The concept of materiality as it applies to a financial statement audit
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Article Posted date 02 March 2021 3 min read
Making information in financial statements more relevant and less cluttered has been one of the key focus areas for the International Accounting Standards Board (the Board). Companies make materiality judgements not only when making decisions about recognition and measurement, but also when deciding what information to disclose and how to present it. However, management are often uncertain about how to apply the concept of materiality to disclosure, and find it easier to defer to using the disclosure requirements within IFRS® Standards as a checklist. To help preparers of financial statements, the Board had previously refined its definition of ‘material’1 and issued non-mandatory practical guidance on applying the concept of materiality2. As the final piece of the materiality improvements, the Board has now issued amendments on the application of materiality to disclosure of accounting policies. The recent amendments on accounting policy disclosures could prove helpful for preparers in deciding which accounting policies to disclose in their financial statements. The focus on company-specific information should further discourage boilerplate disclosure. Refined definition of material In October 2018, the Board refined its definition of material to make it easier to understand and apply. This definition is now aligned across IFRS Standards and the Conceptual Framework. “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.” [emphasis added] The refined definition of material complements the non-mandatory IFRS
Practice Statement 2 guidance the Board issued in 2017, which outlines a four-step process that preparers can use to help them make materiality judgements and provides guidance and examples on how to make materiality judgements in preparing their financial statements. Amendments on accounting policy disclosures The Board has recently issued amendments to IAS 1 Presentation of Financial Statements and an update to IFRS Practice Statement 2 Making Materiality Judgements to help companies provide useful accounting policy disclosures. The key amendments to IAS 1 include:
The Board also amended IFRS Practice Statement 2 to include guidance and two additional examples on the application of materiality to accounting policy disclosures. The amendments are consistent with the refined definition of material: “Accounting policy information is material if, when considered together with other information included in an entity’s financial statements, it can reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements”. The amendments are effective from 1 January 2023 but may be applied earlier. Further guidance on disclosures © 2022 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. When accountants conduct an audit or review, they can’t test every transaction. Instead, they set a “materiality” threshold. This benchmark is used to obtain reasonable assurance in an audit — or limited assurance in a review — of detecting misstatements that could be large enough, individually or in the aggregate, to be material to the financial statements. What is materiality? Unfortunately, there’s no specific definition of materiality under U.S. Generally Accepted Accounting Principles (GAAP). But the Conceptual Framework for Financial Reporting under International Financial Reporting Standards (IFRS) says: Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report. Several definitions of materiality exist. But the universal premise is that a financial misstatement is material if it could influence the decisions of financial statement users. How do auditors determine materiality? To establish a level of materiality, auditors rely on rules of thumb and professional judgment. They also consider the amount and type of misstatement. The materiality threshold is typically stated as a general percentage of a specific financial statement line item. For example, let’s suppose Joe Auditor sets a materiality threshold of 1% of revenue for ABC Company. For 2017, the company reports annual revenue of $190 million, so its materiality threshold is $1.9 million. During fieldwork, Joe unearths a clerical error that caused ABC to understate revenue by $1 million. Is this error material? Although a $1 million error may seem significant, it’s less than 1% of the company’s annual revenue. So, it’s immaterial to ABC’s overall financial performance. On the other hand, if the company had overstated its revenue by $1 million due to a fraud scheme involving a senior executive, Joe may deem the misstatement as material because it involved a member of the senior leadership team and potential criminal activity. Regardless of whether a misstatement of revenue is considered material, it may trigger a material misstatement in accounts receivable. In other words, the balances recorded as due from customers may be materially different from the actual amounts due. It’s all relative As these examples demonstrate, materiality is a relative concept. In practice, auditors must evaluate a material misstatement on a standalone basis and within context of a company’s financial statements overall. What constitutes a material misstatement for one company may not reach the materiality threshold for another. Materiality is a matter of professional judgment and your audit team’s experience. 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What is materiality in relation to financial statement?Materiality is an accounting principle which states that all items that are reasonably likely to impact investors' decision-making must be recorded or reported in detail in a business's financial statements using GAAP standards.
What is the main purpose of the materiality concept in financial accounting?Materiality concept in accounting refers to the concept that all the material items should be reported properly in the financial statements. Material items are considered as those items whose inclusion or exclusion results in significant changes in the decision making for the users of business information.
What is the concept of materiality?Materiality is a concept that defines why and how certain issues are important for a company or a business sector. A material issue can have a major impact on the financial, economic, reputational, and legal aspects of a company, as well as on the system of internal and external stakeholders of that company.
Why is the concept of materiality important in audit?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.
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