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The Bruce Column — Quality, not quantity, should define materiality

19 Oct 2012

The use of materiality as a means of bringing coherence to disclosures has come to the fore in the latest thinking from the UK Financial Reporting Council, says our resident columnist, Robert Bruce.

There is probably only one aspect of current financial reporting on which everyone can unequivocally agree. There is too much of it. As a result there have been cascades of suggested solutions for trimming the mass of information. People have tried to cut clutter. They have tried to shorten the reports. They have tried to make them more readable. But we still face a forest of trees and little chance of seeing the wood within.

Another tack is required. And as the IASB rolls up its sleeves to start its work on a disclosure framework there is no shortage of advice. It would be best to start from the point of agreement. There is too much stuff being disclosed in a relatively disorganised way. What is required is a better way of defining what should and shouldn’t be there without making the process too rigid and prone to excess boilerplatery.

Back in 2011 ESMA, the European Securities and Markets Authority, pointed to one way forward with its consultation paper on the issue of materiality in financial reporting. And in August this year it produced a summary of the responses which it received. Perhaps the most significant was this: ‘Responses across most stakeholder groups raised concerns about the length of disclosures reaching the point where they could obscure readers’ understanding of the entity’s financial position and performance. Many respondents considered that proper application of the materiality concept could address this position.’

And so it comes as no surprise to find the UK’s Financial Reporting Council devoting a sizeable chunk of its new paper, ‘Thinking about Disclosures in a Broader Context’, to the topic. ‘In our view’, it says at the outset, ‘the “disclosure problem” is not just about quantity; the quality of disclosures, in terms of meeting the needs of users, is also an issue. Financial reports have become a disjointed collection of disclosures driven by different authoritative sources. The objective of financial reporting seems to have been forgotten as disclosures have become more about compliance than communication’.

And for the FRC too the answer is a disclosure framework as an attempt to ‘empower preparers to apply materiality more robustly to disclosures’. From there a principle is developed: ‘Materiality is entity-specific. Preparers apply materiality to disclosure requirements set by regulators so that financial reports only provide disclosures that are relevant to the entity’.

But the water simply becomes muddier when it comes to disclosure. ‘Materiality as a concept in relation to recognition and measurement is well-established’, the paper says. ‘However, what materiality means from a disclosure perspective is less clear. Therefore, it is not surprising that materiality is not being applied robustly to disclosures’. So there is a resulting confusion. ‘Some would say that we have a principle-based model for recognition and measurement, but a compliance-based model for disclosures’. And what does this lead to? ‘The overall result is disclosure of immaterial information that leads to clutter’, concludes the paper.

The problem is the lack of precision, something which both preparers and users of financial reporting like to depend upon. The IASB’s Conceptual Framework essentially defines whether information is material or not by whether its omission or misstatement would mislead users. The UK Accounting Standards Board adds the point that by shunting too much immaterial information into the financial statements ‘the resulting clutter can impair the understandability of the other information provided’ And amongst IFRSs IAS 1 makes it clear that ‘an entity need not provide a specific disclosure required by an IFRS if the information is not material’.

So the building blocks do exist. It is just that they are scattered about in disparate places and not made plain in some central repository. What the FRC is suggesting is that some classification criteria might make it simpler. They suggest three: ‘top-level’, the sort of disclosures ‘that would be of interest to the 10-minute reader’; middle level, based on the ‘concept of materiality as described in accounting standards; and bottom level where ‘items that are considered to be insignificant or trivial’ would languish.

As so often the problem will be definitions, boundaries and precision. Or, as the FRC puts it: ‘Determining the order of magnitude of these different terms can be difficult’.

It suggests the following: ‘significant, material, not material, immaterial’, and, finally, ‘insignificant’. That makes sense. But the task ahead would be to set boundaries between them. The FRC agrees that this is ‘not an easy task’ but is sure that the IASB will be up to it. ‘We recommend that the IASB considers this point and as a minimum uses the terms consistently’, it says. And then provides a helpful graphic showing how the application of a framework to materiality in disclosures within financial statements might work.

It is a start. But it is only one of many proposals, ideas and initiatives which the IASB will be presented with as it starts its own thinking process. There is a long way to go and Hans Hoogervorst’s proposed timeline for completing the IASB’s conceptual framework programme by 2015 is very ambitious.