Material misstatements

What Are Material Misstatements?

Material misstatements are significant errors or omissions in a company's financial statements that could reasonably be expected to influence the economic decisions of users. In the realm of financial accounting and auditing, a misstatement is considered material if its size or nature, or a combination of both, makes it probable that a reasonable person relying on the financial report would have changed or been influenced by its inclusion or correction. These types of misstatements are a critical concern for auditors and regulators, as they directly impact the reliability and trustworthiness of a company's financial reporting.

History and Origin

The concept of materiality in accounting and auditing has evolved significantly, particularly with the growth of public markets and the need for standardized financial information. A pivotal moment in the formalization of "material misstatements" and their evaluation came with the issuance of Staff Accounting Bulletin (SAB) No. 99 by the U.S. Securities and Exchange Commission (SEC) in August 1999. This bulletin emphasized that relying solely on quantitative thresholds to assess materiality is inappropriate and that qualitative factors must also be considered¹⁶, ¹⁷, ¹⁸, ¹⁹. Prior to SAB 99, some companies and auditors might have considered misstatements immaterial if they fell below a certain percentage of earnings or assets, for example, 5%. However, SAB 99 clarified that even quantitatively small misstatements could be material if they mask a change in earnings, conceal a failure to meet analysts' expectations, or alter trend information, among other qualitative factors¹⁴, ¹⁵. This guidance underscored the importance of a holistic approach to evaluating the significance of financial errors.

Key Takeaways

• Material misstatements are errors or omissions in financial statements significant enough to influence economic decisions.
• Their assessment involves both quantitative and qualitative factors, moving beyond simple numerical thresholds.
• Auditors are responsible for designing and performing audits to detect material misstatements.
• The presence of material misstatements can lead to restatements, regulatory penalties, and a loss of investor confidence.
• Companies strive to prevent material misstatements through robust internal controls and adherence to accounting standards.

Formula and Calculation

There is no universally accepted formula for calculating a material misstatement because its determination is largely a matter of professional judgment, encompassing both quantitative and qualitative factors. Auditors establish a "materiality threshold" during the planning phase of an audit to guide their work. This threshold is not a strict formula but rather a benchmark.

For example, an auditor might initially set overall materiality for the financial statements as a whole at a percentage of a key financial metric, such as:

• 5-10% of pretax income
• 0.5-1% of total assets
• 0.5-1% of total revenues

Once an overall materiality figure is determined, auditors also establish "performance materiality," which is typically lower than the overall materiality. This helps ensure that the aggregate of uncorrected and undetected misstatements does not exceed the overall materiality level¹³.

For instance, if overall materiality is set at $1,000,000, performance materiality might be set at $750,000. Any individual misstatement or aggregate of misstatements exceeding these thresholds would then be evaluated for materiality. However, even smaller amounts can be considered material if qualitative factors are present (e.g., misstatement affects compliance with loan covenants, changes a loss to income, or impacts management compensation).¹²

Interpreting Material Misstatements

Interpreting material misstatements involves a thorough analysis that extends beyond simple numerical comparisons. While quantitative benchmarks provide an initial guide, the ultimate determination rests on whether the misstatement would alter the "total mix" of information available to a reasonable investor. For instance, a small misstatement in revenue recognition might be deemed material if it turns a reported profit into a loss, thereby misleading users about the company's profitability. Similarly, an error that causes a company to miss its earnings forecast could be considered material, even if the dollar amount is relatively small.

Auditors apply professional judgment by considering the nature of the misstatement, its context within the financial statements, and its potential impact on user decisions. This includes assessing whether the misstatement affects particular areas that users typically focus on, such as compliance with regulatory requirements or debt covenants. The Public Company Accounting Oversight Board (PCAOB) emphasizes the auditor's responsibility to identify and assess risks of material misstatement during audit planning, highlighting the continuous and iterative nature of this process¹⁰, ¹¹. When evaluating the significance, auditors also consider the entity's specific circumstances and how the misstatement might influence decisions based on financial metrics like profitability or cash flow.

Hypothetical Example

Imagine a publicly traded company, "TechInnovate Inc.," reports annual net income of $10 million. During their year-end audit, the auditors discover an error in revenue recognition. TechInnovate had prematurely recognized $500,000 from a software license agreement that, under generally accepted accounting principles (GAAP), should have been deferred to the following fiscal year.

Initially, $500,000 might seem small compared to $10 million in net income (5% of net income). However, upon further investigation, the auditors find that TechInnovate was under immense pressure to meet an analyst's earnings per share (EPS) target of $0.50. With the $500,000 misstatement, TechInnovate reported an EPS of $0.51. Without it, their EPS would have been $0.48, missing the target.

In this scenario, despite the quantitative amount being 5% of net income, the misstatement is likely considered material due to qualitative factors:

1. Earnings Management: The misstatement allowed the company to meet or slightly exceed an important analyst expectation, which could mislead investors about its true performance.
2. Impact on Trends: This one-time adjustment might obscure a declining trend in actual performance.
3. Management Intent: While not always provable, if the misstatement was intentionally used to manipulate reported earnings, it would be highly material.

Therefore, the auditors would insist on a restatement of the financial statements to correct this material misstatement.

Practical Applications

Material misstatements are a core concept in the fields of corporate governance, auditing, and regulatory oversight.

• Auditing: External auditors are tasked with providing an auditor's opinion on whether a company's financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework (e.g., GAAP). Their primary goal is to obtain reasonable assurance that the financial statements are free from material misstatement, whether due to error or fraud⁹. This involves extensive risk assessment and testing of account balances and transactions. Audit firms, such as KPMG, have specific guidance on determining materiality for different financial statement components⁸.
• Regulatory Compliance: Regulatory bodies like the SEC play a crucial role in preventing and addressing material misstatements. Companies are required to file financial reports that are free from such errors. If a material misstatement is discovered in previously issued financial statements, companies are often required to issue a restatement, correcting the errors and explaining their impact. The SEC's Staff Accounting Bulletin No. 99 provides detailed guidance on evaluating materiality, particularly emphasizing the interplay of quantitative and qualitative factors⁷.
• Investment Analysis: Investors and financial analysts rely heavily on accurate financial statements to make informed decisions. A material misstatement can lead to flawed investment decisions, impacting asset valuation and portfolio performance.

A notable example of significant material misstatements leading to severe consequences is the Wirecard scandal. In June 2020, the German payments company filed for insolvency after revealing that €1.9 billion ($2.1 billion) in cash balances, which auditors had been seeking, was "missing" from its accounts. ⁵, ⁶This massive financial hole, resulting from fraudulent financial reporting, led to the company's collapse, a significant loss for investors, and prompted Germany to introduce new regulations to strengthen financial market integrity and audit oversight.
³, ⁴

Limitations and Criticisms

While the concept of material misstatements is fundamental to financial reporting integrity, its application presents certain limitations and invites criticism. The primary challenge lies in its subjective nature. Materiality is not purely quantitative; it requires significant professional judgment from auditors and management. This subjectivity can lead to inconsistencies in application across different audits or companies. What one auditor deems material, another might not, especially when considering qualitative factors.

Critics also point out that the judgment-based approach can be influenced by pressure to meet earnings targets or avoid negative disclosures. There have been instances where audit firms faced scrutiny for setting materiality thresholds inappropriately high, potentially overlooking errors that, in aggregate, could mislead financial statement users. ²Furthermore, detecting all material misstatements is inherently difficult due to the sheer volume of transactions and the potential for sophisticated fraud. The very existence of material misstatements, particularly those arising from fraud, can expose weaknesses in a company's internal controls and audit processes, impacting the reliability of the balance sheet and income statement.

Material Misstatements vs. Immaterial Errors

The key distinction between material misstatements and immaterial errors lies in their potential impact on the decisions of financial statement users. An immaterial error is a mistake or omission in the financial statements that is not significant enough, either individually or in aggregate, to influence the economic decisions of a reasonable person relying on those statements. Such errors might be corrected in subsequent periods or simply noted, as they do not fundamentally distort the financial picture. For example, a minor clerical error in recording a small expense that does not affect overall profitability or key ratios would typically be considered an immaterial error.

In contrast, a material misstatement is an error or omission that does have the capacity to influence user decisions. As discussed, this influence is judged not only by the dollar amount but also by qualitative factors, such as whether it changes a profit into a loss, affects regulatory compliance, or enables earnings management. While all material misstatements are errors, not all errors are material misstatements. The distinction is crucial for auditors, as they are primarily concerned with ensuring that financial statements are free from material misstatements. Auditors determine performance materiality to ensure they detect misstatements that could be material when aggregated, even if individually small.
¹

FAQs

What causes material misstatements?

Material misstatements can arise from various sources, including unintentional errors (e.g., mathematical mistakes, incorrect application of accounting principles, or oversight), and intentional misrepresentations (fraud). Weak internal controls, human error, complex transactions, and pressure to meet financial targets can contribute to their occurrence.

Who is responsible for detecting material misstatements?

While management is responsible for preparing accurate financial statements, independent external auditors are primarily responsible for designing and performing their audit to obtain reasonable assurance that the financial statements are free from material misstatement. This is a core part of their role in providing assurance to investors and other stakeholders.

What happens if a material misstatement is found?

If a material misstatement is identified in financial statements that have already been issued, the company is typically required to correct it through a financial statement restatement. This involves re-issuing the affected financial statements with the corrections, along with an explanation of the changes. Regulatory bodies may impose penalties depending on the nature and cause of the misstatement.

Can a small error be a material misstatement?

Yes, a small error in dollar amount can be a material misstatement if qualitative factors are present. For example, an error that allows a company to meet a crucial analyst forecast, avoid a debt covenant violation, or manipulate the trend of earnings could be deemed material, regardless of its quantitative size. This qualitative aspect is crucial in assessing materiality.

How does materiality relate to the audit opinion?

Materiality is central to the auditor's opinion. An auditor's opinion states whether the financial statements are presented fairly, in all material respects. If an auditor identifies material misstatements that are not corrected by management, they will issue a modified opinion (e.g., qualified or adverse opinion), indicating that the financial statements are not presented fairly due to the uncorrected material misstatements.