A misstatement is inconsequential

What Is Materiality?

Materiality, within the realm of accounting and auditing standards, refers to the significance of an omission or misstatement of information in a company's financial statements that could influence the economic decisions of users. It is a fundamental concept for auditors and financial preparers, guiding them in determining which information is important enough to be accurately reported and which, if misstated, could mislead investors or other stakeholders. Essentially, a misstatement is considered material if it is probable that a reasonable person relying on the financial reports would have their judgment changed or influenced by the inclusion or correction of the item. Materiality is not solely about the size of an amount; qualitative factors can also render a seemingly small misstatement material.

History and Origin

The concept of materiality has evolved significantly, particularly in the context of financial reporting and auditing. While the underlying idea of "significance" has always been implicit in financial disclosure, formal guidance began to solidify in the late 20th century. A pivotal moment for materiality in the United States came with the issuance of Staff Accounting Bulletin No. 99 (SAB 99) by the U.S. Securities and Exchange Commission (SEC) on August 13, 1999.¹⁶ This bulletin clarified that relying solely on quantitative thresholds, such as the common "5% rule of thumb" where misstatements below 5% of a benchmark were often deemed immaterial, was inappropriate.¹⁵,¹⁴ SAB 99 emphasized that qualitative factors must also be considered in assessing materiality, such as whether a misstatement masks a change in earnings or involves an illegal act.¹³,¹² This shift underscored that even seemingly minor discrepancies could be material if they impact the overall perception of a company's financial health or management's integrity. Internationally, the International Auditing and Assurance Standards Board (IAASB) also provides guidance on materiality, notably in International Standard on Auditing (ISA) 320, which deals with materiality in planning and performing an audit.¹¹,¹⁰

Key Takeaways

• Materiality determines the significance of financial information, impacting whether a misstatement or omission could influence user decisions.
• Both quantitative (size) and qualitative (nature) factors are crucial in assessing materiality, as emphasized by regulators.
• Auditors use materiality to plan their audit procedures and evaluate the impact of identified misstatements.
• Intentional misstatements, even if quantitatively small, are often considered material due to their qualitative implications.
• Materiality is a matter of professional judgment, requiring careful consideration of all surrounding circumstances.

Interpreting Materiality

Interpreting materiality involves a dual assessment of both quantitative and qualitative factors. Quantitatively, a misstatement's size relative to key financial benchmarks, such as net income, total assets, or revenue, is considered. For instance, a misstatement of $1 million might be immaterial for a multinational corporation with billions in revenue, but highly material for a small startup. Qualitatively, the nature of the misstatement is evaluated. Examples of qualitative factors that could make a small misstatement material include whether it:

• Changes a loss into profitability or vice versa.
• Affects compliance with regulatory requirements or loan covenants.
• Involves management fraud or illegal acts.
• Affects segment information, even if immaterial to the financial statements as a whole.
• Conceals a failure to meet analysts' expectations.

Auditors apply these considerations throughout the audit process, from planning the scope of their work to evaluating the cumulative effect of uncorrected misstatements on the financial statements.

Hypothetical Example

Consider "Tech Innovations Inc.," a publicly traded software company. Its annual net income is $50 million. During its annual audit, the auditors discover an accounting error of $2 million related to improperly recognized revenue from a software subscription.

Step 1: Quantitative Assessment
A $2 million misstatement represents 4% of the $50 million net income ($2 million / $50 million = 0.04 or 4%). While a common "rule of thumb" might suggest 5% as a quantitative threshold for materiality, this alone is not sufficient.

Step 2: Qualitative Assessment
The auditors investigate further and find that if this $2 million misstatement were corrected, Tech Innovations Inc.'s net income would drop to $48 million. Importantly, this correction would cause the company to miss its publicly announced earnings per share (EPS) target by a narrow margin. Missing an EPS target, even by a small amount, can significantly impact investor confidence and stock price.

Conclusion: Despite being quantitatively below the traditional 5% "rule of thumb," the $2 million misstatement is deemed material due to its qualitative impact on the company's ability to meet its announced earnings targets and the potential for a reasonable investor's judgment to be influenced. The company would likely need to correct this misstatement before its financial statements could receive an unqualified audit opinion.

Practical Applications

Materiality is a cornerstone of financial reporting and auditing, with broad applications across various financial disciplines:

• Financial Reporting: Companies apply materiality when preparing their financial statements in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). This ensures that only significant information is presented, avoiding an overload of trivial details while maintaining transparency.
• Auditing: Auditors use materiality to plan the scope of their audit procedures, determining the level of detail required for testing different accounts and disclosures. They also use it to evaluate the impact of misstatements found during the audit. The Public Company Accounting Oversight Board (PCAOB) Auditing Standard 2810 (AS 2810) requires auditors to evaluate whether uncorrected misstatements are material, individually or in combination, considering both quantitative and qualitative factors.⁹,⁸
• Regulatory Compliance: Regulatory bodies, such as the SEC, rely on the concept of materiality to enforce financial reporting requirements. SEC Staff Accounting Bulletin No. 99 (SAB 99) provides explicit guidance on assessing materiality, particularly warning against the sole reliance on quantitative thresholds.⁷,⁶
• Internal Controls: Companies design and implement internal controls to prevent or detect material misstatements. Under the Sarbanes-Oxley Act of 2002, public companies must assess and report on the effectiveness of their internal control over financial reporting, a process where materiality judgments are critical.⁵

Limitations and Criticisms

While essential, materiality is not without its limitations and criticisms. One primary challenge lies in its subjective nature. Because materiality relies heavily on professional judgment, different auditors or preparers might arrive at different conclusions regarding the materiality of a specific misstatement, even given similar facts. This subjectivity can lead to inconsistencies in financial reporting and audit outcomes.

Another criticism centers on the practical application of qualitative factors. While regulators emphasize their importance, quantifying their impact can be difficult. The "5% rule of thumb," despite official discouragement, sometimes still implicitly influences judgments, potentially leading to overlooking qualitatively material but quantitatively small misstatements.⁴ Furthermore, audit planning materiality, which is often set higher than accounting materiality to achieve audit efficiency, has been a subject of debate, with concerns that it might, in some cases, compromise audit effectiveness if not carefully managed.³ The inherent complexities of making precise risk assessment and judgment calls mean that applying materiality effectively remains a continuous area of focus and debate in the accounting profession.

Materiality vs. Accounting Error

Materiality and an accounting error are distinct but related concepts in financial reporting. An accounting error is simply a mistake or inaccuracy in the recording, processing, or presentation of financial data. This could be a clerical error, a miscalculation, or an oversight in applying accounting standards. Examples include incorrect entries in the general ledger, misclassified expenses on the income statement, or a misstatement of assets on the balance sheet.

Materiality, on the other hand, is a threshold or judgment applied to an accounting error (or omission) to determine its significance. An accounting error is not automatically considered material. It becomes material only if its omission or misstatement, individually or in aggregate with other errors, could reasonably be expected to influence the economic decisions of users made on the basis of the financial statements. Therefore, while all material misstatements originate from accounting errors or omissions, not all accounting errors are material. An immaterial accounting error might be corrected in the normal course of business without requiring a restatement of prior financial reports.

FAQs

What makes a misstatement material?

A misstatement is material if its omission or inaccurate reporting would likely influence the decisions of a reasonable person relying on the financial statements. This assessment considers both the quantitative size of the misstatement and its qualitative nature, such as whether it changes a company's trend or involves fraud.

Is there a specific percentage threshold for materiality?

While a 5% "rule of thumb" was historically used as a preliminary quantitative guide, regulatory bodies like the SEC have explicitly stated that exclusive reliance on any numerical threshold is inappropriate.²,¹ Professional judgment, incorporating both quantitative and qualitative factors, is always required to determine materiality.

Who determines materiality in an audit?

The auditors, in conjunction with management and those charged with governance (like the audit committee), determine materiality. Auditors establish a materiality level during audit planning to guide their procedures and evaluate findings.

How does materiality affect the audit report?

If auditors find that the financial statements contain material misstatements that are not corrected by the company, they will issue a modified audit opinion, such as a qualified or adverse opinion. This signals to users that the financial statements are not presented fairly in all material respects.

Can a small misstatement still be material?

Yes, a quantitatively small misstatement can be deemed material due to its qualitative nature. For example, a small misstatement that conceals an illegal act, allows a company to meet a specific earnings per share (EPS) target, or impacts a trend in the cash flow statement could be considered material because it might alter the perception of a reasonable investor.