Materiality

Peer Review Guide

Materiality

Definitions and Applications:

Materiality Definition - U.S. GAAP
Materiality Definition - Securities and Exchange Commission
Materiality Definition- International Accounting Standards
Current Auditing Standards, Background and Presumptions
New Auditing Standard SAS No. 107
Application of Materiality to Audits
Application of Materiality to Compilation and Review

Evaluation Considerations:

Materiality Evaluation Context
Reporting
Financial Statement Presentation, Recognition and Measurement
Financial Statement Disclosures
Procedures and Documentation

Definitions and Application

Materiality Definition - U.S. Generally Accepted Accounting Principles:

Materiality is defined in the glossary of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information as:

"¼the 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 changed or influenced by the omission or misstatement."

Materiality - Securities and Exchange Commission:

The SEC references the above U.S. GAAP definition of materiality in its Codification of Staff Accounting Bulletins. The materiality section of the codification points out that this definition:

is in substance identical to the formulation used by the courts in interpreting the federal securities laws. The Supreme Court has held that a fact is material if there is -

a substantial likelihood that the...fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available.

The SEC discussion of materiality addresses the issue of quantifying materiality and references the use of benchmarks

Materiality Definition - International Accounting Standards:

Materiality is defined in the glossary of the International Accounting Standards Board’s “Framework for the Preparation and Presentation of Financial Statements” as:

Materiality—Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cutoff point rather than being a primary qualitative characteristic which information must have if it is to be useful.

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Current Auditing Standards and Presumptions

The primary discussion of materiality is contained within American Institute of CPAs (AICPA) Statement on Auditing Standards (SAS) No. 47, Audit Risk and Materiality in Conducting an Audit. That standard and subsequent amendments are incorporated into AICPA Professional Standards section AU §312 which premises the discussion of materiality in audits with two concepts:

"The concept of materiality recognizes that some matters, either individually or in the aggregate, are important for fair presentation of financial statements in conformity with generally accepted accounting principles, while other matters are not important." (AU section 312.03)

"In planning the audit, the auditor is concerned with matters that could be material to the financial statements. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not material to the financial statements are detected." (AU section 312.05)

The standard explains that materiality is not a constant. It varies between two entities of different size and nature. It also can vary for the same entity from year to year. Although SAS No. 47 does not establish a requirement to document the auditor's consideration of materiality; however, SAS No. 107 (discussed below) does require auditors to document materiality of the financial statements taken as a whole.

New Auditing Standard SAS No. 107

Statement on Auditing Standards, Audit Risk and Materiality in Conducting and Audit (SAS No.107), will replace SAS No. 47 and includes the following updated guidance with respect to materiality in the context of an audit :

"The auditor's consideration of materiality is a matter of professional judgment and is influenced by the auditor’s perception of the needs of users of financial statements. The perceived needs of users are recognized in the discussion of materiality in Financial Accounting Standards Board Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information, which 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 changed or influenced by the omission or misstatement." That discussion recognizes that materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative considerations.

User Perspective: SAS No. 107 also emphasizes that an auditor’s judgment "as to matters that are material to users of financial statements is based on consideration of the needs of users as a group; the auditor does not consider the possible effect of misstatements on specific individual users, whose needs may vary widely." SAS No. 107 goes on to state that:

"The evaluation of whether a misstatement could influence economic decisions of users, and therefore be material, involves consideration of the characteristics of those users. Users are assumed to:

Have an appropriate knowledge of business and economic activities and accounting and a willingness to study the information in the financial statements with an appropriate diligence;

Understand that financial statements are prepared and audited to levels of materiality;

Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment, and the consideration of future events; and

Make appropriate economic decisions on the basis of the information in the financial statements.

The determination of materiality, therefore, takes into account how users with such characteristics could reasonably be expected to be influenced in making economic decisions."

Benchmarks. SAS No. 107 does not quantify levels of materiality, but offers the following guidance with respect to benchmarks:

"Examples of benchmarks that might be appropriate, depending on the nature and circumstances of the entity, include total revenues, gross profit, and other categories of reported income, such as profit before tax from continuing operations. Profit before tax from continuing operations may be a suitable benchmark for profit-oriented entities but may not be an appropriate benchmark for the determination of materiality when, for example, the entity’s earnings are volatile, when the entity is a not-for-profit entity, or when it is an owner-managed business where the owner takes much of the pretax income out of the business in the form of remuneration. For asset-based entities (for example, an investment fund) an appropriate benchmark might be net assets. Other entities (for example, banks, insurance companies) might use other benchmarks."

This standard was issued in 2006 and is effective for audits of periods beginning on or after December 15, 2006. Earlier application is permitted.

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Application of Materiality to Audits

Section AU 312.10 states that:

"¼consideration of materiality is a matter of professional judgment and is influenced by [the auditor’s] perception of the needs of a reasonable person who will rely on the financial statements."

Section AU 312.10 explains the perceived needs of a reasonable user by quoting Financial Accounting Standards Board (FASB) Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information. That concepts statement defines materiality as:

"¼the 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 changed or influenced by the omission or misstatement."

Section AU 312.10 also observes a recognition in FASB Concepts Statement No. 2 that materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative considerations. As mentioned in the preceding section, SAS No. 107 assumes materiality from the perspective of users as a group rather than the needs of individual users.

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Application of Materiality to Compilation and Review

Materiality, as it applies to compilation and review engagements, is identified in Statements on Standards for Accounting and Review Services (SSARS) No. 1 (AICPA Professional Standards section AR §100.13.) This standard defines the accountant’s performance responsibility for compilations as:

"¼the accountant should read the compiled financial statements and consider whether such financial statements appear to be appropriate in form and free from obvious material errors. In this context, the term errors refers to mistakes in the compilation of financial statements, including arithmetical or clerical mistakes, and mistakes in the application of accounting principles, including inadequate disclosure."

The reporting responsibility for review engagements is one of limited assurance that, as stated in AR §100.24:

"¼there are no material modifications that should be made in the financial statements in order for them to be in conformity with generally accepted accounting principles." [The standard includes other comprehensive bases of accounting (OCBOA) in this reference.]

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Evaluation Considerations

Materiality Evaluation Context

The following discussion about materiality evaluation is written in the context of how a peer reviewer might evaluate materiality for purposes of performing a peer review of a CPA firm. These considerations are not necessarily the same ones used by an accountant in reporting on audit and accounting engagements.

Quantitative materiality estimates should be used only as a guide, not an absolute threshold.

Generally accepted accounting principles presume general-purpose use of financial statements. Therefore, decisions about materiality based on anticipated limited distribution of the financial statements are not appropriate.

Reporting

Identification of the level of service (audited, reviewed, compiled)
Identification of the financial statements and periods presented
Identification of the basis of accounting
Description of the scope of the service
Identification of significant departures from accounting basis
Statement of assurance (i.e., opinion, limited assurance, no assurance)
Judgment

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Financial Statement Presentation, Recognition and Measurement

Presence of all required financial statements
Formats required by professional standards or audit/accounting guides
Appropriateness of account balances and classes of transactions
Inclusion of all significant account balances and classes of transactions
Adequacy of classifications
"Reasonable reader" needs (i.e. would decisions about the entity change or be influenced by the method of presentation, recognition or measurement?)
Judgment

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Financial Statement Disclosures

Significance of the related financial statement balance
Quantitative significance of the disclosure
Qualitative aspects of the disclosure
"Reasonable reader" needs (i.e., would decisions about the entity change or be influenced if the disclosure were present?)
Not applicable vs. not material (when preparing a disclosure checklists)
Judgment
FASB Statements of Financial Accounting Standards include a caveat at the end of each Statement to indicate that the "provisions of the Statement need not be applied to immaterial items." However, financial statement preparers should always consider the cumulative effect that numerous, immaterial (and omitted) items could have on the financial statement taken as a whole.

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Procedures and Documentation

Significance of the procedures to the engagement as a whole
Significance of the procedure to the testing of critical assertions associated with a financial statement element or class of transactions
Presence of compensating alternative procedures
Degree of absent documentation
Required vs. recommended documentation
Judgment

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Peer Review Guide > Materiality