What is materiality?
Materiality is to reasonable assurance what white stripes are to a basketball court. Materiality is the boundary in which we audit financial statements. Step outside the lines, and the referee blows the whistle.
The problem, however, is the lines of materiality aren't clearly laid stripes. They are judgmental and movable and different for each game. Nevertheless, we accountants cry for sameness and regularity. It is our nature to seek certainty. And so we develop forms and procedures to corral this thing called materiality. But even with our methods (and forms), we must be mindful that our goal is to opine upon information that is true. Not perfect information, but reliable financial statements.
What is Materiality?
The Financial Accounting Standards Board defines materiality this way: The omission or misstatement of an item in a financial report is material 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 the item.
This definition is quite different than a formula such as 1% of total revenue (or any other computation), but we need some clearly laid stripes, do we not?
Material misstatments can include:
- the omission of a significant disclosure
- an incomplete disclosure
- a known misstatement of a financial statement line
- an unknown misstatement of a financial statement line
- an unreasonable estimate
Readers of financial statements--management, owners, lenders, vendors, and others--make decisions. While the concept of materiality is not directed toward any one potential financial statement user, the auditor should be aware of the auditee's risks. Some businesses have high levels of debt, for example, and their compliance with debt covenants may be of concern. Auditors become aware of risk factors by performing risk assessment procedures, and once those risks are identified, they will impact materiality.
The auditor's job is to provide reasonable assurance concerning the financial statements. So how do we go about doing this? One critical step is computing materiality.
In order to compute materiality, we first decide which base to use such as total revenues, total assets, net income. Since we need consistency, we select a base that is relevant and similar over time. Often total assets or total revenues are good choices. So what's an example of a poor base? Net income would be a poor choice for a business that "salaries out" all its profits each year--a zero profit does not give you much to work with.
Once the base is selected, we need to apply a percent to compute materiality. This percent is not defined in professional standards, so again, we are left to judgment. Most CPAs defer to forms providers (such as PPC); others create their own percentages. Either way, we need results that will provide "reasonable assurance." There are no magic percentages, but we want a materiality amount that is tight enough--large misstatements may falsely "influence the decisions that users make."
Materiality will be proportional. Materiality for a billion dollar company will be much higher than for a million dollar one. Also the percentages may be different based on the dynamics of the business. A company that is highly leveraged with debt might merit a lower scale of percentages. Risks deserve tighter definitions.
One problem with using a materiality calculation is the auditor may have undetected misstatements. What if, for example, our materiality was $100,000 and we had $90,000 in passed adjustments and $35,000 in undetected misstatements? In such a situation, we might opine that the financial statements are fairly stated and they are not. Similarly, the cumulative aggregation of errors noted in various transaction cycles may exceed materiality. We need cushion to cover the risk of undetected error and the aggregation of uncorrected misstatements. This cushion comes in the form of performance materiality.
AU-C 320.A14 describes performance materiality in the following manner:
Performance materiality is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in the financial statements exceeds materiality for the financial statements as a whole. Similarly, performance materiality relating to a materiality level determined for a particular class of transactions, account balance, or disclosure is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in that particular class of transactions, account balance, or disclosure exceeds the materiality level for that particular class of transactions, account balance, or disclosure.
Performance materiality calls for materiality thresholds at the transaction or account level. Usually performance materiality is calculated at 50% to 75% of materiality. Why the range? We are still responding to risk. If you believe the risk of undetected misstatements is high, then use a lower percent in the range (e.g., 55% of materiality). Likewise, if your client is less inclined to record detected error, a lower percent should be used. Remember your goal: the combined effect of undetected error and uncorrected misstatements can't exceed materiality for the statements as a whole. We don't want misstatements--in whatever form--to wrongly influence the decisions of financial statement users.
As we audit transaction areas, we need to summarize uncorrected missatements.
AU-C 450.11 says the following about uncorrected misstatements:
The auditor should determine whether uncorrected misstatements are material, individually or in the aggregate. In making this determination, the auditor should consider:
- the size and nature of the misstatements, both in relation to particular classes of transactions, account balances, or disclosures and the financial statements as a whole, and the particular circumstances of their occurrence and
- the effect of uncorrected misstatements related to prior periods on the relevant classes of transactions, account balances, or disclosures and the financial statements as a whole.
We need to accumulate uncorrected misstatements (sometimes referred to as passed adjustments) in a manner that will allow us to judge the effect from various perspectives--account level, transaction class levels, financial statement level. This is more than computing a number and comparing passed adjustments with the effect on net income or total assets. We are always asking, "Will these passed adjustments materially affect a user's judgment of the financial statements?"
So what are the documentation requirements for uncorrected misstatements?
AU‐C 450.12 requires that the auditor document:
- The amount designated by the auditor below which misstatements need not be accumulated (clearly trivial).
- All misstatements accumulated and whether they have been corrected.
- A conclusion as to whether uncorrected misstatements, individually or in the aggregate, cause the financial statements to be materially misstated, and the basis for the conclusion.
Some identified misstatements are so small that they will not be accumulated. We call these trivial misstatements.
AU-C 420.A2 says the following about trivial misstatements:
The auditor may designate an amount below which misstatements would be clearly trivial and would not need to be accumulated because the auditor expects that the accumulation of such amounts clearly would not have a material effect on the financial statements.
Why create a trivial misstatement amount? To increase our efficiency. All detected differences below the trivial misstatement amount (e.g., $5,000) are not accumulated and, the auditor will not create a passed adjustment (no journal entry is necessary). The auditor simply notes the trivial difference on the work paper, and she is done. No further documentation is required. If you expect dozens of passed adjustments, then the trivial misstatement amount should be smaller. You don't want the accumulation of trivial misstatements to become not-so-trivial.
How Do You Calculate Materiality Amounts?
I'm curious. How does your firm compute materiality? Do you use a form (such as one from PPC) or has your firm created its own materiality document?