By Gary Kabureck, Member, International Accounting Standards Board
'Financial statements need to communicate better'... was the essence of a pointed message the International Accounting Standards Board (Board) heard in early 2013. In response, our chair Hans Hoogervorst committed us to address, and resolve, what is colloquially referred to as 'the disclosure problem'. From this sprung an integrated suite of related projects under an umbrella title, the 'Disclosure Initiative', and by 2016 Hans' commitment had evolved into our unifying theme for the next five years: Better Communication in Financial Reporting.
Preparers define the disclosure problem as 'too much irrelevant information' (AKA disclosure overload) whereas investors see it more as 'not enough relevant information'. Both groups agree that whatever is communicated is neither organised nor presented effectively. So. . .what to do?
As our journey began, it soon became obvious that materiality—how it is defined and how it is applied—was a major contributor to the problem. The Disclosure Initiative set out to, once and for all, comprehensively address the problems caused by how the concept of materiality is applied in practice. Embedded practices only change slowly so we knew this would be a multi-step endeavor. Here goes:
Our first concrete deliverable occurred in late 2014 with amendments to IAS 1 Presentation of Financial Statements. These amendments accomplished several things such as providing much needed flexibility for preparers in organising footnotes and how to deal with vexing issues such as aggregation and subtotals. It also included our first foray into addressing disclosure materiality. The Board clarified that just because a particular item—say investment securities—was material for inclusion on the face of the financial statements, it does not automatically mean every enumerated disclosure on that subject is also material.
Further, we made it clear that the materiality, and hence the need—or lack thereof—for a specific disclosure is assessed in the context of the financial statements taken as a whole. We also took our first steps towards addressing how we draft disclosure requirements. We observed that IFRS disclosure requirements often begin with phrases such as 'At a minimum an entity shall disclose. . .'. Widespread practice interpreted such wording literally. That was never our intention and we clarified that the materiality concept always overrules any 'at a minimum' type language.
Further developing our views on applying materiality, in 2017 we published our second major deliverable in this project in the form of IFRS Practice Statement 2 Making Materiality Judgements (Practice Statement), a 50-page document providing non-mandatory application guidance. We did consider if it should be mandatory. In the end, we concluded such would be impractical after considering the wide variety of local laws on the subject. Case in point—witness the Financial Accounting Standards Board's recent challenges trying to revise the US GAAP definition of materiality. While officially non-authoritative, I expect over time the Practice Statement will have an outsized impact on practice. It is written in such a way that individual jurisdictions could make it locally authoritative if they want to. And don't forget, its guidance represents the unanimous consensus of the Board that sets accounting standards used in over 140 countries as how to best think about materiality. Let me focus on a few of its key messages:
It begins by defining who the audience for a company's financial reporting is: who are the primary users and what information do they need? We have concisely defined the primary users as investors, lenders and other creditors—current or potential—who must rely on general purpose financial statements for much of their information needs. A company may have several classes of primary users and the focus of materiality judgements—especially for disclosures—should be on their common information needs.
The implications of defining the 'customers' for a company's financial reporting this way are significant. First, it eliminates non-capital providers from its scope as well as company insiders and others with sufficient influence to receive financial information from the company more privately. By focusing materiality judgements around common information needs this definition also largely eliminates atypical investors with unique or personal information needs, and users—even if investors—who have unreasonable demands. Lastly, we confirm that the relevant decisions financial reporting is intended to assist are those of capital allocation, in other words to make or change investment or credit-related buy, sell, hold or lend decisions. If an amount reported or disclosed is unlikely to reasonably influence those decisions, then it likely isn't material.
The Practice Statement outlines a practical guide to making materiality judgements and assessing their implications. To me it's the punchlines which are key. It makes it clear that materiality is assessed in the context of the financial statements taken as a whole—be it for errors or omissions in recognition and measurement, presentation or disclosures. So, for example, an omitted disclosure which may be material to understanding a company's share-based compensation disclosures may nonetheless be immaterial to understanding the financial statements taken as a whole. Importantly, we remind preparers of financial statements that deliberate errors to achieve a desired reporting outcome are always prohibited!
While not as comprehensive as I personally would have preferred (for example, it doesn't address 'deliberate errors' from widely accepted bookkeeping conventions) the Practice Statement is a great document and it provides impressive guidance on a variety of historically challenging issues such as how to deal with cumulative errors, materiality and interim reporting, disclosure implications when there is widely available information from other sources, the continuing relevance of prior period information, amongst others.
In late 2018, the Board finalised a revised definition of 'material'. The revisions are important but not profound. First, several different IFRS Standards had ever so slightly different iterations of the definition, so it was important to conform them. One thing I have learned over the years: if you want things to be understood the same way, then word them the same way! The new definition reads as follows (emphasis added):
'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.'
The highlighted text deserves some discussion. We elevated the notion of 'obscuring' from supporting guidance elsewhere in the IFRS literature, to the primary definition. This is not about a preparer's writing style; rather what we have in mind is something akin to the buried facts doctrine found in securities law. In other words, a material fact might as well be omitted if it is so hard to find or understand. You may recall Enron was a master of this art.
The new language, 'could reasonably be expected', replaces current text which says in relevant part '. . .could influence the decisions. . .' Leaving it at 'could influence' is too broad as anything could influence some user. We also noted our current supporting guidance already incorporates 'could reasonably be expected' language which we concluded more accurately describes the long-standing intention of the Board. We briefly considered if the word 'would' is a better place to be than 'could' but quickly rejected such. In our view 'would influence' is too disadvantageous to primary users and the middle ground of 'could reasonably be expected' strikes the appropriate balance.
Our materiality journey is almost complete—only one major task remains. I began this article by observing the way we write Standards contributes to the disclosure problem. Too often our Standards, especially in the disclosure requirements, use phrases such as 'an entity at a minimum must disclose. . .' Further, it is rare for our Standards to include higher-level disclosure objectives. In theory, the 2014 amendments to IAS 1 should resolve the matter. Still, old habits die slowly, and the problematic wording still exists in many Standards.
The final act of the Disclosure Initiative is to study how we draft Standards. We have selected for analysis two disclosure-heavy Standards which have been criticised for requiring voluminous disclosures. They are IAS 19 Employee Benefits and IFRS 13 Fair Value Measurement. We have two objectives: first, to develop a better process for drafting IFRS Standards and, secondarily, to potentially amend those Standards to address known issues. I predict we will be successful in both. Whether this eventually leads to an oft requested Standards-level review of all disclosure requirements, only time will tell.
This article is organised as a timeline. But some critical things are timeless. The first is the paramount role of judgement in financial reporting. We cannot write rules for everything so judgement is a part of the process. Management judgements should be unbiased and neutral or, in other words, reasonable. Likewise, it is critical for auditors and regulators to respect management's reasonable judgements even if not their preferred solution.
Another timeless concept is that material errors must be timely corrected and deliberate errors, even if quantitatively immaterial but made for the purpose of achieving a pre-determined result (AKA cooking the books), are prohibited.
Lastly, while we cannot 'outlaw' the disclosure of immaterial items, we have done our best to discourage them and have made it clear they cannot obscure material information.
Modernising materiality has been a fascinating journey and much has been accomplished. As a former chief accounting officer of a global corporation, here is how I see it: we have set the stage to eliminate the checklist approach to disclosures; confirmed the framework for assessing materiality is against the financial statements taken as a whole; firmed up and, in practical terms, narrowed the audience for financial reporting and the decisions our Standards are designed to assist them with; refreshed our definition of material and reinforced that judgement is paramount in the process. And to boot, we are building a process for how to better draft future Standards.
Mr. Kabureck is a member of the International Accounting Standards Board. The views expressed in this article are his alone and do not necessarily represent the views of the Board or individual Board members.