The relationship between the concepts of materiality and decision usefulness

Hey everybody,

So today there will be more economics related stuff that I've been writing about. Hope you enjoy and feel free to ask questions if you need clarification!

The objective of general purpose financial reporting is to provide financial information, about the firm in question, that is useful to investors and allows them to make decisions regarding providing resources to the firm. These decisions involve buying, selling or holding equity and debt instruments and providing other resources to the firm. If this information is to be useful, it must be relevant and faithfully represent what it purports to present, the usefulness is enhanced if it is comparable, verifiable, timely and understandable (IASB, Conceptual Framework for Financial Reporting, 2015). Furthermore, it has to provide information that gives an accurate predictions of future economic states (Scott, 2015). Beyer, Cohen, Lys, & Walther, (2010) add to this that information is useful to investors if it allows them to evaluate the return potential of investment opportunities and allows them to design corporate governance mechanisms to monitor the use of their available made funds. In other words, information presented in financial reports, needs to be decision useful.

Providing investors with decision useful information, is according to Williams & Ravenscroft, (2015) the responsibility of accounting professionals. It are these professionals who determine which information provides the most utility to their users. Part of this information is presented in the financial statements. Financial statements provide information about the financial effects of transactions and other events in a certain period. This information is classified into elements such as assets, liabilities, equity, income and expenses. However, not all assets, liabilities, equity, income and expenses are recognized and reported (IASB, Conceptual Framework for Financial Reporting, 2015). The materiality concept, as states by Nobles, Mattison, & Matsumura (2015), states that a company must perform strictly proper accounting only for significant items. Information is significant, or in accounting terms material, when it affects the choice for a decision made by an investor, which is consistent with the definition given to materiality by IFRS, (IFRS, 2017).

Material errors or misstatements or material omissions may cause investors to make decisions whom they would not, or would have made, if this information was included in the financial reports (Imhoff, 2003). The responsibility of deciding which information is material and relevant for decisions of investors, are accounting professionals and the company itself. The practice statement regarding making materiality judgments by the IFRS states that the company should assess whether information is material to the financial statements regardless of whether such information is publicly available from other sources (IFRS, 2017). Listed firms are required by law to be audited by chartered accountants. One of the tasks of auditors is to assess whether the judgment of the firm regarding non-material information is correct. Gibbins, Salterio, & Webb, (2001) found that firms tend to negotiate with accountants regarding the materiality of information, and that these negotiation typically arose because of unclear or non-existent GAAP.

To help solve this problem the IFRS has issued a practice statement including a process which should be utilized in determining whether information is material and should be assessed by accountants. The first step is to identify information based on the requirements of IFRS standards and knowledge about primary users common information needs. The second step involves assessing this information via quantitative and qualitative factors. The third step is to organize this information within the draft of financial statements and the last step is to review the draft of financial statements (IFRS, 2017). A graphical overview of the materiality process can be found in figure 1 in the appendix.

Decision usefulness of accounting information is therefore linked to the materiality principle, since information deemed material is information that is deemed decision useful for investors, because it provides more accurate predictions of future economic states. Furthermore, when an auditor tested that misstatements are not material, the auditor concludes that the financial statements are fairly presented (Eilifsen, Messier Jr., Glover, & Prawitt, 2014), which is a characteristic of decision-useful information. Companies and accounting professionals need to judge whether information is material and therefore decision useful, but negotiations may arise due to unclear regulations in accounting principles. Therefore companies should apply the materiality process in a consequent manner so that they may provide investors with material, decision useful information in their financial reports.

I hope you enjoyed reading this article. I'll post some more about materiality later this week.

Have a great day everybody!