer valuable insights into auditors’ materiality assessments, as demonstrated in this extract from BP’s audit report:

Disclosure of overall and performance materiality in BP's audit report.
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The UK Financial Reporting Council shared findings from its Audit Quality Thematic Review, highlighting frequently employed materiality benchmarks across various sectors. For instance, there’s a summary of benchmarks used within the healthcare, pharmaceuticals, and chemicals sectors in selected audit reports:

A summary of materiality benchmarks used within the healthcare, pharmaceuticals, and chemicals sectors.

It’s beneficial for entities to set their own quantitative thresholds when evaluating materiality. If feasible, this should align with the materiality assessments of their auditors. Entities can establish different materiality levels for items affecting profit or loss, balance sheet classifications, aggregations, and for disclosures.

IAS 1 mandates both individual and collective assessment of materiality. Thus, an immaterial item might become material when combined with other individually insignificant items. Therefore, it’s essential to monitor any uncorrected misstatements identified during a period to estimate their collective materiality. Conversely, a material misstatement cannot be balanced by another. For instance, overstating expenses doesn’t nullify overstated revenue.

Over time, the combined effect of previous immaterial misstatements might become material. For example, neglecting to recognise a yearly $100 liability for a decade leads to an understatement of liabilities by $1,000. Even if $100 might be immaterial annually, the accumulated understatement might become material over time. In such scenarios, entities can’t report a $1,000 liability and expense in the current period as it would materially distort the current results. Thus, entities should correct such errors retrospectively, even if they weren’t material in previous years.

Qualitative considerations

It’s important to recognise that an item’s immateriality isn’t solely based on it falling beneath a specified quantitative threshold. For instance, if a misstatement is deliberately made to achieve a specific presentation or outcome, it’s deemed material, regardless of its value (IAS 8.8/41). This arises because such a misstatement wouldn’t have occurred if the entity didn’t anticipate it to influence decisions made by financial statement users. This shouldn’t be mistaken for simplifications an entity might adopt, which aren’t aimed at achieving a particular presentation or outcome.

When assessing materiality, qualitative factors to consider include:

  • Whether misstatements allow the entity to meet financial projections (either its own or market consensus).
  • If misstatements enable the entity to comply with regulatory requirements, debt covenants or contractual obligations.
  • The capacity of misstatements to turn net losses into profits or boost managerial bonuses.
  • Misstatements significantly skewing segment reporting, essential KPIs, related party disclosures, or other specific financial reporting aspects, even if they have a minor quantitative effect on the overall financial statements.

IAS 1.30A introduces the notion of ‘obscuring’ material information, which means presenting it in a manner similar to omitting or wrongly stating that information. Examples of situations that may lead to obscuring of material information, as outlined in IAS 1.7, include:

  • Disclosing details about a material item in unclear or ambiguous language,
  • Scattering information about a material item throughout the financial statements,
  • Inappropriately aggregating dissimilar items or disaggregating similar ones,
  • Overloading the financial statements with immaterial information to the point where a user struggles to discern the material content.

Interim financial statements

Materiality thresholds are reduced in interim financial statements. As per IAS 34, materiality should be based on interim results, not anticipated full-year outcomes (IAS 34.IN9, IAS 34.23, and IAS 34.25). For instance, the first quarter’s materiality threshold is only a quarter of the annual financial statement’s threshold.

Is it possible to maintain annual materiality levels in interim statements and still comply with IFRS? The answer is no, as IAS 34 is unambiguous on this matter. Interestingly, US GAAP is more flexible, permitting the use of annual materiality thresholds in interim financial statements, provided there’s additional disclosure for items material only for the interim period (ASC 270-10-45-16 and ASC 250-10-45-27).

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