As auditors, we constantly grapple with the concept of materiality. Materiality is different for every Company and must be determined with the financial statement’s users in mind. In this article, we will discuss the concept of materiality, the users of a financial statement, and the auditor’s responsibility throughout the audit process.
Materiality is a concept relating to the significance of a financial amount, transaction or misstatement. The objective of a financial statement audit is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework (typically GAAP). As auditors, in the normal course of an audit, we calculate a materiality threshold, which we use to determine the severity of potential misstatements.
Standard setters have steered away from providing specific quantitative guidelines as to how to calculate materiality. In practice, auditors consider the users of a Company’s financial statement to tailor audit materiality.
Definition of Users
Users of a financial statement will vary depending on the Company. The users of a closely held business’ financial statement with minimal bank financing are much different than the users of a publicly traded company’s financial statement with shareholders, a board of directors, multiple levels of financing and employee stock option plans. These users need to be identified before making materiality decisions.
A good example to describe the concept of materiality (true story) is as follows: A reclassification adjustment was identified during an audit. This entry had no impact on this Company’s bank covenants, it did not change net income and it did not affect any incentive calculations. From an audit perspective, this error was immaterial. When brought to the attention of the Company’s management team, they discussed the entry and even had differing opinions amongst themselves regarding the impact of the reclassification. Finally, the decision was made to record the reclassification because it affected a key performance measure used internally by the Company. In this situation, there were further users of the financial statement who would be impacted by this adjustment.
This is a classic example of why materiality is not a one-size-fits-all amount, but rather, dependent on the user and how their decisions might be impacted by the financial results.
Accumulation of Potential Misstatements
All potential misstatements are accumulated throughout the audit process and examined individually and in the aggregate to determine the overall impact of the misstatements on a financial statement user. A misstatement below the calculated threshold may not skew the financial results as a whole, but could force a bank covenant to fail or lead an investor to make a decision that they may not otherwise make. A misstatement of this nature would be considered material even though it is below the originally calculated threshold.
Your auditors should have a conversation with you when potential misstatements are identified to be sure that they understand all of the potential ramifications that the misstatement may have. Additionally, your auditors are required to communicate any unrecorded financial statement misstatements at the conclusion of an audit. Learn more about Audit Letters in our blog post, “Required Communication Letters in an Audit – Their Meaning’s Revealed.”
Materiality is more than just an audit calculation or a hard dollar threshold, it is the thoughtful process of determining the potential impact of misstatements on all of the users of a financial statement. Materiality must be contemplated not only by auditors during a Company’s annual audit, but also by management throughout the year, as the financial statements are constantly used to make decisions affecting the operations of the Company.
For more information on materiality or the audit process, please contact us.