Materiality Concept in Financial Reporting

Question:

Write report on materiality concept as applied in wesfarmers ltd. 

Materiality concept is discussed at large in this study. There are different instances that have been elaborated to enable easy understanding of this concept. The various places where materiality is applicable have also been looked into details and relevant examples have been given. Different firms including security firms and governmental firms have been given a cross-check on the materiality concept. A financial report for Wesfarmers Limited for the 2015 financial year is basically used as the case study.

Using the 2015 financial report for Wesfarmers Limited provided, an analysis has been done to establish how the materiality concept has been applied in the preparation of the report. The International Standards regarding financial reports have also been examined on the basis of International Accounting Standards Board (IASB) and Australian Accounting Standards Board (AASB). These standards have also been looked into details to examine their application on the Wesfarmers Limited 2015 Annual Financial Report (Carlile, Nicolini, Langley, & Tsoukas, 2013, p.312).

Various methods of establishing materiality have also been examined and various omissions and misstatements that occur in context to materiality concept. The various problems that are often are associated with materiality are captured in this study. The transformation of these problems in the Wesfarmers Limited 2015 annual report is also checked with their implications. The relationship between materiality employed in the Wesfarmers 2015 Annual Financial Report and the provision of the International Accounting Standards Board is given a close comparison. Conclusion based on the study that was undertaken is provided at the end of the study to enable one to quickly identify the basic focus of the study.

Materiality is a term that is mostly associated with the financial institutions. Materiality is measured based on the nature and the size of the item or information in question. This concept is applicable when selecting items to be included when making a financial report. When material items are included in the financial report, the report will appear easy and well composed to use by the investors and other users.

Wesfarmers Limited is an Australian Industry based in Perth, Western Australia. Wesfarmers Limited is a conglomerate industry, combines a number of corporations. This company was initially established as a co-operative to offer services and merchandize to the Western Australian farmers. It operates on chemicals, fertilizers, mining of coal, industrial and safety products (Eilifsen, & Messier Jr, 2013, p.67)

Wesfarmers conform to the requirement of AASB to release an annual financial report based on their operations. The Australian government formulated AASB in 1991 to set standards that are to govern Australian corporations and entities. AASB formulate standards and frameworks that govern the preparation of a financial report preparation for all Australian corporations, entities, and companies.

Internationally, a body known as International Accounting Standards Board was formulated to provide frameworks and standards that have to be conformed to when preparing a financial report. All these standards AASB and IASB have their basis of the concept of materiality. Wesfarmers Limited also complies with all these standards to ensure they prepare a standard financial report that will not raise arguments and debates.

Wesfarmers Limited – An Overview

Materiality of an item or information is usually based on size and nature of such information or item. Materiality concept is an aspect of accounting where trivial matters are not disclosed in a financial statement and all important matters are disclosed.

For instance, a company planning to base its operation in some geographical landscape would need to inquire about such section. If the company realizes that this segment had been a source of revenue to the company then, the information about this section of landscape would be noted in the financial report.

In 2015, Wesfarmers Limited had a net profit of $ 2,440million after tax. If it happens another company owed $23 to the company, the debt would, thus, be considered immaterial and would not be included in the report.

The Australian Accounting Standards Board (AASB) requires that financial statements for a particular company should disclose all the material information. AASB 1031 (paragraph 8) materiality standard identifies that consideration should be made regarding materiality as this is useful to various financial statement users (Schlesinger, Libby, & Geiszler, 2013, p.31).

According to the Corporations Act 2001, the financial statements presented by a given organization should be ‘true and fair’. This implies that the information presented in the financial report should not contain any material omissions or misstatements as that would influence the reasoning of a financial statement user such as an investor. The Australian Accounting Standards Board (AASB) defines omissions or misstatements of items are material, if they could, individually or collectively, influence the economic decisions that users make on the basis of financial statements (Anderson, Doxey, Geiger, Gist, Janvrin, & Polinski, 2016, p.125).

In 2015, Wesfarmers Limited had a net profit of $ 2,440million after tax, if for example; a loss of $2million was made in the same financial year 2015. The procedure for calculating materiality of the loss is as follows; determine the base figure, the amount whose materiality is to be established is calculated as the base figure. If the percentage is equal to or more than 10% of the base figure, the amount is considered to be material. On the other hand, if the percentage is equal to or less than 5%, the amount in question will be deemed as immaterial. The net profit of $2,440 million is used as the base figure in this example. The loss would be disregarded since it only represents 0.082% of the net profit. The loss would, therefore, be considered to be immaterial since it will not have much effect on the decision-making of Wesfarmers Limited way-forward towards the 2016 financial year statement. A value that is between 5% and 10% will need the judgment of the account to whether it is material or immaterial. Under such circumstance, the judgment of the auditors would be sought to decide whether to consider the item as material or immaterial.    

Materiality as studied is applicable in preparation of a standard financial report. However, applying this concept of materiality is always associated with some challenges.

Application of Materiality in Wesfarmers Ltd 2015 Financial Report

AASB 101 standards, paragraph 7 states that the materiality of an item may vary greatly depending on several factors which may include the size and nature of the omission or misstatement in the financial statement. The variance in materiality may be often associated with some problems or challenges.

Some of the problems associated with materiality may include;

Problem of Inaccurate Data

Materiality always involves inclusion of important information and exclusion of material that is considered immaterial. However, at times the data that is included on the financial report may be incorrect; this will means that the users of the financial report will base their decision on incorrect data. Materiality cannot therefore help Wesfarmers Limited to establish whether the figures that are given in the report are the actual figures (Gaylord, 2014, p.123)

Problem of Misstatements

At times the auditors, of Wesfarmers Limited may make omission of information that is crucial for the users of their financial report. It may also happen that they don’t include some amount that was to be included. Such misstatements may cost Wesfarmers Limited as this information is vital for the continuity of the business. The investors and other financial statement users might lack a point where to base their decisions.

Languages of Disclosure

IASB and AASB describe disclosure on materiality in their standards. The language used in writing the standards may sometimes not be very much clear to the preparers and auditors of the financial report; this may result into some vital information missing out in the financial report. In some instances, analysts may complain that some useful information for economic decisions is missing. This is because such information is not specified in the standards (even though standards clarify entities and firms need to disclose additional information that may be necessary to achieve the objectives a basic financial report).  The language used by IASB/AASB standards may, therefore, not be easily understood by the analysts of Wesfarmers Limited.

Use of inappropriate Judgment Level

This has been a problem to the firms for quite some period of time. Large entities like Wesfarmers Limited will always tend to comply with what the International Standards such as IFRS state about unleashing a financial report. This has lead to such firms disclosing everything that IFRS specifies without regarding the materiality or understandability of such information. These firms claim they want to avoid arguments that may arise between users, auditors, regulators etc. Inappropriate level of judgment therefore arises among the preparers of the financial reports (Acito, Burks, & Johnson, 2015, p.321).

Materiality of an Item

It is always a challenging task for the auditors of Wesfarmers Limited to decide on whether an item is material or not. At times, an item that one auditor may consider to be material may be considered immaterial by another auditor thus a confusion may arise. Basing on the auditors own judgment on the materiality of an item, decision on the materiality of an item needs critical thinking.

Materiality concept is not well-handled with the existing IASB/AASB/IFRS standards and frameworks.  Therefore, most audits for financial reports tend to depend much on the quantitative and qualitative judgment of the financial auditors of Wesfarmers Limited and even other related companies.

International Accounting Standards on Materiality

A project on materiality needs to take into account the cause of inability, difficulty, or reluctance to use judgment. However, International Accounting Standards Board (IASB) is the process of introducing more standards that will help to guide the professionals on how to deal with the materiality concept. This will help about the problems of unclear languages of disclosure that has been making auditors leave out important information. 

Materiality concept is crucial for all decision-making processes and it is necessary to understand and put into practice the General Accepted Accounting Principles (GAAP).  In order to measure the level of materiality of item or information, a contextual qualitative and quantitative analysis is always done to such provisions.

The following factors are important for Wesfarmers Limited when evaluating the materiality of an item or information;

Environment or Surrounding

One needs to observe their environment /surrounding when evaluating the materiality of an aspect. Therefore, the preparers and auditors of financial report need to look at the prospect economical, environmental, social surroundings before establishing the materiality of an item.

Rank of information or an item

An item or information in this context is the specific thing whose materiality is to be determined. The ranking refers to how much value Wesfarmers Limited attaches to the information or item.  The more important issues are considered more material than those that are less crucial. Priority is, thus, given to the items or information that much value is attached.

The concept of materiality postulates that when unleashing financial reports, very important information is included in the statement while the less important information is disregarded or omitted in these reports. On the aspect of omission, some misstatement might also occur resulting in inaccurate judgment basing of the financial report users. These misstatements may inconvenience the decision of the financial report users. It is, therefore, necessary that these misstatements be taken good care of. The obvious causes of these misstatements may be;

• Lack of accuracy in collecting data.
• Disregarding disclosure of an important information.
• Variation in the amount, description or grouping of the financial report.

Materiality is determined without regarding the degree of inherent uncertainty that is involved in measuring different aspects.  This concept is usually applicable in two steps;

1. Strategizing the approach – This involves setting on how to carry out a detailed materiality test. Preliminary materiality is acquired and divided into portions. These portions or segments are known as audit segments.
2. Evaluation of the results – Here, the results are cross-checked. Total value errors are identified for every edit segment of the preliminary materiality. Comparisons are then made of the total value of error with the level of preliminary materiality.

Materiality establishment is an involving stage of financial report statement. Wesfarmers Limited tends to establish materiality by planning the whole financial audit process into audit phases (Carlile, Nicolini, Langley, & Tsoukas, 2013, p.355).

When the preliminary materiality at a lower level than necessary is determined, the risk that within the financial audit engagement to be effectuated an additional activity of audit collecting evidence is determined.

When the materiality establishment is at a higher level than it should actually be imposed, then, it implies that the risk of not identifying some significant errors is determined (Hsu, Lee, & Chao, 2013, p.124).

Comparing the materiality, and the level of the audit risk, there is always an inverse proportion report. That is, a higher material level implies a smaller audit risk and vice-versa.

The estimated value of errors can be calculated as;

Approximated value of errors = Errors in the Sample   x   Total value of the analyzed 

Relationship between Materiality in Wesfarmers Ltd Financial Report and AASB

                               Total Value of the Sample                   amount (of the audited account)

However, these audit risks can be diminished. In order to achieve this, the auditors and financial statement preparers tend to;

• Reduce the risk of external non-detection by modification of the background control.
• Attenuation of evaluated risk by making an erroneous presentation. Here, some extended test controls are carried out. 

In order to meet IASB and AASB standards, materiality as a concept was applied in making the 2015 financial report for Wesfarmers Limited. Non-material information was disregarded while the material information for use in decision by the financial statement users was included.   

The basis of Wesfarmers 2015 Annual Report is as follows;

• Wesfarmers Limited’s financial report has been prepared on the basis of historical cost except for a few financial assets and liabilities measured at a fair value.
• Wesfarmers Limited’s financial report has been compiled in accordance with Australian Accounting Standards and other pronouncements of the Australian Accounting Standards Board (AASB) and the Corporations Act 2001.
• The 2015 financial report for Wesfarmers Limited is outsourced and released following the Financial Reporting Standards and framework that was administered by International Accounting Standards Board.

In context with basic provisions of AASB on materiality, the following aspects were employed by the auditors of Wesfarmers Limited in preparing the 2015 Annual report;

Separation of material items

It is a provision of AASB that material items or information of different types be presented differently in the financial statement. The categorization is based on the nature and size of the material items or information. In the financial report released by Wesfarmers Limited, different items and information were categorized according to their nature. For instance, there is a category known as Auditors’ Remuneration (pg.129), Director and Executive Disclosures (pg.133). The information is categorized according to their nature. The earnings of each individual employee is clearly stated and each amount is classified on what it actually represents e.g. share based on capital, retirement benefits.

Disclosure

There are standards provided by the AASB that should be disclosed by a company. The provisions of AASB that should be disclosed are;

• The weighted average number of ordinary shares used as the denominator in calculating basic and diluted Earnings Per Share (EPS) and a reconciliation of these denominators to each other.
• Amounts used as numerators in calculating basic and diluted Earnings per Share (EPS) and a reconciliation of profit or loss.

All these information is provided in the 2015 financial report released by the auditors of Wesfarmers Limited. There is a provision of Executive Remuneration and EPS over the past years presented (pg. 133). These are necessary provisions that are required by AASB due to the quantity and quality of their materiality.

Interval of Financial Reports

AASB requires that all the entities and companies based in Australia should provide a financial report annually. Wesfarmers Limited provides an Annual Financial Report, thus, Wesfarmers Limited is complying with the requirements of AASB on the frequency of recording a financial report. An annual financial report summarizes all transactional reports that were carried out by Wesfarmers Limited for a single financial year (Legoria, Melendrez, & Reynolds, 2013, p.101).

Materiality is essential when executing an approved audit plan’s provision and helps in making conclusions of a financial audit. When materiality is applied while making a financial report, the report will appear to be well composed as only important details will be included. Otherwise, the report would have seemed huge to prepare and even the users and investors would lack the courage to use it as it would be containing a lot of unnecessary data. When unleashing a financial report, material items are included while the immaterial ones are disregarded or omitted. However, at times, a number of misstatements might take place. These misstatements can be categorized as either likely misstatements or known misstatements (Carey, Potter, & Tanewski, 2014, p.113). The misstatements as a result of misapplication of financial accounting principles are the known misstatements while the likely misstatements are those that arise as a result of overlooking or misinterpretation of data. Such misstatements may cost the Wesfarmers Limited since the financial report users will base their decision on false data or information.  

Conclusion

Conclusion

The all study was primarily based on materiality concept and its employment in making the financial report of Wesfarmers Limited 2015 Annual Financial Report. It is depictive that materiality is greatly deployed in the report and materiality proves to be an important factor of consideration when preparing a financial report.

Materiality comprises of expressions of materiality and it expresses the maximum error level that is admissible of the data that is given in a financial statement. This is significant in avoiding the possibility of the user’s decision being affected. Materiality also constitutes essential elements in decision-making process in financial audit in the planning phase.

On the decision on materiality of information, most auditors tend to base the materiality of an item on their own judgment and experience. These auditors rarely try to adopt innovative methods to obtain materiality. It is, thus, advisable that ample statistical methods to be applied in accounting for decision-making on the materiality of an item.

In circumstances where guidelines for materiality is not applied in making decisions, qualitative and quantitative methods are often in determination the  position of the accountant on materiality in decision making. Qualitative approach may include the accountants’ own decision or view which may be based on past experiences and the quantitative method may be based on historical financial and non-financial data of the organization.  

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Evaluation of Materiality