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

Background

While reviewing the draft Materiality Practice Statement (PS), certain external reviewers questioned the appropriateness of the proposed guidance on assessing whether a covenant is material.

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 suggests that information about covenants will always be material if the likelihood of a breach 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 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 paragraph 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.

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. These guidance require an entity and an auditor, respectively, to consider covenants when establishing materiality for their respective purposes.

The Staff continue to believe that to require an assessment of how a covenant would influence the preparation of the information on which the covenant is assessed would create a circular assessment. They also believe that the proposed guidance is not inconsistent with any of the existing Standards.

Staff recommendation

In light of the above, the Staff recommend that no change be made to the Materiality PS.