The International Atomic Energy Agency’s: Materiality Framework


Director’s Cut of the Article

Overview
Materiality Definitions
Audit versus Accounting versus Management Materiality
Concept and Methodology
Method to the Material Madness
Practical Applications and Continuous Improvement
Document Need – Decision Document
Document Need – Materiality Log
Approve and Implement
Conclusion

Overview

Auditors and accountants are generally familiar with the concept of materiality.  For non-financial managers and the layman, it can be a mystery.  For example, a large value financial transaction may be deemed unimportant when preparing the financial statements while the same accounting department demands its line managers to record transactions at excruciating detail.

To improve the understanding and management of materiality, organizations can adopt the International Atomic Energy Agency’s (IAEA) Materiality Framework.  It is a conceptual model and a methodology to understand, document and defend materiality decisions.  As a result, preparers and readers of financial statements have a higher level of confidence in their product.  Auditors can monitor the value and long-term life of a materiality decision.  Internal managers and staff can understand their role in making and identifying materiality decisions.

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Materiality Definitions

The Canadian Public Sector Accounting Standards Board (PSAB) and IPSAS’ definitions
are kissing cousins.  Their key components are:

  • Influence Decision Makers: The inclusion or exclusion of something may cause the readers of a financial statement to come to a different conclusion.
  • Have an Aggregate Effect: in isolation, one small thing may not make a difference but lots of little things added together may be important.
  • Involve Professional Judgement: There are no hard and fast rules but instead something is material because a professional has assessed it so.

The specific definitions are as follows:

PSAB 1201.015: Materiality is a matter of professional judgment in the particular circumstances. Materiality may be judged in relation to the reasonable prospect of its significance in the making of assessments and judgments by the users of financial statements. A material item would be expected to affect assessments of and judgments on government financial operations and management.

PSAB 2130.009: … Materiality is the term used to describe significance of financial statement information to decision makers. An item of information, or an aggregate of items, is material if it is probable that its omission or misstatement would influence or change a decision. Materiality is a matter of professional judgment in the particular circumstances.

IPSAS 1.7: Materiality Omissions or misstatements of items are material if they could, individually or collectively, influence the decisions or assessments of users made on the basis of the financial statements. Materiality depends on the nature or size of the item or error, or a combination of both, could be the determining factor.


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Audit versus Accounting versus Management Materiality

Before we leave the definition part, a quick word on the difference between what is deemed material to management or accountants or auditors.  Audit Materiality is the broadest of the three. Auditors are concerned with not only known errors but also possible further (undetected) errors in the financial statements. The purpose of Audit Materiality is to provide reasonable assurance that the financial statements are a fair presentation of the organization’s financial position and status.

Accounting Materiality has a narrower focus and concerns itself with whether financial transactions have been accurately recorded based on the policies and directions from Management and the relevant accounting standards.

Management and Accounting Materiality overlap but Management Materiality also goes where the other two do not. It concerns itself with the policies and processes adopted by the organization to prepare its audited financial statements and as well as other outputs. Examples of these other outputs include internal management reports and non-financial publications such as news releases or published corporate reports.

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Concept and Methodology

So how do organizations manage the overlapping and competing concepts and
definitions of materiality?  By using a conceptual model to understand what is materiality and then applying a rigorous process to manage materiality decisions.  The model helps the organization understand and manage the roles of Audit, Accounting and Management Materiality.  The methodology guides an organization through a decision making process
and then provides a robust method to manage those decisions through their life cycle.

The model is the IAEA Materiality Framework. It is a 2 x 2 matrix that captures the Audit-Accountant-Management continuum.  On the X-axis is the question ‘What is being measured’ by a materiality decision.  The two general perspectives along this axis:

  • The Judgment/Decision perspective includes the role of estimates, disclosures and presentation questions. A key judgment is the selection of accounting estimates.
  • The Error/Fraud perspective considers the likelihood of such events occurring, the internal processes to prevent them from occurring and the resulting impact on the financial statements and their readers.

Along the Y-axis is the question, ‘Who is Affected’ by a materiality decision from both an external/accounting and an internal/business aspect.

  • External/accounting: Preparers, auditors and readers of financial statements are interested in the accounting definition and quantification of materiality.
  • Internal/business: Because the term materiality has also entered the general business lexicon, it has a lay connotation. This lay definition is integral to the external/accounting definition because of the management processes support the accounting-audit functions.

Internal to each of the resulting quadrants of the above matrix is the question ‘What is Affected’? What is the organizational product being evaluated and what standard/regulation/industry norm impacts the decision making process?

Combined, these two dimensions result in the 2 X 2 IAEA Materiality Framework. Each of the four quadrants can be assigned to one of three materiality considerations: 1) Business or Management, 2) Accounting and 3) Audit.

2x2 Matrix describing what is materiality and relative tolerances and actions by auditors, accountants and management.

2×2 Matrix describing what is materiality and relative tolerances and actions by auditors, accountants and management.

Materiality tolerances differ across the quadrants.  For example, management will have little or no tolerance for error and management must have zero tolerance for fraud. By contrast, external auditors will certify that financial statements are materially free from these considerations.  This does not indicate acceptance on the part of the auditor – instead it represents reasonable assurance that if fraud or error has occurred, it will not affect the decisions a reader may make using the audited Financial Statements.

 

Quadrant

Auditor View Accounting View

Management View

1: Internal Business X Error & Fraud Materially Free Accounting Policies and Management Assurance Operational processes, internal reporting
2: Internal Business X Judgment &   Decision Support financial reporting processes Support accounting processes and policies Operational decisions and non-audited   internal and external reporting (e.g. marketing or communication information)
3: External X Judgment & Decision Correct application of accounting   standards, industry norms in the creation of financial statements Application of standards and norms.  (e.g. capitalization threshold) Support for the accounting process
4: External X Error & Fraud Reasonable assurance error & fraud   does not impact the financial statements Support for the auditing process Support for the auditing process


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Method to the Material Madness

The Materiality Framework can help an organization avoid the endless circuitous arguments of what is materiality and what is being measured by it. It can help an organization clearly explain why the auditors may use 10% error tolerance while line managers are expected to record transactions accurately (and in excruciating detail). It also leads into the discussion, where are the rules of thumb?

Most of the accounting literature on materiality is concerned with benchmarks and thresholds suitable for a publicly-listed, for-profit organization. The IAEA Materiality Framework uses the principle that each materiality decision must be evaluated on its own unique circumstances and only in aggregate and in context to the product being produced. As a result, a benchmark or rule of thumb should be seen as method to eliminate the trivial and inconsequential as opposed to acceptance of error, fraud or poor judgment.


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Practical Applications & Continuous Improvement

This of course leads to the question: How exactly do you evaluate the unique circumstances and aggregate Materiality decisions? The answer is with the second part of the Framework, a rigorous process to manage materiality decisions.

This process has two overarching parts. First decide that something is material and then secondly document that decision so it can be applied and periodically re-affirmed. The Decision Process can be broken into three distinct phases which are as follows:

Materiality Decision Sequence

Materiality Decision Sequence

These steps can be as simple or as complex as an organization needs them to be.  For example, the IAEA used a review process using affected business areas and the finance department.  Scale your process accordingly.


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Document Need – Decision Document

The first step of Documenting the Need for a decision is to determine whether the matter is trivial or not. ISA 450 has a simple method of separating trivial from potentially material by applying this test:

“When there is any uncertainty about whether one or more items are clearly trivial, the matter is considered not to be clearly trivial”.

This is a bit of circular check but it does work. Thus, if it is trivial, document it in the materiality log (discussed below) and move on to more important matters. If it is non-trivial, then document the problem, the proposed-solution in anticipation of a decision.

A materiality decision makes use of a form whose intent is to simply help the organization think through their decisions.

Form Element Why is it needed?
ORIGINATOR:   Who requested and is the ‘operational’ owner of the decision Provides   context and authority for need for a decision.
Materiality Number and Description: From materiality log. Internal   control of decisions
DECISION:   A clear, concise statement describing the decision.  This should be the same statement as found   in the materiality log.  The threshold may be an absolute value or a percentage, e.g. €300 or 10%. This is   the ‘elevator’ description used in communications
APPLICATION: where in the financial statements, internal reports or other locations is   this decision being applied to?  What   does it primarily affect? Context   and focus for the decision.  Helps to   ensure the decision is considering the right problem.
BACKGROUND & RATIONALE: The rationale for the threshold and the basis for selecting   the value or percentage; the benefits and risks to the Agency. To help   those coming after you, what is the back story for this decision?
ANALYSIS COMPLETED: If you have calculated something to be non-material, what are   those calculations and what were the methodology and assumptions of the   calculation?

  • Alternatives considered and their   relative cost or reasonability;
  • Impact of a decision relative to   Financial Statement component, e.g. % of assets
  • Estimated impact per unit, e.g.   sum of the maximum impact per purchase order
Why do we   know it is not material, what analysis was completed, what proof do we have? This is the section that should be compelling to management who in turn will use it to   assess the risk of making this decision.
IMPACT ON THE READER: How will this decision affect both external, internal and   internal operational reporting? Accounting and non-financial focus based on publication.
ENDORSEMENT: Who has signed off on this decision? Where   does the buck stop?
LIFE SPAN: when does the decision expire?  For the IAEA, no decision may live longer than 3 fiscal years without   renewal. This prevents complacency with decisions.

At first blush, completing a form can seem onerous and bureaucratic. Unfortunately individuals (and often non-accountable accountants) can make materiality decisions that may have risks to the organization (e.g. reputational), based on good to possibly bad information. The analysis process supports accountant or manager professional judgment. It also demonstrates that a decision was arrived at in a thoughtful and defensible manner.


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Document Need – Materiality Log

The second part of the documentation is the materiality log. Within the IAEA, this is maintained in a Microsoft Excel spreadsheet that has the columns generally matching the above form. Additional fields unique to the log are noted in the following graphic and table.

Sample of a Materiality Log

Sample of a Materiality Log

Log Element

Example and Discussion

Title “Materiality Decision Log for Fiscal Year 2099”; a separate log is rolled   forward and created each year.
Summary of   Impact “Summary of Impact ($ 000s)”; what is cumulative impact to each general section of the financial statements of the decision in question.
Decision   Status Where in the approval cycle is the decision; for example Proposed, Under Review or Approved.  Trivial decisions or those made by a senior member of the organization (or audit committee) may not need to go through the approval process.
Primary IPSAS “IPSAS 17”; as applicable, substitute in the relevant accounting standard.
Impact ($000) 8.0: in thousands, a maximum yearly impact per financial statement section as calculated and presented in the analysis section of the Analysis section of the form.
Form “Yes or No”; is there a materiality decision form for this decision.
Expiry Date “31/12/14”;   last day of the fiscal year decision can be used.  Note this reflects the last date that transactions are affected not the date when reports are produced.
Agency   Information A summary of the basis for the decision and who is current owner of the decision; this   may parallel the originator section of the form.
Comments Other key details relevant to those using the log.

One completed form represents one line on the materiality log. One line may also represent one line on the main financial statements with its offsetting entry. The log allows organization to quickly scan the form and determine, in aggregate, the impact of the decisions made to date and their impact on the various organizational information products, including the financial statements.

To get on to the log, an organization will need to establish a method of reviewing and approving its materiality decisions. Within the IAEA, final approval was typically made by the organization’s controller. After a decision is made, as required, implement the decision within the organization.

Beyond managing materiality decisions, the log can also be used by the accounting department or business for continuous improvement or work planning. For example, the IAEA intends to improve its full costing of assets, including staffing costs to implement them. The materiality process demonstrated, however, that these costs were not particularly material. The decision log provides the mechanism to revisit and monitor the decision to support future systems development and IPSAS compliance improvements.

Contrast this methodology with the alternative I have observed in accounting departments, typically around year end. Sometime around 9pm on a Friday night, someone quickly dashes off an email saying that such and such activities are ‘probably not material’. Soon that email is lost but continues to be referenced years into the future for not only the original activity but a myriad of other things as well!  Contrast this with a good conceptual model, a rigorous process and a centrally maintained log – it beats the mythical emails every time.

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