Question

The primary area of income statement creativity is the opportunistic classification of revenue, gains, expenses, and losses. Although materiality is defined subjectively, one rule of thumb suggests that the misstatement or omission of an item that falls under a 5% of revenue threshold is not material in the absence of particularly egregious circumstances. Equally important is the appropriate classification of amounts within the statement of comprehensive income and the statement of financial position. The financial statement users have placed greater importance on relevance of individual accounts balances and the overall picture presented by the financial statements.

Required
a) Explain the term materiality and state the circumstances in which a small item (low value) can be termed to being material
b) State the items that can be classified as other comprehensive income (OCI) under the International Financial Reporting Standards framework
c) Discuss whether the absolute usefulness of the financial statements is achievable

Answer 1

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Amswer-a

a) Explain the term materiality and state the circumstances in which a small item (low value) can be termed to being material (5 marks)

Materiality; the Accounting Standards Board defines materiality as the final test of what information should be given in a particular set of financial statements and note that materiality tests asks whether the resulting information content is of such significance as to require its inclusion in the financial statements.

Materiality refers to the impact of an omission or misstatement of information in a firm’s financial statements on the users of these statements. An item is considered material if its inclusion would have changed or altered the decisions of the financial statement users.

International Accounting Standards Committee (1989) defines information as materiality as follows: “information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements”.

The Financial Accounting Standards Board explains materiality as “the magnitude of an omission or misstatement of accounting information that, in 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 misstatement”.

Circumstances in which a small item (low value) can be termed to being material;

• Where a minor item would have changed a net profit to net loss then that item could have been considered as material.

• If its inclusion in the financial statements would change a ratio sufficiently to bring an entity out of compliance with its lenders agreements/covenants

b) State the items that can be classified as other comprehensive income (OCI) under the International Financial Reporting Standards framework (8 marks)

• Changes in fair value of available-for-sale financial assets

• Foreign currency translation on foreign subsidiaries

• Actuarial gains and losses arising on a defined benefit pension plan

• Changes in the fair value of a financial instrument in a cash flow hedge

• Revaluations of properties, plants and equipments

• Share of other comprehensive income of associates

• Income taxes relating to components of other comprehensive income

c) Discuss whether the absolute usefulness of the financial statements is achievable (7 marks)

This may be difficult to achieve because of the following grounds:

• Different accounting policies and frameworks. The accounting frameworks such as IFRS allows preparers of financial statements to use accounting policies that most appropriately reflect their circumstances of their entities. A degree of flexibility is crucial in order to present reliable information of a particular entity however, use of diverse accounting policies amongst different entities impairs the level of comparability between financial statements. Use of different frameworks such as IFRS and US GAAP by entities operating in different geographical areas presents similar problems when comparing financial statements. However the problem is being overcome by use of IFRS and convergence process between leading accounting bodies to arrive at a single set global standards.

• Accounting estimates: accounting requires use of estimates in preparation of financial statements where precise amounts cannot be established. These estimates are inherently subjective and lack precision since they involve use of management’s foresight in determining values included in the financial statements. Estimates that are not based on objective and verifiable information reduces reliability of accounting information.

• Professional judgment: the greater the use of judgment involved the more subjective financial statements would tend to be.

• Verifiability: audit is one of the main mechanisms that enables users to replace trust on financial statements. However it only provides reasonable and not absolute assurance on the truth and fairness of these statements meaning that despite carrying audit according to acceptable standards, certain material misstatement in the financial statements may remain undetected de to inherent limitations of the audit.

• Use of historical cost: this fails to account for the change in price levels of assets over a period of time. This reduces relevance of accounting information by presenting assets at amounts that may be far less than realizable values and also fails to account for the opportunity cost of utilizing those assets.

• Measurability: accounting only takes into account transactions that are capable of being measured in monetary terms. Financial statements do not account for those resources and transactions whose values cannot be reasonably assigned such as the competence of workforce or goodwill.

• Fraud and errors: financial statements are susceptible to fraud and errors which can undermine the overall credibility and reliability of information contained therein. Deliberate manipulation of these statements which is geared to achieving predetermined results has been an unfortunate reality in the resent past and has been popularized by major accounting disasters such as Enron scandals and Imperial Bank of Kenya disaster.