Materiality In Financial Statements

It is the responsibility of an independent auditor to plan and perform an audit of financial statements that will provide reasonable assurance of detecting errors and irregularities that are material in nature. According to the Financial Accounting Standards Board, the essence of the concept of materiality is: “The omission or misstatement of an item in a financial report is material if, in the 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.” Materiality is a term that is hard to quantify, and must be determined for each individual situation. Public accounting firms have established informal quantitative and qualitative measures in an attempt to establish materiality thresholds. These measures have been affected and enhanced by statements of the Securities and Exchange Commission and other regulatory agencies and professional organizations.

In setting the preliminary judgment about materiality, auditors establish the maximum amount by which they believe the statements could be misstated and still not affect the decisions of reasonable users. An amount is considered material when it is one dollar more than the amount required for a user of financial statements to change their decision. Two broad types of materiality have been recognized: quantitative and qualitative. Quantitative materiality is economic in nature and exclusively depends on the effect of a fact on the company’s financial performance. Typically, public accounting firms have established quantitative materiality thresholds, and have used specific mathematical procedures in this process. Once the effect of a fact exceeds a certain percentage or amount of the item serving as the base measurement (ie. net income, stock price, or total assets), the fact is disclosed as a material statement. Qualitative materiality is not as straightforward or easy to measure. In an attempt to clarify qualitative materiality, FASB asserted that “materiality judgments can properly be made only by those who have all the facts.” Thus, qualitative materiality takes into account the relevance and reliability of a fact to determine its effects on the financial statements, encompassing the information available in its entirety.

The Securities and Exchange Commission (SEC) is an agency of the federal government whose purpose is to help to provide investors with reliable information for use in making financial and investment decisions. The SEC has determined that the creation of accounting principles and auditing standards should be left to the accounting professionals, namely the Financial Accounting Standards Board (FASB) and the Auditing Standards Board (ASB). However, the position of the SEC is greatly taken into account when changes are proposed. Recently, the SEC disclosed its position on the practice of using quantitative benchmarks in determining materiality. On August 12, 1999, the SEC released Staff Accounting Bulletin 99. This bulletin expressed the view of the SEC that “exclusive reliance on certain quantitative thresholds to assess materiality is inappropriate.” SAB 99 eliminated the common “rule of thumb” practice followed by most public accounting firms that allowed transactions affecting financial statements by an amount less than five percent to be disregarded and deemed immaterial. The quantifying of materiality in a percentage term should be just the beginning of a materiality analysis. The emphasis of the SEC’s bulletin was to encourage auditors to view facts in the context of the surrounding circumstances. All relevant factors, both quantitative and qualitative, must be accounted for and “magnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, will not generally be a sufficient basis for a materiality judgment.”

To assist auditors in determining relevant considerations in determining materiality, SAB 99 provided a partial list of situations where misstatements that are quantitatively small may be deemed material. These situations include misstatements which:

 Arise from an item capable of precise measurement or from an estimate and, if so, the degree of imprecision inherent in the estimate

 Mask a change in earnings or other trends

 Hide a failure to meet analysts’ consensus expectations for the enterprise

 Change a loss into income or vice versa

 Concern a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operation or profitability

 Affect the registrant’s compliance with regulatory requirements, loan covenants or other contractual requirements

 Have the effect of increasing management’s compensation

 Involve the concealment of an unlawful transaction

SAB 99 is an attempt by the SEC to provide guidance to auditors when dealing with areas that have the possibility of becoming material. This guidance will help to provide investors with more complete information, which is necessary to make sound financial decisions.

The concept of materiality in financial reporting is a sensitive and difficult topic to define. The quantitative measures of materiality, which were almost exclusively followed for so long by public accounting firms, are not sufficient when making the decision regarding financial disclosures. The issuance of SAB 99 will help auditors to more closely consider qualitative measures, which are notably more difficult to pinpoint, yet can carry a great impact on materiality and financial decisions.

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