Making materiality judgements (AASBPS2_12-17_COMPmay19_01-20)

An entity may find it helpful to follow a systematic process in making materiality judgements when preparing its financial statements. The four-step process described in the following paragraphs is an example of such a process. This description provides an overview of the role materiality plays in the preparation of financial statements, with a focus on the factors the entity should consider when making materiality judgements. In this Practice Statement, this four-step process is called the ‘materiality process’.

The materiality process describes how an entity could assess whether information is material for the purposes of presentation and disclosure, as well as for recognition and measurement. The process illustrates one possible way to make materiality judgements, but it incorporates the materiality requirements an entity must apply to state compliance with Australian Accounting Standards. The materiality process considers potential omission and potential misstatement of information, as well as unnecessary inclusion of immaterial information and whether immaterial information obscures material information. In all cases, the entity needs to focus on how the information could reasonably be expected to influence decisions of the primary users of its financial statements.

Judgement is involved in assessing materiality when preparing financial statements. The materiality process is designed as a practice guide to help an entity apply judgement in an efficient and effective way.

The materiality process is not intended to describe the assessment of materiality for local legal and regulatory purposes. An entity refers to its local requirements to assess whether it is compliant with local laws and regulations.

The steps identified as a possible approach to the assessment of materiality in the preparation of the financial statements are, in summary:

(a)                Step 1—identify. Identify information that has the potential to be material.

(b)                Step 2—assess. Assess whether the information identified in Step 1 is, in fact, material.

(c)                Step 3—organise. Organise the information within the draft financial statements in a way that communicates the information clearly and concisely to primary users.

(d)                Step 4—review. Review the draft financial statements to determine whether all material information has been identified and materiality considered from a wide perspective and in aggregate, on the basis of the complete set of financial statements.

When preparing its financial statements, an entity may rely on materiality assessments from prior periods, provided that it reconsiders them in the light of any change in circumstances and of any new or updated information.

An entity identifies information about its transactions, other events and conditions that primary users might need to understand to make decisions about providing resources to the entity.

In identifying this information, an entity considers, as a starting point, the requirements of the Australian Accounting Standards applicable to its transactions, other events and conditions. This is the starting point because, when developing a Standard, the Board identifies the information it expects will meet the needs of a broad range of primary users for a wide variety of entities in a range of circumstances.^{[23], [AusCF23]}

When the Board develops a Standard, it also considers the balance between the benefits of providing information and the costs of complying with the requirements in that Standard. However, the cost of applying the requirements in the Standards is not a factor for an entity to consider when making materiality judgements—the entity should not consider the cost of complying with requirements in Australian Accounting Standards, unless there is explicit permission in the Standards.

An entity also considers its primary users’ common information needs (as explained in paragraphs 21–23) to identify any information—in addition to that specified in Australian Accounting Standards—necessary to enable primary users to understand the impact of the entity’s transactions, other events and conditions on the entity’s financial position, financial performance and cash flows (see paragraph 10). Existing and potential investors, lenders and other creditors need information about the resources of the entity (assets), claims against the entity (liabilities and equity) and changes in those resources and claims (income and expenses), and information that will help them assess how efficiently and effectively the entity’s management and governing board have discharged their responsibility to use the entity’s resources. ^{[24], [AusCF24]}

In respect of not-for-profit entities, primary users need information about the service potential of existing resources, as noted in paragraph Aus18.1. For example, a significant impairment in the service potential of an entity’s assets could result in the entity needing either to obtain additional resources in order to maintain the level or scope of its activities in providing goods or services or to reduce its activities. Donors to the entity might seek explanation of the significant impairment in considering whether to continue to provide resources to the entity or to withdraw their support.

The output of Step 1 is a set of potentially material information.

An entity assesses whether the potentially material information identified in Step 1 is, in fact, material. In making this assessment, the entity needs to consider whether its primary users could reasonably be expected to be influenced by the information when making decisions about providing resources to the entity on the basis of the financial statements. The entity performs this assessment in the context of the financial statements as a whole.

An entity might conclude that an item of information is material for various reasons. Those reasons include the item’s nature or magnitude, or a combination of both, judged in relation to the particular circumstances of the entity.^[25] Therefore, making materiality judgements involves both quantitative and qualitative considerations. It would not be appropriate for the entity to rely on purely numerical guidelines or to apply a uniform quantitative threshold for materiality (see paragraphs 53–55).   

The following paragraphs describe some common ‘materiality factors’ that an entity should use to help identify when an item of information is material. These factors are organised into the following categories:

(a) quantitative; and

(b) qualitative—either entity-specific or external.

The output of Step 2 is a preliminary set of material information. For presentation and disclosure, this involves decisions about what information an entity needs to provide in its financial statements, and in how much detail^[26] (including identifying appropriate levels of aggregation an entity provides in the financial statements). For recognition and measurement, the output of Step 2 involves the identification of information that, if not recognised or otherwise misstated, could reasonably be expected to influence primary users’ decisions.

An entity ordinarily assesses whether information is quantitatively material by considering the size of the impact of the transaction, other event or condition against measures of the entity’s financial position, financial performance and cash flows. The entity makes this assessment by considering not only the size of the impact it recognises in its primary financial statements but also any unrecognised items that could ultimately affect primary users’ overall perception of the entity’s financial position, financial performance and cash flows (eg contingent liabilities or contingent assets). The entity needs to assess whether the impact is of such a size that information about the transaction, other event or condition could reasonably be expected to influence its primary users’ decisions about providing resources to the entity.

Identifying the measures against which an entity makes this quantitative assessment is a matter of judgement. That judgement depends on which measures are of great interest to the primary users of the entity’s financial statements. Examples include measures of the entity’s revenues, the entity’s profitability, financial position ratios and cash flow measures.

Not-for-profit entities are primarily concerned with the achievement of objectives other than the generation of profit, such as service delivery. Accordingly, it may not be appropriate to assess materiality by reference to profitability. In these cases, it is more appropriate to consider materiality in absolute and relative terms.

In absolute terms, consideration is given by not-for-profit entities to the financial report as a whole. In particular, consideration is given to factors that may indicate deviations from normal activities, such as the reversal of a trend, turning a profit into a loss, or creating or eliminating the margin of solvency in the statement of financial position. For example, where the entity’s financial position has deteriorated, and the entity has revalued its assets upwards, information regarding the revaluation of those assets would be likely to be material.

In relative terms, items are compared by not-for-profit entities to any directly related items. For example, the amount of interest revenue would be compared with the amount of the relevant loans. Such a comparison may indicate that information about the interest is material because the amount is lower (or higher) than expected, having regard to the loan balance and the applicable interest rates. This could indicate changes in the proportion of loans being made to different categories of borrowers in comparison with previous periods.

For the purposes of this Practice Statement, qualitative factors are characteristics of an entity’s transactions, other events or conditions, or of their context, that, if present, make information more likely to influence the decisions of the primary users of the entity’s financial statements. The mere presence of a qualitative factor will not necessarily make the information material, but is likely to increase primary users’ interest in that information.

In making materiality judgements, an entity considers both entity-specific and external qualitative factors. These factors are described separately in the following paragraphs. However, in practice, the entity may need to consider them together.

An entity-specific qualitative factor is a characteristic of the entity’s transaction, other event or condition. Examples of such factors include, but are not limited to:

(a) involvement of a related party of the entity;

(b) uncommon, or non-standard, features of a transaction or other event or condition; or

(c) unexpected variation or unexpected changes in trends. In some circumstances, the entity might consider a quantitatively immaterial amount as material because of the unexpected variation compared to the prior-period amount provided in its financial statements.

The relevance of information to the primary users of an entity’s financial statements can also be affected by the context in which the entity operates. An external qualitative factor is a characteristic of the context in which the entity’s transaction, other event or condition occur that, if present, makes information more likely to influence the primary users’ decisions. Characteristics of the entity’s context that might represent external qualitative factors include, but are not limited to, the entity’s geographical location, its industry sector, or the state of the economy or economies in which the entity operates.

Due to the nature of external qualitative factors, entities operating in the same context might share a number of external qualitative factors. Moreover, external qualitative factors could remain constant over time or could vary.

In some circumstances, if an entity is not exposed to a risk to which other entities in its industry are exposed, that fact could reasonably be expected to influence its primary users’ decisions; that is, information about the lack of exposure to that particular risk could be material information.

An entity could identify an item of information as material on the basis of one or more materiality factors. In general, the more factors that apply to a particular item, or the more significant those factors are, the more likely it is that the item is material.

Although there is no hierarchy among materiality factors, assessing an item of information from a quantitative perspective first could be an efficient approach to assessing materiality. If an entity identifies an item of information as material solely on the basis of the size of the impact of the transaction, other event or condition, the entity does not need to assess that item of information further against other materiality factors. In these circumstances, a quantitative threshold—a specified level, rate or amount of one of the measures used in assessing size—can be a helpful tool in making a materiality judgement. However, a quantitative assessment alone is not always sufficient to conclude that an item of information is not material. The entity should further assess the presence of qualitative factors.

The presence of a qualitative factor lowers the thresholds for the quantitative assessment. The more significant the qualitative factors, the lower those quantitative thresholds will be. However, in some cases an entity might decide that, despite the presence of qualitative factors, an item of information is not material because its effect on the financial statements is so small that it could not reasonably be expected to influence primary users’ decisions.

In some other circumstances, an item of information could reasonably be expected to influence primary users’ decisions regardless of its size—a quantitative threshold could even reduce to zero. This might happen when information about a transaction, other event or condition is highly scrutinised by the primary users of an entity’s financial statements. Moreover, a quantitative assessment is not always possible: non-numeric information might only be assessed from a qualitative perspective.

Appendix A to this Practice Statement provides guidance on assessing the materiality of key management personnel related party transactions of not-for-profit sector entities.

Classifying, characterising and presenting information clearly and concisely makes it understandable.^{[27], [AusCF27]} An entity exercises judgement when deciding how to communicate information clearly and concisely. For example, the entity is more likely to clearly and concisely communicate the material information identified in Step 2 by organising it to:

(a) emphasise  material matters;

(b) tailor information to the entity’s own circumstances;

(c) describe the entity’s transactions, other events and conditions as simply and directly as possible without omitting material information and without unnecessarily increasing the length of the financial statements;

(d) highlight relationships between different pieces of information;

(e) provide information in a format that is appropriate for its type, eg tabular or narrative;

(f) provide information in a way that maximises, to the extent possible, comparability among entities and across reporting periods;

(g) avoid or minimise duplication of information in different parts of the financial statements; and

(h) ensure material information is not obscured by immaterial information.

Financial statements are less understandable for primary users if information is organised in an unclear manner. Similarly, financial statements are less understandable if an entity aggregates material items that have different natures or functions, or if material information is obscured,^[28] for example, by an excessive amount of immaterial information.

Furthermore, an entity considers the different roles of primary financial statements and notes in deciding whether to present an item of information separately in the primary financial statements, to aggregate it with other information or to disclose the information in the notes.

The output of Step 3 is the draft financial statements.

An entity needs to assess whether information is material both individually and in combination with other information^[29] in the context of its financial statements as a whole. Even if information is judged not to be material on its own, it might be material when considered in combination with other information in the complete set of financial statements.   

When reviewing its draft financial statements, an entity draws on its knowledge and experience of its transactions, other events and conditions to identify whether all material information has been provided in the financial statements, and with appropriate prominence.

This review gives an entity the opportunity to ‘step back’ and consider the information provided from a wider perspective and in aggregate. This enables the entity to consider the overall picture of its financial position, financial performance and cash flows. In performing this review, the entity also considers whether:

(a) all relevant relationships between different items of information have been identified. Identifying new relationships between information might lead to that information being identified as material for the first time.

(b) items of information that are individually immaterial, when considered together, could nevertheless reasonably be expected to influence primary users’ decisions.

(c) the information in the financial statements is communicated in an effective and understandable way, and organised to avoid obscuring material information.

(d) the financial statements provide a fair presentation of the entity’s financial position, financial performance and cash flows.^{[30], [AusCF30]}   

The review may lead to:

(a) additional information being provided in the financial statements;

(b) greater disaggregation of information that had already been identified as material;

(c) information that had already been identified as immaterial being removed from the financial statements to avoid obscuring material information; or

(d) information being reorganised within the financial statements.

The review in Step 4 may also lead an entity to question the assessment performed in Step 2 and decide to re-perform that assessment. As a result of re-performing its assessment in Step 2, the entity might conclude that information previously identified as material is, in fact, immaterial, and remove it from the financial statements.

The output of Step 4 is the final financial statements.