Materiality (3)

Materiality is really a quantitative threshold linked very closely to the qualitative characteristics of
relevance.

Materiality (4)

The relevance of information is affected by its nature and materiality.

Materiality (5)

In other words, materiality is a subquality of relevance based on the nature or magnitude or both of the
items to which the information relates.

Materiality (6)
The Conceptual Framework does not specify a uniform quantitative threshold for materiality or
predetermine what could be material in a particular situation.

Materiality is a Relativity

Materiality of an item depends on relative size rather than absolute size. What is material for one entity
may be immaterial for another.

An error of P500,000 in the financial statements of a multinational entity may not be important but may
be so critical for a small entity.

When is an Item Material?

There is no strict or uniform rule for determining whether an item is material or not.

Very often, this is dependent on good judgement, professional expertise, and common sense.

As a general guide, an item is material if knowledge of it could reasonably affect or influence the
economic decision of the primary users of the financial statements.

New Definition of Materiality

The IASB provided the following new definition of materiality:

Information is material if omitting, misstating, or obscuring; it could reasonably be expected to influence

the economic decisions that primary users of general purpose financial statements make on the basis of
those statements which provide financial information about a specific reporting entity.

In other words, an information is material if the omission, misstatement, and obscuring of the
information could reasonably affect the economic decision of primary users.

The revised definition of materiality highlights three important aspects:

a. Could reasonably be expected to influence

b. Obscuring information

c. Primary Users

Could Reasonably be Expected to Influence

The could reasonably be expected to influence threshold adds an element of reasonability of financial
information on which economic decision is based.

By incuding the term could reasonably expected to influence in the new definition, material information
shall be limited to the economic decision of primary users rather than to all users which is too broad in
scope.

Moreover, the could reasonably be expected to influence threshold insures that information capable of
influencing economic decision of the primary users shall be included in the financial statements.

Obscuring Information

Obscuring information is a new concept added to the new definition of materiality.

Information is obscured if presenting or communicating it would have a similar effect as omitting or

misstating the information.

Obscuring information means the presentation of financial information not readily understood or not
clearly expressed.

Obscuring information may be characterized by deliberate vagueness, ambiguity, and abstruseness.

Examples of obscured material information are:

a. The language is vague or unclear

b. The information is scattered throughout the financial statements.

c. Dissimilar items are aggregated inappropriately

d. Similar items are dissaggregated inappropriately

Primary Users

The new definition of materiality narrows the definition to primary users who are primarily affected by
general purpose financial statements.

The primary users include the existing and potential investors, lenders and other creditors.

The new definition specified that only primary users of financial statements are considered because
these groups are the users to whom general purpose financial statements are primarily directed.

Such primary users cannot require reporting entities to provide information directly to them and
therefore must rely on general purpose financial reports for how much financial information is needed.

The other users include the employees, customers, government agencies and the public in general.

Factors of Materiality

Materiality depends on the magnitude and nature of the financial information.

In the exercise of judgement in determining materiality, the relative size and nature of an item are
considered.

The size of the item in relation to the total of the group to which the item belongs is taken into account.

For example, the amount of advertising in relation to total selling expenses, the amount of office salaries
to total administrative expenses, the amount of prepaid expenses to total current assets, and the
amount of leasehold improvements to total property, plant, and equipment.

The nature of the item may be inherently material because by its very nature it affects economic
decision.

For example, the discovery of a P20,000 bribe is a material event even for a very large entity.

Faithful Represention

Faithful representation means that financial reports represent economic phenomena or transactions in
words and numbers.

Stated differently, the descriptions and figures must match what really existed or happened.
Simply worded, faithful represention means that the actual effects of the transactions shall be properly
accounted for and reported in the financial statements.

For example, if the entity reports purchases of P5,000,000 when the actual amount is P8,000,000, the
information would not be faithfully represented.

To record a sale of merchandise as miscellaneous income would not also be a faithful representation of
the sale transaction.

Ingredients of Faithful Representation

To be a perfectly faithful representaion, a depiction should have three characteristics, namely:

a. Completeness

b. Neutrality

c. Free from error

Completeness

Completeness requires that relevant information should be presented in a way that facilitates
understanding and avoids erroneous implication.

A complete depiction includes all information necessary for a user to understand the phenomenon or
transaction being depicted, including all necessary description and explanation.

Actually, to be complete, the financial statements shall be accompanied by notes to financial statements.

The purpose of the notes is to provide the necessary disclosures required by Philippine Financial
Reporting Standards.

Standard of Adequate Disclosure

Completeness is the result of the standard of adequate disclosure or principle of full disclosure.

The standard of adequate disclosure means that all significant and relevant information leading to the
preparation of financial statements shall be clearly reported.

Adequate disclosure however does not mean disclosure of just any data.

The accountant shall disclose a material fact known to him which is not disclosed in the financial
statements but disclosure of which is necessary in order that the financial statements would not be
misleading.

The standard of adequate disclosure is best described by disclosure of any financial facts significant
enough to influence the judgement of informed users.

Neutrality

A neutral depiction is without bias in the preparation or presentation of financial information.

A neutral depiction is not slanted, weighted, emphasized, de-emphasized, or otherwise manipulated to

increase the probability that financial information will be received favorably or unfavorably by users.

In other words, to be neutral, the information contained in the financial statements must be free from
bias.

The financial information should not favor one party to the detriment of another party.

The information is directed to the common needs of many users and not to the particular needs of
specific users.

Neutrality is synonymous with the all-encompassing principle of fairness.

To be neutral is to be fair.

Prudence

The Revised Conceptual Framework has reintroduced the concept of prudence.

Prudence is the exercise of care and caution when dealing with the uncertainties in the measurement
process such that assets or income are not overstated and liabilities or expenses are not understated.

Neutrality is supported by the exercise of prudence.

Conservatism

Conservatism is synonymous with prudence.

Conservatism means that when alternatives exist, the alternative which has the least effect on equity
should be chosen.

In the simplest words, conservatism means "in case of doubt, record any loss and do not record any gain.

For example, if there is a choice between two acceptable assets values, the lower figure is selected.
Accordingly, inventories are measured at the lower of cost and net realizable value.

Contingent loss is recognized as a "provision" if the loss is probable and the amount can be reliably
measured.

Contingent gain is not recognized but disclosed only.

It is to be emphasized that conservatism is not a license to deliberately understate net income or net
assets.

For example, if an entity has a cash of P500,000 and reports only P100,000, this is not conservatism but
fraud or inaccurate reporting.

Expresions of Conservatism

"Anticipate no profit and provide for probable and measurable loss"

"In the matter of income recognition, the accountant takes the position that no matter how sure the
businessman might be in capturing the bird in the bush, he, the accountant must see it in the hand."

"Don't count your chicks until the eggs hatch."

Free From Error

Free from error means there are no errors or omissions in the description of the phenomenon or
transaction.

Moreover, the process used to produced the reported information has been selected and applied with
no errors in the process.

In this context, free from error does not mean perfecly accurate in all respects.

For example, an estimate of an unobservable price or value cannot be determined to be accurate or

inaccurate.

However, a representation of that estimate can be faithful if the amount is described clearly and
accurately as an estimate.

Moreover, the nature and limitations of the estimating process are explained, and no errors have been
made in selecting and applying an appropriate process for developing the estimate.

Measurement Uncertainty
Measurement uncertainty arises when monetary amounts in financial reports cannot be observed
directly and must instead be estimated.

Measurement uncertainty can affect faithful representation if the level of uncertainty in providing an
estimate is high.

However, the use of reasonable estimate is an essential part of providing financial information and does
not undermine the usefulness of the financial information.

as long as the estimate is clearly and accurately described and explained, even a high level of
measurement uncertainty does not affect the usefulness of the financial information.

Substance Over Form

If information is to represent faithfully the transaction and other events it purports to represent, it is
necessary that the transactions and events are accounted in accordance with their substance and not
merely their legal form

Substance over form is not considered a seperate component of faithful representation because it would
redundant.

Faithful representation inherently represents the substance of an economic phenomenon or transaction

rather than merely representing the legal form.

Representing a legal form that differs from the economic substance of the underlying economic
phenomenon or transaction could not result in a faithful representation

Examples of Substance Over Form

An example is when the lessee leased property from the lessor.

The terms of the lease provide that the lease transfers ownership of the asset to the lease by the end of
the lease term.

In form, the contract is a lease as popularly understoond.

But in substance, in reality, if the "transfer of the ownership provision" is to be considered, the real
intent of the parties is an installment purchase of an asset by the lessee from the lessor.

Accordingly, the lessee shall record an acquisition of right use of asset and set up a liability.

The periodic rental is conceived as an installment payment representing interest and principal.
-

Enhancing Qualitative Characteristics

The enhancing qualitative characteristics relate to the presentation or form of the financial information.

The enhancing qualitative characteristics are intended to increase the usefulness of the financial
information that is relevant and faithfully represented.

The enhancing qualitative characteristics are comparability, understandability, verifiability, and timliness.

Relevant and faithfully represented financial information is useful but the information would be most
useful if it is comparable, understandable, verifiable, and timely.

Comparability

Comparability means the ability to bring together for the purpose of noting points of likeness and
differense.

Comparability is the enhancing qualitative characteristic that enables users to identify and understand
similarities and dissimilarities among items.

Comparability may be made within an entity or between and across entities.

Comparability within an entity is the quality of information that allows comparisons within a single entity
through time or from one accounting period to the next.

Comparability within an entity is also known as horizontal comparability or intracomparability.

Comparability between and across entities is the quality of information that allows comparisons
between two or more entities engaged in the same industry.

Comparability across entities is also known as intercomparability or dimensional comparability

For information to be comparable, like things must look alike and different things must look different.

Comparability is not enhanced by making unlike things look alike or making like things look different.

Consistency

Implicit in the qualitative characteristic of comparability is the principle of consistency.

Consistency is not the same as comparability.

In a broad sense, consistency refers to the use of the same method for the same item, either from period
to period within an entity or in a single period across entities.

Comparability is the goal and consistency helps to achieve that goal.

In a limited sense, consistency is the uniform application of accounting method from period to period
within an entity.

On other hand, comparability is the uniform application of accounting method between and across
entities in the same industry.

An entity cannot use the FIFO method of inventory valuation in one year, the average method method in
the next year, again the FIFO method in succeeding year and so on.

If the FIFO method is adopted in one year, such method is followed from year to year. Consistency is
desirable and essential to achieve comparability of financial statements.

However, consistency does not mean that no change in accounting method can be made.

If the change would result to more useful and meaningful information, then such change shall be made.

But there shall be full disclosure of the change and the peso effect thereof.

It is inappropriate for an entity to leave accoounting policies unchanged when better and acceptable
alternatives exist.

Understandability

Understandability requires that financial information must be comprehensible or intelligible if it is to be

most useful.

Accordingly, the information should be presented in a form and expressed in terminology that a user
understands.

Classifying, characterizing, and presenting information "clearly and concisely" makes it understandable.

An essential quality of the information provided in financial statements is that it is readily

understandable by users.

But the complex economic activities make it impossible to reduce the financial information to the
simplest terms.

Accordingly, the users shall have an understanding of the complex economic activities, the financial
accounting process, and the terminology in the financial statements.

Financial statements cannot realistically be understandable to everyone.

Financial reports are prepared for users who have a reasonable knowledge of business and economic
activities and who review and analyze the information diligently.

At times, even well-informed and diligent users may need to seek the aid of an adviser to understand
information about complex phenomena or transactions.

Understandability is very essential because a relevant and faithfull represented information may prove
useless if it is not understood by users.

Verifiability

Verifiability means that different knowledgeable and independent observers could reach concensus,
although not necessarily complete agreement, that a particular depiction is a faithful representation.

In other words, verifiability implies concensus.

The financial information is verifiable in the sense that it is supported by evidence so that an accountant
that would look into the same evidence would arrive at he same economic decision or conclusion.

Verifiable financial information provides results that would be substantially duplicated by measures using
the same measurement method.

Accordingly, verifiability helps assure users that information represents the economic phenomenon or
transaction it purports to represent.

Verifiability is synonymous with objectivity.

Types of verification

Verification can be direct or indirect.

Direct verification means verifying an amount or other representation through direct observation. For
example, by counting cash.

Indirect verification means checking the inputs to a model, formula, or other technique and recalculating
the inputs using the same methodology.

An example is verifying the carrying amount of intentory by checking the inputs in quantites and costs,
and recalculating the ending inventory using the same cost flow assumption, such as first in, first out.

Timeliness
Timeliness means that financial information must be available or communicated early enough when a
decision is to be made.

Relevant and faithfully represented financial information furnished after a decision is made is useless or
of no value.

For example, the most important attribute of quarterly or interim financial information is its timeliness.

Generally, the older the information, the less useful.

However, some information may continue to be timely long after the end of reporting period because
some users may need to identify and asset trends.

Timeliness enhances the truism that without knowledge of the past, the basis for prediction will usually
be lacking and without interest in the future, knowledge of the past is sterile.

What happened in the past would become the basis of what would happen in the future.

Cost Constraint on Useful Information

Cost is a pervasive constraint on the information that can be provided by financial reporting.

Reporting financial information imposes cost and it is important that such cost is justified by the benefit
derived from the financial information.

In other words, the cost constraint is a consideration of the cost incurred in generating financial
information against the benefit to be obtained from having the information.

The benefit derived from the information should exceed the cost incurred in obtaining the information.

However, the evaluation of the cost constraint is substantially a judgemental process.

Assessing whether the cost of reporting outweighs or falls short of the benefit is difficult to measure and
becomes a matter of professional judgment.