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 noted 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 believes that breaching a covenant is similar to a contingent liability because both are affected by uncertain future events. Accordingly, the Staff continues 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 believes that removing the guidance is the best alternative in light of the objectives of the PS.

The Staff believes 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 believes 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 recommended 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).

Discussion

The Board members had strongly opposing views on this issue. The Staff recommendations were approved by a narrow margin. The discussion centred on issue 2.

Those who supported removing the guidance raised the following points:

• One of the main objectives of the PS is to promote a change in behaviour on how materiality is assessed. Having an immediate conflict between the PS and the regulatory and auditing requirements would hardly assist in achieving this objective, and would undermine the three-way relationship and dialogue between the preparer, auditor and regulator. In contrast, removing the guidance would remove a clear point of tension from the document.
• The ED originally proposed that materiality judgements should be influenced by the existence of covenants, i.e. directly opposite to what the current draft of the PS proposes. As such, the stakeholders have not had a chance to comment on the current proposals. Furthermore, given that the PS is not supposed to introduce new guidance or interpretation, by exposing one way of thinking but finalising it in the completely opposite way, neither of which is supposed to be ‘new’ guidance, is inherently contradictory and indicates that the Board itself has not clearly thought through the matter. Retaining the guidance under such circumstances would only create confusion.
• Some members think that a non-authoritative PS is not the right place to include such guidance, because it will have no weight against other authoritative guidance in case of conflicts. If the Board were to issue guidance on how covenants would affect the materiality assessment of other information, some Board members believed that it should be discussed head-on specifically with the aim of producing authoritative guidance, rather than as a by-product of a general discussion on materiality.
• One Board member believed that it is more of a reciprocal assessment than a circular assessment if covenants were considered when making materiality judgements on other information. It would involve ‘a quick peek’ of the covenants, existing information and a mental calculation of what materiality would be and then reassessing the impact again. He observed that such reciprocal assessments are applied to many things when preparing financial statements. As such, an outright prohibition on considering covenants may not be appropriate. Given the discussions around the table, it is evident that the Board members are not on the same page nor are they clear that they have got this right. Hence he believed that it would be better to remove the guidance to bring the situation back to neutral ground.

Those who supported retaining the guidance observed as follows:

• Regulatory and auditing guidance should not drive the Board’s decisions as they are created for different purposes. The Board is not required, nor is it able, to consider all regulatory requirements when making decisions. This case should be no different. Furthermore, the Staff was not sure whether regulators apart from the SEC require covenants to be considered when making materiality judgements. Since the SEC requirements apply only a subset of IFRS financial statements preparers, these Board members believed that it is not appropriate to remove the guidance just because of a conflict with one regulator.
• As mentioned above, one of the objectives of the PS is to trigger a change in behaviour. If the Board is shrinking away from this guidance because of the potential conflicts and the likely debates that it will sparkle, then the Board would have missed its objective.
• The Board has debated this issue before and arrived at the current proposal. If it abandons it now, it could be seen as endorsing the current behaviour (whatever that may be).