The accounting concept of materiality means that only information that is important to investors needs to be included in the financial statements. Information about trivial matters can be excluded. Even though this sounds straightforward, applying the concept in practice is not always easy.
Companies often find it difficult to decide what is material. Consequently, rather than exercising judgement about what to include in financial statements, they use the requirements in the International Financial Reporting Standards (IFRS) as if they are a checklist. This results in financial statements that comply with the accounting requirements but do not communicate information effectively to investors.
The International Accounting Standards Board is working to make the communication of financial information more effective. Hence, helping companies to decide whether information is material is an important part of the Board’s Better Communication in Financial Reporting theme—our focus for the next few years.
Concept of Materiality
Whether information is material is a matter of judgement. The concept of materiality works as a filter through which management sifts information. Its purpose is to make sure that the financial information that could influence investors’ decisions is included in the financial statements. The concept of materiality is pervasive. It applies not only to the presentation and disclosure of information but also to decisions about recognition and measurement.
When making materiality judgements, companies need to consider a range of facts and circumstances, including both quantitative factors (for example, how big the amount involved is) and qualitative factors (for example, the specific circumstances of the company). When the concept of materiality is not applied appropriately, it may result in disclosure of too much information (sometimes called clutter) or too little information.
In order to reinforce the role materiality plays in the preparation of financial statements and help companies exercise judgement, we have published the IFRS Practice Statement 2, Making Materiality Judgements. It provides companies with guidance on making materiality judgements when preparing financial statements in accordance with IFRS Standards.
This non-mandatory document gathers in one place all the IFRS requirements on materiality and adds practical guidance and examples a company may find helpful in deciding whether information is material.
It also suggests a four-step process for companies to follow when preparing their financial statements. Applying that four-step process, a company:
- identifies information that has the potential to be material;
- assesses whether the information identified is, in fact, material. In other words, whether an investor could reasonably be expected to be influenced by the information when making investment decisions
- organizes the information so that it is communicated in a clear and concise manner
- reviews the draft financial statements considering materiality from a wider perspective and as a whole.
In addition, the Practice Statement includes specific guidance on how to make materiality judgements on prior period information, errors, and covenants, and in the context of interim reporting.
Our Practice Statement is designed to promote positive changes in behavior, encouraging companies to exercise judgement when deciding what information to include in in their financial statements.
For behavioral change to take place, however, it is important that companies, auditors and regulators work together towards the common goal of providing better information to investors.
Hans Hoogervorst is the Chairman of the International Accounting Standards Board (IASB), the standard-setting body of the International Financial Reporting Standards (IFRS) Foundation. Prior to his appointment to the IASB in 2011, he was the Chairman of the executive board of the Netherlands Authority for the Financial Markets (AFM) and has also chaired the IOSCO technical committee. He has previously held a number of positions in the Dutch Government, including minister of finance, and also has experience from the banking sector.
See more by Hans Hoogervorst