One of the most vexing topics in financial-statement work is defining materiality. I often liken it to “what is important,” “what do the owners or lenders focus on,” “what matters to the board,” and sometimes even “what you wouldn’t want to see as a newspaper headline.” Any one of these seems to make more sense […]
One of the most vexing topics in financial-statement work is defining materiality. I often liken it to “what is important,” “what do the owners or lenders focus on,” “what matters to the board,” and sometimes even “what you wouldn’t want to see as a newspaper headline.” Any one of these seems to make more sense to my clients than what we find in the Merriam-Webster’s definition —– “the quality or state of being material” — which most might agree is ambiguous at best.
Like so many things in life, beauty is in the eye of the beholder. What is significant to management based on its understanding of operations and objectives may be quite different from the perspective of the auditor. Accounting literature tells us materiality is “… information that if omitted or misstated could influence decisions that users make on the basis of the information being presented.” Full circle to “what matters.”
Materiality is not simply a calculation but a consideration that includes the relevance of information being reported, the impact on those relying on information, and the degree of completeness of information being reported. When thinking about materiality in terms of “what matters,” both management and auditor consider an array of perspectives.
If a transaction stream has a significant impact on financial reports, such as revenue or revenue recognition, it would likely be considered material, as would a transaction that is unique, such as the sale of a division. It is worth mentioning that the auditor’s consideration of materiality includes employing a variety of different lenses.
For example, potentially uncollectible receivables that in total are equivalent to 20 percent of an entity’s net worth would be worthy of consideration — even if the individual balances are not “material.” The type of industry and the economic environment, as well as ownership structure, also influence the application of materiality.
Ultimately, the auditor’s determination of materiality is a matter of professional judgment and is influenced by the auditor’s perception of user needs. When users articulate a specific set of parameters, for example, single audit or statutory reporting, additional considerations apply. Each audit situation is unique and thus materiality is an entity-specific adventure in determining the relevance of the nature or magnitude of a transaction or balance. The result? An item that is material for one entity may well be of little or no importance for another.
It is important for management and those charged with governance to understand that professional standards require auditors to apply materiality both in planning and in performing the audit. This includes evaluating the effect of identified misstatements or potential for misstatement, evaluating the impact of uncorrected misstatements and forming the opinion in the auditor’s report.
Materiality is often thought of in terms of a percentage of revenue or gross profit or a percentage of total assets or pretax income, but may be derived from a blended method or based upon non-financial circumstances. The ongoing considerations of materiality may be further refined in terms of lines of business or, as is the case in governmental reporting, opinion units.
As is obvious from the volumes that have been written on the importance and nuances of materiality, the concept is not necessarily straight forward. The perfect example may be the often-misunderstood situation in which material misstatements were not identified but the system of internal control was not adequate to prevent or detect such errors. (Materiality applies here in terms of determining appropriate reporting of such design or operational deficiencies.)
What is the best approach to understanding the impact and applicability of materiality on your audit process? An open and ongoing dialogue with your CPA, of course.
Gail Kinsella is a partner in the accounting firm of Testone, Marshall & Discenza, LLP. Contact Kinsella at gkinsella@tmdcpas.com