Question

24. Why does it make sense to define materiality from the user's perspective? 25. What similarities are there between materiality and disclosure? 26. Discuss how the concept of conservatism may be changing as viewed by Watts.

Answer 1

Question no : 24

In layman terms,Anything which affects the decision of the user is material in Financials.Exmaples of decision can be : To further invest in business,to discontinue,to relocate the business structure etc.

The concept of materiality is directly linked to the decision-making requirements of financial statement users. Materiality has been defined by the FASB in Statement of Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information as… “The omission or misstatement of an item is material in a financial report, if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of an item.” (p. 73)

The materiality is to be decided in the persepective of the user not in perspective of auditor,accountant etc.Because utlimately user(mainly investor) is the one who makes the significant decision for the business.Hence it is always relevant to make materiality in the persepctive of user.  

Question no : 25

Information in Financial statements is considered material if its omission or misstatement affects decision-making process of any reasonable individual relying on the information.

Materiality helps accountants as well as auditors to determine when that information is material or not and it decides the disclosure requirement. The difficult aspect of both materiality and disclosure is determining how much is too much or too little.

There is formula to decide materiality and professional judgment is required and it varies from case to case.In niut shell,the similarity is disclosure depends on the materiality aspect.

Question no : 26

As per Watts, conservatism to be eliminated to attain the neutrality of information.

Conservatism is defined as the differential verifiability required for recognition of profits versus losses. Its extreme form is the traditional conservatism adage: "anticipate no profit, but anticipate all losses."

Conservatism can be viewed as weakness,distorting of information rathen than strength of accouting.

Watts has explained through his "Conservatism in Accounting Part I: Explanations and Implications".

The below is a set of phrase with watts:

"conservatism in the balance sheet is of dubious value if attained at the expense of
conservatism in the income statement, which is far more significant.”

Some of the examples are :

• In debt covenants, conservatism reduces the likelihood management will forego
positive net present value projects, overstate earnings and assets, and make what is
effectively a liquidating dividend payment to shareholders at the expense of debt-holders.
• In compensation contracts, conservatism reduces the likelihood that managers will exert
effort to overstate net assets and cumulative earnings in order to distribute the net assets
of the firm to themselves instead of exerting effort to take positive net present value
projects.
• In corporate governance, conservatism provides timely signals for investigating the
existence of negative net present value projects and taking appropriate actions if they
exist. Conservatism protects the shareholders’ option to exercise their property rights