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Materiality practice statement

Date recorded:

Materiality Practice Statement - Sweep issue: Covenants - Agenda paper 11

Background

While reviewing the draft Materiality Practice Statement (PS), some external reviewers questioned the appropriateness of the proposed guidance on covenants.

Staff analysis

Issue 1

The PS states at paragraph 84 that even if the consequences of breaching a covenant is significant, the information about that covenant would not be material – and thus need not be disclosed in the financial statements – if the likelihood of breaching it is remote.

Some reviewers were of the view that this guidance introduces a new disclosure threshold because it suggests that information about covenants will always be material if the likelihood of breaching it is higher than remote.

The Staff note that the ‘remote likelihood’ concept is taken from IAS 37.28. This paragraph requires a contingent liability to be disclosed unless the possibility of an outflow of economic benefits is remote. The Staff believe that breaching a covenant is similar to a contingent liability because both are affected by uncertain future events. Accordingly, the Staff continue to believe that IAS 37.28 provides an appropriate basis for confirming the guidance on disclosing information about covenants.

Issue 2

The PS states at paragraphs 85 and 86 that an entity makes materiality judgements in the preparation of its draft financial statements without considering the existence of covenants. The entity then assesses its compliance with any covenants once the draft financial statements have been prepared. This is because covenant terms are often defined on the basis of information in IFRS financial statements, and to require an assessment of how a covenant would influence the preparation of the information on which the covenant is based would be circular.

Some reviewers believed that this guidance conflicts with the US Securities and Exchange Commission’s guidance on materiality as well as the requirements of International Standard on Auditing 450. They require an entity and an auditor, respectively, to consider covenants when establishing materiality for their respective purposes. Some reviewers also believed that having guidance that conflicts with local regulations might be seen as a new interpretation of the existing requirements in the Standards, which would be contrary to the nature of a PS.

In light of these comments, the Staff considered (a) retaining, (b) removing, or (c) replacing the affected guidance. On balance, the Staff believe that removing the guidance is the best alternative in light of the objectives of the PS.

The Staff believe that having guidance that conflicts with those in the auditing standards and local regulations would create confusion among parties involved in financial reporting. This would in turn defeat the objective of having the PS serve as a reference point for discussions between an entity, its auditors and regulators on the assessment of materiality.

The Staff also believe that replacing the guidance with something that suggests that covenants can influence materiality judgements would not be operational. Firstly, this would conflict with the Board’s decision in November 2016. Secondly, such guidance might result in an endless reassessment of materiality the closer the entity gets to a covenant breach. Finally, if materiality judgements are influenced by covenants, then other contractual agreements with terms that are based on the figures in the financial statements might also influence materiality judgements, e.g. profit sharing agreements and management incentive plans. In the extreme case, this might result in all figures in the financial statements being material.

Staff recommendation

In light of the above, the Staff recommend that the Board:

  • Retain the guidance in paragraphs 82-84 regarding how to assess the materiality of information related to covenants (see issue 1); and
  • Remove the guidance in paragraphs 85-86 and example Q regarding the impact of covenants on the materiality of other information (see issue 2).

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