Is a prior-year error or covenant breach material?
How to judge whether an error found in last year's figures, or a loan covenant matter, is material to a client's statements, and what follows either way.
By Achekam · · 4 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
Two discoveries tend to arrive late in a year-end file. The first is an error in last year's signed statements: an invoice recorded twice, a supplier accrual missed, depreciation run on an asset already sold. The second is a loan agreement nobody read closely, with a covenant the client may or may not have met. Both force the same question, and both are easy to answer badly under deadline pressure: does it matter enough to change what the statements say?
The answer is a materiality judgement, and the IASB has published guidance on exactly these situations. This article covers what that guidance addresses, how to approach errors and covenants in practice, and how to record the outcome in Achekam without losing it at the next roll-forward.
Practice Statement 2's guidance on errors and covenants
IFRS Practice Statement 2, Making Materiality Judgements, provides guidance on making materiality judgements about prior-period information, errors and covenants, and in the context of interim reporting. IFAC's article "Making Sense of Materiality" describes the same feature: the Practice Statement includes specific guidance on prior period information, errors and covenants.
The Practice Statement is guidance, not a requirement, but it is written by the standard-setter for precisely the judgement a preparer has to make here. Read the relevant sections before deciding, and refer to them in the file note. A conclusion supported by the standard-setter's own reasoning is much harder to challenge than "management considered it immaterial".
When a prior-year error is material enough to restate
IAS 8 defines prior period errors as omissions from, and misstatements in, the entity's financial statements for one or more prior periods arising from a failure to use, or misuse of, available reliable information. Two features of that definition matter. The information must have been available when the earlier statements were prepared; a later change in circumstances is not an error. And the definition covers omissions as well as wrong numbers, so a missing disclosure can be an error too.
Under IAS 8, unless it is impracticable to determine the effects of the error, an entity corrects material prior period errors retrospectively by restating the comparative amounts for the prior period or periods presented in which the error occurred. The requirement turns on the word "material". That makes the materiality judgement the gateway: restate, or correct in the current year.
Points to weigh in that judgement:
- The size of the error against the figures it affects, both last year's and this year's.
- The lines it touches. An error that moves profit, or crosses from an asset to a liability, matters more than one that moves an amount between two expense lines.
- Accumulation. Several small errors, each immaterial alone, may be material together. So may the same small error repeated over several years.
- Who relied on last year's figures and for what: a lender's covenant test, a share sale, a tax return.
Where the conclusion is that the error is material, the restatement mechanics, including the disclosures, are covered in restating for a prior period error.
Covenant terms that make small figures matter
Loan covenants change the materiality picture because they turn particular figures into triggers. A covenant that sets a minimum ratio, or a maximum level of borrowing, gives a lender rights the moment the line is crossed. A misstatement that would be trivial in most contexts can be decisive if it moves the client from one side of a covenant to the other.
So when a client has borrowings with covenants:
- Obtain the loan agreement and list each covenant, how it is measured and when it is tested.
- Recalculate each covenant on the draft figures, and again after any proposed adjustment.
- Identify how much headroom exists. Thin headroom lowers the size at which a misstatement matters.
- Consider whether a breach, or a waiver obtained, needs disclosure, and whether it affects how the borrowing is classified; see current or non-current liability.
Record the calculations in the working papers. A reviewer who sees a covenant in the loan note and no covenant calculation in the file will ask for one.
Correcting the current year with a reversible adjusting entry
Where an error is judged immaterial, it is commonly corrected in the current year rather than by restatement. Where it is material, the comparatives are restated. Either way, an entry is needed.
In Achekam's Studio, staff post corrections as year-end adjusting entries against the client's trial balance. If an adjusting entry later proves wrong, it is reversed with a record of who reversed it and why, never deleted. That trail matters for errors in particular: the file shows not only the correction but how the firm got there, which is useful if the judgement is later questioned.
What a roll-forward does not carry: adjusting entries and typed comparatives
Staff can roll a set of statements forward to the next year, carrying settings, policies, notes and wording and rebuilding every figure from the new trial balance. Adjusting entries, typed comparatives and signatures are not carried forward.
That has two consequences for errors. First, a correction made only as an adjusting entry in the Studio will not appear in next year's figures unless the client's own books record it too; agree with the client, or the bookkeeper, that the entry will be posted in the ledger. Second, restated comparatives entered by hand do not roll forward; the following year's comparatives come from that year's process. Note both points in the completion memo so that next year's team does not rediscover the error.
IFAC's article on making sense of materiality explains why materiality is hard to apply in practice and how Practice Statement 2 helps companies decide what to include. It is a short read, and worth giving to anyone who will take a materiality judgement to a partner this season.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
