Materiality is a relativity

Relative Size Vs. Absolute Size

Relative rather than absolute means an error that would be considered material for
one company may not be for another.

 Materiality refers to an amount (or transaction) that would influence the

decisions of users.

Example: A large company has a building in the hurricane zone during Hurricane
Sandy. The company building is destroyed and after a lengthy battle with the
insurance company, the company reports an extra ordinary loss of $10,000. The
company has net income of $10,000,000. The materiality concept states that this loss
is immaterial because the average financial statement user would not be concerned
with something that is only .1% of net income.

–Assume the same example above except the company is a smaller company with
only $50,000 of net income. Now the loss is 20% of net income. This is a substantial
loss for the company. Investors and creditors would be concerned about a loss this
big. To the smaller company, this $10,000 would be considered material.

When is an item material?

Straight-Line

Depreciation Expense = Cost − Salvage Value/ Useful Life of the Asset

New Definition of Materiality

 (a) Considers whether misstatements probably change or influence economic

decisions of users, rather than could influence economic decisions. Use of the
term “could” potentially sets a very low bar. (b) The users of financial statements
are “reasonable” when making decisions; (c) Users have a reasonable
understanding of business, economic activities and financial reporting.

 The amendments explain that information is obscured if it is communicated in a

way that would have a similar effect as omitting or misstating the information.

Material information may be obscured if information regarding a material item,

transaction or other event is scattered throughout the financial statements, or
disclosed using a language that is unclear. Material information can also be obscured
if dissimilar items, transactions or other events are inappropriately aggregate
(grouped) or conversely, if similar items are inappropriately disaggregated.

The amended IAS 1 explains that information is obscured if it is disclosed using

vague or unclear language or it is ‘lost’ in immaterial information so that a reader is
unable to determine which information is material and which isn’t.

Factors of Materiality

 The magnitude of an omission or misstatement of accounting

information that, in the light of surrounding circumstances,
makes it probable that the judgment of a reasonable person
relying on the information would have been changed or
influenced by the omission or mis-statement

Example: (Size) Fuel expense of vehicles are now charged as selling and
distribution expense in the financial statements. Previously it was considered
administration expense.
 Maldives Plc’s total sales for the financial year 2012 amounts to $100 million and
its total assets are $50 million. The company’s external auditors have found out that
$3 million worth of sales shouldn’t be recognized in financial year 2012 because the
risks and rewards inherent in the sales have not been transferred.

This amount of $3 million is material in the context of total assets of $50 million. The
company should adjust its financial statements.

Example: (Nature) The salaries paid to a company’s executives and directors is

material due to qualitative reasons (even it is not material quantitatively). It is
because the investors would like to make sure that the management is not
overcompensating itself.

FAITHFUL REPRESENTATION

 Faithful representation requires that transactions and events should be

accounted for in a manner that represent their true economic substance rather
than the mere legal form. This concept is known as Substance Over Form.

Substance over form requires that if substance of transaction differs from its

legal form than such transaction should be accounted for in accordance with its
substance and economic reality.

Example: ABC LTD sold 3000 bread loafs to XYZ Bakers in the year 2011 costing $1
each. XYZ Bakers has the option to return unsold breads to ABC LTD within 7 days
of the sale. In the first week of 2012, XYZ Bakers returned 200 of unsold bread loafs
to ABC LTD. How much sale should ABC LTD recognize in the income statement for
the year 2011? 2800

1.  Completeness: Depiction of all necessary information for a user to understand

the phenomenon being depicted. It includes all necessary descriptions and
explanations (adequate or full disclosure of all necessary information). All of the
information that a user needs in order to form a clear picture of the results,
financial position, and cash flows of a business are included in the financial
statements

 The full disclosure principle states that information that would “make a
difference” to financial statement users or would be useful in decision-making
should be disclosed in the financial statements. This way investors or creditors
can see a total picture of the company before they choose to take any action.

 Footnotes to the financial statements serve as a way for a company to

provide additional explanations for various portions of their financial statements.
2. Neutrality: Depiction is without bias in the selection or presentation of Financial
information must not be manipulated in any way in order to influence the decision of
users. (fairness and freedom from bias), We often refer to a term called True and Fair
View in Accounting. 

For example, biased financial statements could be used to give an overly

optimistic view of a business in order to encourage a prospective buyer to pay a
higher price for it. Conversely, financial statements could be made to look worse
in order to reduce its related income tax liability.

 Prudence requires that accountants should exercise a degree of caution in the

adoption of policies and significant estimates such that the

assets and income of the entity are not overstated whereas liability and
expenses are not under stated.

The rationale behind prudence is that a company should not recognize an asset at a
value that is higher than the amount which is expected to be recovered from its sale
or use. Conversely, liabilities of an entity should not be presented below the amount
that is likely to be paid in its respect in the future.

Example: Inventory is recorded at the lower of cost or net realizable value (NRV)
((estimated selling price of goods, minus the cost of their sale ))rather than the
expected selling price. This ensures profit on the sale of inventory is only realized
when the actual sale takes place.

For example say Sporty Mac had in his running franchise business some very old
sports equipment. This had been bought for £10,000. It had never sold and is is
sitting in his store and. In reality the equipment is worth nothing.
In this example what would the prudence concept say ? It would say he should write
the value of the equipment down to zero as it is worthless.

 Under the conservatism principle, if there is uncertainty about incurring a

loss, you should tend toward recording the loss. Conversely, if there is
uncertainty about recording a gain, you should not record the gain.

For example , if the collections staff believes that a cluster of receivables will
have a 2% bad debt percentage because of historical trend lines, but the sales
staff is leaning towards a higher 5% figure because of a sudden drop in industry
sales, use the 5% figure when creating an allowance for doubtful accounts,
unless there is strong evidence to the contrary.

3. Free from error: means there are no errors and inaccuracies in the description of

the phenomenon and no errors made in the process by which the financial
information was produced. (no inaccuracies and omissions). That does not mean no
inaccuracies can arise, particularly in case of making estimates. The standards
expect that the estimates are made on a realistic basis and not arbitrarily. 
 If there is a continuing series of "errors" that tend to bias the results of the
financial statements in a certain direction, this may be considered a case of
financial reporting fraud.

Measureent Uncertainty

Financial statements often contain estimates and other information based on

uncontrollable events that can impact future financial reporting and transactions. 

Substance Over Fom

Substance over form is an accounting concept which means that the economic

substance of transactions and events must be recorded in the financial statements
rather than just their legal form in order to present a true and fair view of the affairs of
the entity.

Example: A company buys vans from a bank under a lease agreement for the
purposes of transport. Under that agreement, the company will have to pay some
advance and will pay the remaining amount for vans in 4 year installments. Now
although after paying the advance bank will provide the company with the possession
of the vans and company will own those vans from an “economic point of view”, but it
will not be recognized as the “legal owner” of those vans until it pays the final
installment.