Fall 2008
By William J. Holmes, CPA
When AICPA issued SAS 107, Audit Risk and Materiality in Conducting an Audit, as part of its set of "Risk Assessment Standards," it indicated in SAS 107 that the auditor’s consideration of materiality is a matter of professional judgment. This judgment is to be largely influenced by what the auditor perceives to be the needs of financial statement users, as discussed in FASB Concepts Statement No. 2 (CON 2), Qualitative Characteristics of Accounting Information, in connection with discussions of materiality. Specifically, CON 2 defines materiality as the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been influenced by the omission or misstatement.
It has been a long-held belief in the accounting profession that materiality judgments are primarily quantitative in nature, but CON 2 notes that whether an item is large enough for users of the information to be influenced by it will be affected by the nature - as well as the amount - of the item. That is, items too small to be thought material if they result from routine transactions may be material if they arise in abnormal circumstances. In other words, magnitude (quantitative materiality) by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made (qualitative materiality), will generally not be a sufficient basis for a materiality judgment. This is confirmed by SAS 107, which concludes that materiality judgments are made in light of surrounding circumstances, and involve both quantitative and qualitative considerations.
Furthermore, the more important an item is, the finer the "screen" should be used to determine whether it is material. For example, CON 2 observes that a failure to separately disclose a nonrecurrent item of revenue may be material at a lower threshold should that revenue turn a loss into a profit or reverse the trend of earnings from a downward to an upward trend. CON 2 further notes that amounts too small to warrant disclosure or correction in normal circumstances may be considered material if they arise from abnormal or unusual transactions or events. Consequently, the relative, rather than the absolute, size of a judgment item determines whether it should be considered material in a given situation.
The SEC also weighed in on the issue of materiality. Staff Accounting Bulletin (SAB) 99 further stressed the need to consider both qualitative as well as quantitative factors in assessing the materiality of a misstatement. In reaching its conclusions, SEC staff relied upon the guidance set forth in CON 2 as well as court decisions, and noted that the concept of materiality in accounting literature is in substance identical to the formulation used by the courts in interpreting the federal securities laws.
SAB 99 notes that "one rule of thumb... suggests that the misstatement or omission of an item that falls under a 5 percent threshold is not material in the absence of especially egregious circumstances." However, SEC staff concludes that while it "has no objection to such a ‘rule of thumb’ as an initial step in assessing materiality... quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations. Materiality concerns the significance of an item to users of a [company’s] financial statements. Therefore, a matter is material ‘if there is a substantial likelihood that a reasonable person would consider it important.’"
Supplementing its guidance in SAB 99, SEC recently issued SAB 108, Quantifying Financial Statement Misstatements. Its objective is to address consistency and eliminate hanging balance sheet errors. In assessing materiality, the SEC wants registrants to consider both a balance sheet approach and an income statement approach. The balance sheet, or Iron Curtain, method requires consideration of all balance sheet errors and the effects of correction. The income statement, or Rollover, method requires consideration of all income statement errors and effects of correction. The SEC takes the position that measurement of materiality of errors should be under both methods with final determination based on a combination of the two methods - a dual measurement approach.
The principles and concepts set forth in CON 2, SAB 99, and SAB 108 may cause an auditor to evaluate misstatements as material even though they are below a materiality level determined when establishing the overall audit strategy. For example, an illegal payment of an otherwise immaterial amount could be material if there is a reasonable possibility that it could lead to a material contingent liability or a material loss of revenue. Thus, in making such judgments about the materiality of misstatements of lesser amounts than an established materiality level, the auditor should consider whether such misstatements could reasonably be expected to influence the economic decisions of financial statement users. Factors to be considered include, but are not limited to, the potential effect of the misstatement on trends; the change of a loss to income; the effect on a company’s compliance with loan covenants; the possible existence of fraud or illegal acts and violations of contracts; and the failure to meet investor earnings expectations.
The professional literature is quite clear that the quantification of a misstatement is merely the starting point in assessing whether such misstatement is material to the financial statements taken as a whole. In addition to the quantitative assessment of materiality, the auditor must consider the qualitative factors that would reasonably be expected to affect the decisions of users.
William J. Holmes, CPA, is director at Marks Paneth & Shron LLP in New York. He can be reached at wholmes72@msn.com.
Copyright 1998-2008 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission