Materiality (auditing)

From Wikipedia, the free encyclopedia

For other uses, see Materiality.

Materiality is a concept or convention within auditing and accounting relating to the importance of an amount, transaction, or discrepancy. The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in conformity with an identified financial reporting framework such as Generally Accepted Accounting Principles (GAAP). The assessment of what is material is a matter of professional judgment.

Materiality is defined in the International Accounting Standards Board’s "Framework for the Preparation and Presentation of Financial Statements" in the following terms:

"Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful."

The Financial Accounting Standards Board (FASB) has refrained from giving quantitative guidelines for determining materiality. This has resulted in confusion in the use of Auditing Standards No 47, "Audit Risk and Materiality in Conducting the Audit". Several common rules that have appeared in practice and academia to quantify materiality include:

  • Percentage of pre-tax income or net income (i.e., 5% of average pre-tax income (using a 3-year average);
  • Percentage of gross profit;
  • Percentage of total assets; (i.e.,1/2% of total assets);
  • Percentage of total revenue; (1/2% of total revenues);
  • Percentage of equity; (i.e.,1% of total equity);
  • Blended methods involving some or all of these definitions (e.g., use a mix of the above and to find an average);
  • "Sliding scale" methods which vary with the size of the entity. (i.e., 5% of gross profit if between $0 and $20,000; 2% if between $20,000 and $1,000,000; 1% if between $1,000,000 and $100,000,000; 1/2% if over $100,000,000)

Using different means to quantify materiality causes inconsistency in materiality thresholds. Since "planning materiality" should affect the scope of both tests of controls and substantive tests, such differences might be of importance. Two different auditors auditing even the same entity might generate differing scopes of audit procedures, solely based on the "planning materiality" definition used.

[edit] Materiality as an Empirically Discovered Amount

Alternately, one could argue that rather than being a dollar amount developed by the auditor based on their professional judgement, materiality is a market phenomenon that must be discovered by the auditor through research activities. This interpretation is supported by the phrase "is material if its omission or misstatement could influence the economic decisions of financial statement users". Thus, the auditor must determine what amount does influence the decisions of financial statement users via a variety of methods, and potentially average those methods in an attempt to estimate the real monetary amount of materiality (which can never be known since it is simply the collective sentiment of all investors, creditors, managers, and regulators).

Auditors could conceivably ask the Audit committee or Board of directors to determine materiality since these groups represent investors and creditors. Another approach might involve developing a Sensitivity Analysis model that attempts to measure changes in a company's stock price as a function of changes in financial performance - thus revealing what monetary amounts investors perceive to be actionable. In contrast, materiality may be an amount that is important for regulators in some industries. For example, if a regulatory body has declared it is only interested in violations exceeding a particular monetary amount, this number may form the basis of determining materiality.

For an entity with a relatively small number of creditors, investors, managers and regulators, the auditor can simply determine materiality with direct inquiries made to these constituencies. Averaging the materiality amounts provided by these constituencies may lead to audit efficiency, however using the smallest materiality amount noted during the inquiry process ensures that even the most conservative constituent is satisfied with the relevance of the audit findings.

[edit] External links

Languages