MLR

Materiality: It’s what matters

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The concept of materiality is at the core of financial statement audits and independent auditors’ reports.

auditor at desk

The topic is critical to the entire financial oversight and reporting function and is likely one of the most challenging to understand. The difficulty goes beyond the number of syllables in the word (six) or Merriam-Webster’s definition – “the quality or state of being material” – which most might agree is ambiguous at best.

Oddly enough, accounting literature actually provides a better sense of the concept: “information that if omitted or misstated could influence decisions that users make on the basis of the information being presented.”

While this is helpful, auditors might suggest as a starting point a simple perspective – “what matters.”

Each audit situation is unique. Thus, materiality is an entity-specific adventure in determining the relevance of the nature or magnitude of a transaction or balance. The result? An item that is material for one entity may well be of little or no importance for another.

In addition, what is significant in the eyes of management based on their understanding of operations and objectives may differ from the perspective of the auditor, who is responsible for rendering a report on the fairness, in all material respects, of the financial position and results of operations.

Ultimately, the auditor’s determination of materiality is a matter of professional judgment and is influenced by the auditor’s perception of user needs. When users articulate a specific set of parameters, for example, single audit or statutory reporting, additional considerations apply.

It is important for management, audit committees and those charged with governance to understand that professional standards require auditors to apply materiality both in planning and in performing the audit. This includes evaluating the effect of identified misstatements or potential for misstatement, evaluating the effect of uncorrected misstatements and forming the opinion in the auditor’s report.

Management and audit committees are likely most familiar with the notion of materiality in terms of audit adjustments. But they may have little knowledge of the inherent impact of materiality on all things audit related leading up to the closing meeting.

During the planning phase of the audit, the auditor makes judgments about the size of misstatements that would be considered material, which in turn drive the type of risk-assessment procedures to be employed, identification of risks of material misstatement, and the nature and extent of further audit procedures. Planning materiality can be, and often is, revised during the audit in response to the results of audit procedures.

As is evident, materiality is not just a calculation but a consideration that includes the relevance of information being reported, the impact on those relying on information and the degree of completeness of information being reported. When thinking about materiality in terms of “what matters,” both management and auditor consider an array of perspectives.

If a transaction is unique, such as the sale of a division, it would likely be considered material, as would a transaction class that has a significant impact on financial reports, such as revenue and revenue recognition. Likewise, potentially uncollectible receivables that in total are equivalent to 20 percent of an entity’s net worth would be worthy of consideration – even if the individual balances are not “material.”

The type of industry and the economic environment, as well as ownership structure, influence the application of materiality.
Materiality is often thought of in terms of a percentage of revenue or gross profit, a percentage of total assets or pretax income, or perhaps some blended method. These considerations may be further refined in terms of lines of business or, as is the case in governmental reporting, opinion units.

As if the topic were not murky enough, add in the often-misunderstood situation in which material misstatements were not identified but the system of internal control was not adequate to prevent or detect such errors. Materiality applies here as well in terms of determining appropriate reporting of such deficiencies.

In the simplest of terms, a balance, transaction or process is material if it matters enough that an error, omission or inaccurate assertion could substantially influence the decisions of those using the report. Volumes have been written on the concept, importance and nuances of materiality, and while these provide a useful point of reference, the most effective means for understanding the impact and applicability of materiality on your audit process is through an open dialogue between auditor and auditee.