EXPOSURE DRAFT 2015/08
IFRS PRACTICE STATEMENT APPLICATION OF MATERIALITY IN FINANCIAL STATEMENTS
During various stages of its Disclosure Initiative project, the IASB has been informed that there are difficulties around the practical application of materiality, with inappropriate assessments leading to irrelevant information being included, and material information being excluded, from financial statements. It has been suggested that a contributing factor is the lack of guidance in materiality in IFRS.
The concept of materiality links to the objective of general purpose financial reporting, which is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.
Whether information is material or not is a matter of judgement that depends on facts and circumstances affecting each entity. The (draft) Practice Statement aims to illustrate the types of factors that management should take into account when considering whether information is material or not. It is important to note that materiality should be considered within the context of a specific entity.
Aspects of the Exposure Draft to comment
Form of the guidance
A Practice Statement is not a Standard. The IASB‘s reasoning for issuing guidance on applying the concept of materiality in the financial statements in the form of a non-mandatory Practice Statement is based on the following:
- The (draft) Practice Statement will help to promote a greater understanding of the role of materiality in IFRS and how it should be applied in preparing financial statements
- If mandatory guidance was issued in a Standard, concerns could arise about creating conflicts with national legal frameworks
- The IASB would not prohibit an entity from providing additional information in order to meet local requirements in a jurisdiction
- Issuing mandatory guidance in a Standard could risk appearing prescriptive an detract from the need for judgement to be applied
- the IASB observed that issuing guidance as a separate non-mandatory document would help to emphasise that the concept of materiality is pervasive throughout IFRS
- The IASB decided that a Practice Statement was preferable to educational material because it will be subject to full due process (including public consultation) and it will be more accessible and formal because it would be included in the IFRS Bound Volume.
Content of the (draft) Practice Statement
The (draft) Practice Statement proposes guidance in three main areas:
- Characteristics of materiality
- How to apply the concept of materiality in practice when presenting and disclosing information in the financial statements
- How to assess whether omissions and misstatements of information are material to the financial statements.
The IASB has requested comments on:
- Whether any additional content should be included in the (draft) Practice Standard
- Whether the guidance will be understandable by, and helpful to, preparers of financial statements
- Whether there is any content with which respondents do not agree
- Whether any paragraphs/sections are unnecessary
- Whether any aspects of the guidance will conflict with any legal requirements related to materiality within constituents‘ jurisdictions.
EXPOSURE DRAFT 2015/03
CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING
ED/2015/3 Conceptual Framework for Financial Reporting sets out the revised Conceptual Framework structured into an introduction, eight chapters, and two appendices:
- Objective of general purpose financial reporting (GPFR)
- Qualitative characteristics of useful financial information
- General purpose financial statements (GPFS) and reporting entities
- Elements of financial statements
- Recognition and derecognition
- Presentation and disclosure
- Concepts of capital and capital maintenance1
The key proposals in each chapter are summarised below:
Introduction. The first section offers background information. It also describes the purpose of the conceptual framework and its status within the hierarchy of IASB pronouncements. The ED explains that the Conceptual Framework’s primary purpose is to assist the IASB in developing and revising IFRSs (even though it may be useful to parties other than the IASB) and that the framework does not override any specific IFRS. Should the IASB decide to issue a new or revised pronouncement that is in conflict with the framework, the IASB will highlight the fact and explain the reasons for the departure going forward.
Chapter 1 – The objective of general purpose financial reporting. This is the first of the two chapters that were finalised as part of the joint project with the FASB in 2010, so there are only limited changes. In essence, the IASB’s proposals in this chapter aim at giving prominence to the importance of providing information that is needed to assess management’s stewardship of the entity’s resources.
Chapter 2 – Qualitative characteristics of useful financial information. This is the second of the two chapters that were finalised as part of the joint project with the FASB in 2010 (published as Chapter 3 in the 2010 Conceptual Framework). Again, proposed changes are limited. However, the IASB proposes to reintroduce an explicit reference to the notion of prudence and states that the exercise of prudence supports neutrality. Prudence is defined as the exercise of caution when making judgements under conditions of uncertainty. The chapter also contains a proposed addition that would clarify that faithful representation means representation of the substance of an economic phenomenon instead of representation of its legal form only.
Chapter 3 – Financial Statements and the reporting entity.The ED states the objective of financial statements (to provide information about an entity’s assets, liabilities, equity, income and expenses that is useful to financial statements users in assessing the prospects for future net cash inflows to the entity and in assessing management’s stewardship of the entity’s resources) and sets out the going concern assumption. Interestingly, the ED only mentions two statements explicitly: the statement of financial position and the statement(s) of financial performance (the latter being the former statement of comprehensive income); the statement of cash flows and the statement of changes in equity go unmentioned. The chapter also discusses the definition of a reporting entity and the boundary of a reporting entity. It also states the IASB’s conviction that, generally, consolidated financial statements are more likely to provide useful information to users of financial statements than unconsolidated financial statements.
Chapter 4 – The elements of financial statements. The main focus of this chapter is on the definitions of assets, liabilities, and equity as well as income and expenses. The definitions are quoted below:
Asset. An asset is a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits.
Liability. A liability is a present obligation of the entity to transfer an economic resource as a result of past events.
Equity. Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Income. Income is increases in assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from holders of equity claims.
Expenses. Expenses are decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims.
Note that, other than in the DP, the IASB has backed away from changes in the definitions liabilities and equity that would address the problems that arise in classifying instruments with characteristics of both liabilities and equity. Exploring those problems has been transferred to the IASB’s research project on financial instruments with the characteristics of equity.
Chapter 5 – Recognition and derecognition. The ED states that only items that meet the definition of an asset, a liability or equity are recognised in the statement of financial position and only items that meet the definition of income or expenses are to be recognised in the statement(s) of financial performance. However, their recognition depends on three criteria: their recognition provides users of financial statements with (1) relevant information about the asset or the liability and about any income, expenses or changes in equity, (2) a faithful representation of the asset or the liability and of any income, expenses or changes in equity, and (3) information that results in benefits exceeding the cost of providing that information. Nevertheless, the ED also maintains that whether the information provided is useful to users depends on the item and the specific facts and circumstances and requires judgement and possibly varying recognition requirements between standards. Derecognition requirements as presented in the ED are driven by two aims: the assets and liabilities retained after the transaction or other event that led to derecognition must be presented faithfully and the change in the entity’s assets and liabilities as a result of that transaction or other event must also be presented faithfully. The ED also describes alternatives when it is not possible to achieve both aims.
Chapter 6 – Measurement. This chapter is dedicated to the description of different measurement bases (historical cost and current value (fair value and value in use/fulfilment value)), the information that they provide and their advantages and disadvantages. A table offers an overview of the information provided by various measurement bases. The ED also sets out factors to consider when selecting a measurement basis (relevance, faithful representation, enhancing qualitative characteristics, and factors specific to initial measurement) and points out that consideration of the objective of financial reporting, the qualitative characteristics of useful financial information and the cost constraint are likely to result in the selection of different measurement bases for different assets, liabilities and items of income and expense. Appendix A of the ED supplements Chapter 6 and describes cash-flow-based measurement techniques for cases when a measure determined using a measurement basis cannot be observed.
Chapter 7 – Presentation and disclosure. In this chapter, the ED discusses concepts that determine what information is included in the financial statements and how that information should be presented and disclosed. The statement of statement of comprehensive income is newly described as “statement of financial performance”, however, the ED does not specify whether this statement should consist of a single statement or two statements, it only requires that a total or subtotal for profit or loss must be provided. Notably, the ED does not define profit or loss, thus the question of what goes into profit or loss or into other comprehensive income is still unanswered.
Chapter 8 – Concepts of capital and capital maintenance. The proposals in this chapter were taken over from the existing Conceptual Framework with minor changes for consistency of terminology. The IASB states that it would consider revising the description and discussion of capital maintenance if it were to carry out a future project on accounting for high inflation. However, it also states that no such work is currently planned.