How your auditor establishes materiality in an audit or review

Accountants can’t look into every transaction when running an audit or review so they appoint a “materiality” threshold instead. They apply this benchmark to gain reasonable assurance in an audit — or limited assurance in a review — of uncovering misstatements that might be big enough, individually or collectively, to be material to the financial statements.

What is materiality?

Lamentably, U.S. Generally Accepted Accounting Principles (GAAP) has no clear-cut definition of materiality. Fortunately, the Conceptual Framework for Financial Reporting under International Financial Reporting Standards (IFRS) says:

Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.

Various definitions of materiality are available, though the universal assertion is that a financial misstatement is material should it potentially impact financial statement users’ decision-making.

How do auditors determine materiality?

Auditors trust professional judgment and depend on rules of thumb to ascertain the degree of materiality. They will take into account the volume and type of misstatement, as well.

The materiality threshold is most often presented as a general percentage of a specific financial statement line item. To illustrate, Mr. Auditor appoints a materiality threshold of 1% revenue for ABC Company. If the company states an annual revenue of $190 million for 2017, its materiality threshold would be $1.9 million.

In the course of his fieldwork, Mr. Auditor uncovers a clerical error that led ABC to understate revenue by $1 million. Would this error be material? While an error of $1 million certainly sounds substantial, because it’s less than 1% of the company’s annual revenue, it is immaterial to the grand scope of ABC’s financial operations.

To the contrary, had the company overstated its revenue by $1 million because of a senior executive’s duplicitous scheme, Mr. Auditor might hold the misstatement as material since it’s linked to a senior level team member and possible criminal behavior.

No matter the materiality or immateriality of a misstatement of revenue, it could possibly trigger a material misstatement in accounts receivable. This means that the balances recorded as due from customers could differ materially from what’s actually due.

It’s all relative

As illustrated above, materiality is a relative notion. Auditors have to judge a material misstatement on a standalone basis and inside the framework of a company’s universal financial statements. One company’s established material misstatement might fall short of the materiality threshold for another. Materiality is a matter of professional judgment and your audit team’s experience. Call us at (818) 334-8623 or click here to contact us for additional guidance as to what would be considered material for your company.